This is a blog post that talks about the basics of equity waterfalls. It goes into detail on how they work and what to watch out for when using them. We will also discuss some of the most common pitfalls with this type of structure. So if you want to learn more about Equity Waterfalls, keep reading!

Equity Waterfalls: A Basic Overview

There is much information on how equity waterfalls work in the commercial real estate world and why they are used. This blog post will be in-depth in discussing them to make sure you understand everything about this important topic. Many investors are still confused about what an Equity Waterfall structure looks like, despite it being relatively simple to understand. When someone mentions equity waterfall in commercial real estate, they’re describing how cash will flow from an asset, how it’s distributed, and when. 

Unfortunately, there are a myriad ways to structure these distributions, which makes the equity waterfall concept so complex and, in practice, even harder to model. To help with this issue, we have included charts along the way that represent different types of structures that can be implemented into your legal documents if needed. We want our readers to come away from reading this article with complete understanding and clarity.

Understanding What’s Behind the Name

In any equity waterfall, the first step is to identify how much money will be available for distribution once debt service has been paid. In other words, this amount determines where funds from the real estate project’s cash flow go first. Then, the remaining dollars are generally distributed following a priority sequence (hence ‘waterfall’) among limited and general partners - both those who invested initially and their successors, including additional investors or even grantor trusts set up by LPs.

In your mind’s eye, look at it like this. Gains accumulate in a “pool” until that pool is full, at which point profits spill over to the next pool of investors in a tiered manner. It’s just like when water in nature, that collects at the top of a waterfall and then, after reaching a certain level, spills over to a pool below, sometimes multiple times — same for real estate waterfalls. 

The order of priority depends on state law; however, it most commonly starts with profits generated through operating income before considering appreciation (capital gains). At times, there is also an opportunity cost component included that considers what could impact payout ratios. The profits of a project are divided unevenly amongst the project’s partners. Operating partners (e.g., the real estate developer) are given a disproportionately more significant share of the profits if the project beats expectations. A bonus, or a promote, is the extra slice of the pie. Promotes are used as a bonus to incentivize developers to exceed profit expectations.

Standard Equity Waterfall Terms Explained

Before looking at an example, it’s helpful to understand a few terms often used when discussing commercial real estate equity waterfalls. These are all crucial components involved in the structure of a waterfall. In addition, understanding these terms will help you understand why certain tiers of a waterfall function the way they do.

• Return Hurdles: This is the first tier of a waterfall. It’s often referred to as “the hurdle rate” or simply “first-loss.” The return hurdles are percentage returns that must be met before you can move on to each lower tier in the waterfall structure (preferably with no losses).

• Growth Hurdles: This is an extra layer of protection for investors beyond return hurdles— it exists only if it has been written into an agreement between investor and developer. Growth hurdles function similarly to return hurdles, but they apply once all returns have been achieved; growth hurdles ensure there will be future value even after this point, providing further cash flow opportunities down the line.

• Preferred Return: At its most basic level, the preferred return is how partners are reimbursed their equity investment and share of profits until a specific threshold has been achieved. For example, partner A invests $100,000 at a preferred return of 20% in addition to their share of the profits until they have reached that threshold. Partner B then invests $50,000 and has a 12% preferred return rate + their share of the profits after partner A’s threshold is met. As a general rule of thumb, those in line to receive a preferred return are taking on less risk and, therefore, are expected to earn less of an overall return on the project. Preferred investors can include all equity investors or only select equity investors.

• Lookback Provisions: When equity waterfalls distribute cash flow before the disposition of the asset, the deal will typically contain what’s known as a “lookback provision.” This gives the investor their share of gains that occurred on or after the date they invested. So, for example, if Partner B invests $50k in July and partner A sells an asset for a gain of $200k in November, Partner B would be entitled to 50% (or half) of those profits because he had invested before it happened.

• Catch-up Provisions: On the other hand, some equity waterfalls are set up with a “catch-up provision,” which allows them to distribute money flow to various parties throughout the bargain. This provision is meant to correct the early-investor bias that occurs when partner B invests after Partner A. So, for example, if Partner B invests $50k into a deal in July and then exits with his partners at the end of December (inside 12 months), he would be entitled to none of those profits because it happened within 12 months.

After Exit: The logic behind these provisions makes sense – your first money should get you more than your second or third money…right? But sometimes, other factors are involved, like credit market conditions where investors aren’t willing to put new cash into deals despite reasonable exit multiples. At times like this, though, not all equity waterfall structures will produce distributions equally across various classes of equity.

A Common Equity Waterfall Structure

The most basic equity waterfall has four stages. The first stage, as previously said, is where the cash flow builds up into a pool.—once that pool overflows, the profits flow to the next level.

• Tier I. Return of Capital: 100% of cash flow distributions go straight to the LP in this tier.

• Tier II. Preferred Return: All cash flow is distributed to the LP again until a preferred return on their investment is achieved. The preferred return is sometimes called the “hurdle rate” and can range from 7-10% or more.

• Tier III. Catch-Up: The catch-up provision comes into play here. All payments in this level are credited to the GP until they reach a certain proportion of profits.

• Tier IV. Carried Interest: Exacerbating the issue, the GP will get a considerably more significant proportion of cash flow distributions in the form of promotes until all cash flow is consumed.

A Sample Equity Waterfall

Many different types of equity waterfalls are possible. However, to keep things simple, we’ll provide a basic five-tier illustration below based on IRR. The investor has invested $400,000 (10% of the total equity), but the Sponsor has invested $4 million (90% of the total equity). The LP has put down $4 million (90% of the total equity), while the GP has put down $400,000 (10%).

Here’s how a typical waterfall might be organized in this scenario:

And here is how that might take effect, in practice:

This is a typical equity waterfall, which depicts the financial and structural status of a deal in its early phases. As you can see, the LP has put additional money into the partnership (financially), thus earning a higher return before the GP receives a larger share of profits. Remember that the above investment waterfall is only one example of investment waterfalls. Equity waterfalls might get quite complex depending on the number of investors, lenders, and other partners involved in a transaction.

Conclusion

Even for those with many years of expertise, the concepts behind real estate equity waterfalls are sometimes difficult to grasp. They can contain intricate tiers, returns, and interrelated provisions to support a structure of uneven profit distributions from a specific venture. 

Key Takeaways:

- Understand what each tier means.

- Know the difference between a waterfall and an LPI model.

- Use your knowledge to negotiate more equity into your investment or fund.