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.
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.
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.
So you’ve got your net proceeds (that’s supposed to look like a $ sign, there you go). 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. 99% of the time, this is what’s in the operating agreement and the PPM, and it’s described accordingly.
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. 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. Cost segregation and other things like that can adjust that, but I’m just giving you that brief idea.
Your preferred return is coming to your investors. Now the 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.
After the payment of the preferred return, sometimes (and this isn’t very common, especially in a real estate deal, but it certainly does happen in maybe 20 to 30% of the formations that I write), 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.
So that catch-up to the manager is an amount of money that is to bring them to this 6%. 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.” So we give you 6% of the money back. But what that actually has done is it’s decreased the size of this pool here.
You can do the preferred return as a pure catch-up of 6% to the manager to make everybody fair, but that alone would essentially be a 50/50 split, right? So that first 12% of profits would basically be, “Okay, we’re going to split that 12% 50/50. We’re going to pay the investor, then we’re going to pay the manager.” But that’s probably not what your investors are normally thinking a catch-up should be.
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.” Let’s say that we want to do a more complex waterfall. We’re going to split that pool of money, but we’re not going to split all that money. We’re going to say, “Let’s split the profits that way for just the next up to 20% of profit. And then after that, we’re going to split the remaining profit 50/50.” And that’s it.
Let’s put some actual numbers to it. I think that might be useful as well. So 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 two and a half million, so two and a half million goes into this category. That leaves us with an additional 2.5 million left to divide.
Now we’ve got to make a division of the preferred return. Typically, you’ll do that preferred return of 6% on the amount that they invested, which works out fine here. So the next $150,000 goes to your investors, which leaves us with $2,350,000.
Now we’ve got this catch-up piece here. And that is equal to just an additional $35,250. That leaves us with $2,314,750. Okay, so now we’re going to divide that pool up. Let’s just say we’re going to do this simple waterfall here because you’ll get the point.
So we’ve got that additional $2,314,750. Of that, now we give to the investor $1,736,062, and the remaining $578,688 goes to the manager. Not bad, right? So the manager on this deal alone, just from the capital transaction, has made that $578,688 plus the $35,250, plus whatever amount they made in fees. Which means that outside of fees, they’ve made a good $613,938.
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 506b or Rule 506c. That’s what we do every day and make sure we can help you be successful.