Key Takeaways
- A waterfall governs how profits are distributed after a capital event, such as the sale or refinancing of a property.
- Expenses and fees are always paid first, before any distributions are made to investors.
- Return of capital is typically the first investor distribution, followed by a preferred return if one is included.
- Catch-up provisions allow managers to realign economics, but they must be carefully structured and disclosed.
- Profit splits can be simple or tiered, rewarding managers more as performance thresholds are exceeded.
Transcript
What Is a Waterfall in a Syndication or Fund?
So how does a waterfall work in a syndication or a fund? What are the steps? What are the different kinds of things that can go on? That’s what we’re going to talk about.
I thought it’d be helpful to have a visual representation of what exactly happens in a waterfall and how to think about it. That makes it really clear because it isn’t very complicated. But seeing it on paper sometimes can make all the difference in the world. So let’s go to the handy whiteboard.
Starting With a Direct Investment and a Capital Event
Let’s talk first about a direct investment deal where we know what it is, let’s say it’s a piece of real estate. Most of my clients are in real estate, but we have a number of private equity firms, hedge funds, businesses, and all sorts of other people that raise capital. But most are in real estate, so let’s stick with that.
We have a piece of real estate, and let’s talk about a capital event first. A capital event is when the property sells. Yay, capital event! All right, so a capital event occurs. Money comes down and hits this pool, right? So there’s a big pool of money here. Money pool. Alright, so there’s a big money pool.
Paying Expenses and Fees Before Distributions
Now out of this pool, what has to happen first? Before you give any money back to your investors, the next step that happens is expenses. These are expenses that happened before so that we can end up with net profits at the end.
For expenses, the big one obviously would be, if it was real estate, to pay back the loans. The other one, the one that matters most to you, is payment of fees to you, the manager.
Important side note: the payment of fees portion is going to be treated as income on your taxes most of the time. So keep that in mind when you’re doing your tax planning.
This happens first, right? So we pay off those expenses, the loan, whatever there is left. Sometimes there are taxes; I’ve got other videos on that. But most of the time, you’ve got to pay your loans, you’ve got to pay your fees, whatever else is owing, which ends you up at the end of the day with your net proceeds.
Net Proceeds and the Return of Capital
So you’ve got your net proceeds. Now from the net proceeds, this is where we really start thinking about waterfalls.
The most common first step out of a waterfall is a return of capital. This goes to your investors. That money goes to your investors, returning the amount of money they invested. So you’re probably paying out all those Class A units, the amount of their initial capital contribution. Ninety-nine percent of the time, this is what’s in the operating agreement and the PPM, and it’s described accordingly.
This return of capital, as long as it is a return of capital to your investors, is not taxed up to the point of their basis.
Preferred Returns and Investor Priority
After return of capital, what happens next? A lot of times there’ll be a step here that is the preferred return. Let’s say it’s 6%. That goes to the investors.
Your preferred return probably is taxed, and it would be taxed as long as you’ve held the asset for more than one year. It’s going to be taxed to your investors as a capital gain.
Catch-Up Provisions for Managers
After the payment of the preferred return, sometimes there is what’s called a catch-up. That catch-up will normally be to whatever that percentage is of the preferred return. This gets paid to the manager.
What you’re basically saying is, “Okay, investor, here’s all your money back. I’m also going to give you a preferred return, which means I’m going to make sure that you get 6% of your money back before anybody else gets any money.”
But what that actually has done is it’s decreased the size of the pool. And how that catch-up is structured has a major impact on the economics of the deal.
Profit Splits and Tiered Waterfalls
After this, now we’re in splitsville. So here, we might say something like, “Okay, split. We’re gonna give 75% to the investor and 25% to the manager.”
If we want to do a more complex waterfall, we might say, “Let’s split the profits that way up to a certain return, and then after that, we’re going to split the remaining profit 50/50.”
And that’s it.
Walking Through a Numerical Example
Let’s put some actual numbers to it. Let’s say at the end of the day, our net proceeds equal $5 million. For that $5 million, let’s say our investors invested $2.5 million. So $2.5 million goes back as return of capital.
That leaves us with an additional $2.5 million.
Now we pay the preferred return. Six percent of $2.5 million is $150,000, which goes to investors. That leaves $2,350,000.
Now we’ve got the catch-up piece, which is $35,250. That leaves us with $2,314,750.
Now we split that remaining pool. Seventy-five percent goes to the investor, and twenty-five percent goes to the manager. That results in $1,736,062 to investors and $578,688 to the manager.
So the manager on this deal alone, just from the capital transaction, has made $578,688 plus the $35,250 catch-up, plus whatever amount they made in fees. Outside of fees, that’s $613,938.
Final Thoughts on Waterfalls
So this is the way that a waterfall works.
My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group. If we can help you put a syndication or fund together, we’d be happy to talk about it. We work exclusively under Regulation D Rule 506(b) or Rule 506(c).