The preferred return aligns the interest of the sponsor and the equity investors. It is the investment-quality structure preferred by private equity investors the world over.
The order in which equity investors get paid — the “distribution waterfall” in industry jargon — is one of the critical concepts in real estate investing. Distribution waterfalls can get confusing. This article aims to clarify preferred returns, and the order in which stakeholders in real estate projects receive distributions. The explanation of a project’s waterfall distribution is usually found in the investments operating agreement.
The waterfall (profit distribution) structure can be viewed as a risk-management tool, it allows the downside risk to be shifted away from the equity investor while providing upside potential to the sponsor.
The various stakeholders in the capital stack – Lenders, equity investors, sponsors – have varying positions in splitting of profits. The traditional structure represents an inverse hierarchy of payment priority and risk.
The typical waterfall compensates the sponsor for a successful project, while, minimizing the downside risk for the equity investor.
The concept is simple and effective: if the returns are greater than expected, a disproportionate share goes to the sponsor but if the returns are less than expected, a disproportionate share goes to the equity investors. It allows for the risk and return to be distributed in a more equitable manner. The lender always gets paid before the sponsor or the equity investor. The following is a simplified version of a waterfall distribution (one I use), some waterfall structures can be quite complex.
Distribution Waterfall Example: A $12,000,000 Mobile home park development project with an 8% preferred investor return to equity investors and a 50/50 split of excess cash flow.
Equity Investors tripled their investment in 10-years. During the operation holding period of the project the LP investors received $3,200,000 from their 8% preferred return, plus $1,400,000 from yearly profit splits. The project is sold at the end of 10-years, investors original equity investment of $3,600,000 is returned, plus $6,320,000 from the split of the capital gains on the sale. For a total return of $10,920,000 or 303% on the equity investment.
Contact: Jim Glasgow for details or questions. Ph. 210-413-7230
This is not an offer to sell or a solicitation of any offer to buy any securities. Offers are made only
by Prospectus or Private Placement Memorandum, or other offering materials. Only available to accredited investors.