In the commercial real estate world, there are fewer concepts that are more baffling than the equity waterfall.
When we talk about an equity waterfall in terms of commercial real estate, we’re essentially talking about how cash flow from an asset will be distributed and when. There are innumerable ways to structure these distributions, which is what makes equity waterfalls so complex and hard to model.
The equity waterfall (also known as the distribution waterfall) follows an order or hierarchy from which to distribute funds to limited and general partners. Below we further break down the definition of an equity waterfall and its different components so you can get a better understanding of one of commercial real estate’s most intimidating pieces.
Equity Distribution Waterfall Defined
How does the equity waterfall get its name? It all stems from the idea that the cash flow from commercial real estate projects gets split up between partners in numerous ways. The profits gather in a “pool” until they it is full at which point cash will “spill” into the next series of pools in a tiered structure.
In most equity waterfalls, the profits of a project are split unevenly amongst the project’s partners. Operating partners are given a disproportionately larger share of the profits if the project beats expectations. This extra slice of the pie is called the “promote”. Promotes are used as a bonus to incentivize the operating partner to exceed return projections. In the long run, the operating partner of a project will make more money the higher the project’s return is, based on an increased percentage of the profits.
Common Equity Waterfall Features Explained
Before we start talking about the four most commonly-seen tiers, it’s important that you have a grasp on the different features involved in the structure of an equity waterfall. By defining the terms below, it will be much easier to understand how the equity waterfall is structured and why the tiers of the waterfall function the way they do.
A return hurdle defines the rate of return that must be achieved before the cash flow can move on to the next tier of the equity waterfall process. Most waterfalls have multiple return hurdles, which can be based on IRR or equity multiple.
Preferred returns are defined as the first claim on the profits of a project until the desired return is reached. What this means is that the preferred investors on a project are the first ones in line to get the preferred return before any other investors in the project get their cut of the profit. The preferred return essentially creates another pool for the cash flow, and once the cash flow has been distributed to the preferred investors, the excess cash of the pool spills over to the next tier and split as agreed.
Lookback provisions are invoked when cashflow is distributed prior to the disposition of the asset. If the Limited Partners don’t get their minimum agreed upon rate of return after disposition, the general partner is required to give up a portion of the cash flow that was distributed to them prior to sale.
A catchup provision guarantees the Limited Partner 100% of the profits of a deal until an agreed upon rate of return is met. Once that particular rate of return is achieved, all of the remaining profits go to the General Partner, until they’ve achieved a specified rate of return. The catchup provision is similar to the lookback provision in that they are both working towards ensuring that the Limited Partner gets at least their agreed upon return on the project. The only difference is that the lookback provision happens after the fact, with the General Partner retroactively giving the investor the money he is owed. On the other hand, the catchup provision gives the Limited Partner all of the profits up front and only afterward does the General Partner get their cut.
What are the Some Common Structures?
While there are countless ways to build an equity waterfall, the most basic waterfalls contain 4 tiers. These tiers follow the waterfall metaphor, starting with cash flows pooling up with the first tier. Once that tier reaches its capacity, excess funds flow down to the remaining tiers. Below are the four main tiers found in CRE equity waterfalls.
In this first tier, 100% of the distributions of cash flow goes straight to the Limited Partner. This tier is structured in such a way that investors are able to recover all their capital contributed to the project first before the cash flow is be distributed elsewhere.
In this second tier, all of the cash flow is distributed to the Limited Partner once again until the preferred return on their investment is met. The preferred return is also known as the hurdle rate and often ranges anywhere from 7 to 9%.
The third tier of the equity waterfall is all about the catch-up provision. All of the distributions in this tier go to the General Partner of the fund until they achieve a specific percentage of the profits.
The General Partner receives a disproportionately large percentage of profits in the form of promote until all cash flow is exhausted.
Equity waterfalls in commercial real estate projects are often not simple or easy to grasp. They can be filled with complicated tiers, returns, and provisions that all work together to support a structure of uneven distributions of the cash flow from a particular project. By breaking down the different tiers and provisions of an equity waterfall individually, it is possible to get a better understanding of expected returns.