It’s no secret that private investments have exploded in recent years to the point where, in 2019, private offerings (under exemptions of Reg. D) SURPASSED registered offerings in the amount of capital invested by the investing public.
This growth is due in part to recent changes to SEC regulations. They are now permitting the advertising of private offerings, which had previously been prohibited.
For those who have invested in private offerings, the growth of private offerings comes as no surprise. Not only do private investments offer the potential for higher returns, but they do so at less risk and volatility.
The Waterfall Structure.
Most private investments are structured as partnerships between sponsors and investors. Typically, sponsors provide all the labor and some equity, while investors provide most equity and no labor.
More commonly known as private equity investments, these partnerships are typically organized as limited partnerships or limited liability companies. The sponsors take the General Partner or Manager role (GP), and investors are taking the role of limited partners or members (LPs).
Private equity investments are distinguishable from public investments in one key aspect: compensation. While most investors in stock realize gains (if any) entirely from appreciation in the stock price, many private equity investments offer cash flow and appreciation. The waterfall structure is how the partners structure the flow of profits.
The waterfall structure is particularly popular with real estate private equity investments (i.e., syndications). The waterfall structure is how the GPs and LPs align their interests and how each party is compensated relative to their contributions.
The term “waterfall” describes how profits flow down to the partners. No two waterfalls are the same with varying levels of distributions – with each level outlining the relative priority of distributions between GPs and LPs.
For example, LPs may prioritize the upper levels of distributions, while GPs may earn more at the bottom, depending on the offering.
Preferred Returns.
The preferred return is the primary draw of real estate syndications and other private equity investments incorporating a waterfall. The preferred return ensures first dollar profit distributions to the LPs – typically calculated based on capital invested. The preferred return rewards the LPs for their risk-taking in providing the bulk of the capital to the deal and sends a message by the sponsors/GPs that the investors and the GPs won’t be paid until the LPs are paid.
Calculating the preferred return can take various forms (simple interest, compound interest, equity multiple, or IRR), but the most common method is simple interest.
For example, a syndication offering an 8% preferred return will pay the LPs first dollar cash flow until they have received an annual return equal to 8% of their initial investment or capital account balance as the case may be. Although not common, some waterfalls may treat the preferred returns as a return of capital, diminishing the preferred return in the following year.
Example:
Year 1 Capital Balance: $100,000
Year 1 Preferred Return: $8,000
Year 2 Capital Balance: $92,000
Year 2 Preferred Return: $7,360
Tiers.
The different investment tiers establish the priority of distributions and the relative percentage splits at different phases of the investment, including operations and sale, refi, or other capital events.
Cash flow from operations first goes towards paying LPs their preferred distributions. After LPs receive their preferred distributions, the remaining cash flow is split between the GPs and LPs based on pre-established percentages (e.g., 50/50, 60/40, etc.). Unpaid or underpaid preferred returns are typically rolled over to the following year.
For example, if the LPs receive only 6% of their promised preferred return in year 1, they will be entitled to receive 10% in the following year before any additional profit splits.
The sale or refi of a property or properties in a real estate syndication typically triggers another waterfall event. Normally, the proceeds/profits from a property sale first go to the LPs to make up for any unpaid preferred returns. Next, LPs will receive cash flow from the sale as a return of capital. In other words, the LPs will receive next dollar distributions from the sale until their capital accounts are reduced to zero. Finally, the GPs and LPs split the remaining cash flow based on predetermined percentages.
Example Waterfall:
Assumptions –
Maximum Offering: $1M
Total Investors: 10
Average Investment: $100,000
Preferred Return: 8%
Average Annual Cash Flow: $100,000
Term: 5 Years
Sale Price end of 5 Years: $2.5M
Profit Split from Operations: 50/50 (GPs:LPs)
Profit Split from Sale: 60/40 (GPs:LPs)
Year 1 – Year 5 –
Preferred Return: $80,000 ($8,000/investor)
Profit Split: $10,000 to GPs, $10,000 to LPs ($1,000/investor)
End Of Year 5 Sale –
Profits: $1.5M
Return of Capital: $1M
Remaining Cash Flow: $500,000
Profit Split: $300,00 to GPs, $200,000 to LPs ($20,000/investor)
Total Return Per Investor –
Preferred Return and Profits (Years 1-5): $45,000
Profit from sale: $20,000
Total Return: $65,000
Average Annual Return: 13%
