Is this waterfall structure a non-starter for an LP?

Question

LP gets first 7% of returns as pref

-From 7-12% split is 50/50 LP/GP

-From 12-17% split is 25/75 in GP favor

-From 17%+ split is 10/90 in GP favor

That means that if the investment did 30% irr pre-distribution that the LP would get 11% and GP would get 19%, roughly. I mean that seems way outta whack, am I wrong?

If the return total was 17%, LP would get 11% and GP would get 6%. Still a pretty good haul for the GP.

That 10/90 in GP favor seems like nothing ive seen before in normal private equity.

Mike Dymski · Answer

There are a lot of investors who do a nice job of securing low cost funding from friends, family, and passive investors who are not familiar with other opportunities...and it gets chalked up to "returns that beat the market, secured by hard assets".  I would not get too hung up on it (there are tons of opportunities)...and in many of these cases, both the sponsor and investor feel that the partnership is a win win relative to their alternatives.  Matching capital with sponsors is a lot about fit between the two parties rather than good and bad opportunities...and your fit may change over time.  And when/if they start to scale (and/or the economy takes a hit), the market for low cost passive capital will change and investors will want to have wealthy sophisticated investors in their database.

Anders Jax · Answer

@Mike Dymski

25% seems like one hell of a tremendous return, but yes this whole thing is absurd.

These guys have gone from single family deals for short term rental model with unsophisticated investors basically splitting cash flows 50%, and getting 30% returns before asset appreciation, so maybe 40% returns if they are able to sell them at a good cap rate, to wanting to do multi-unit (20-100 bed) hotels, and think they are earning too much for their investors so they are proposing something absurd because its pretty obvious they aren’t familiar with institutional money and their return requirements.

Frustrating, because they do have good returns on what they’ve done, their properties are fantastic, Ive known them for 20 years, but this proposal makes me lose respect and confidence for them as real estate professionals.

Mike Dymski · Answer

Run...for three reasons (1) the risk/return is bad (2) it's not a property type that you/we understand and (3) recourse to the LPs.  #2 and #3 is important even when #1 is not present.

LPs can get mid to high teens for value add opportunities; so, development needs to be higher due to the risk (think 25% range conservatively).

There are a lot of development opportunities floating around and many of them have similar structures and returns as less risky value add or stabilized offerings.  I see a lot from two RIAs (registered investment advisers) who don't access access deal flow on a national level like many part time investors on BP.

Basit Siddiqi · Answer

@Anders JaxI have reviewed partnership/operating agreements for 4 years while working at Big four/mid-sized public accounting firms. I worked in the financial services/real estate group where waterfalls were common.I don't think I ever seen one that aggressive in the GP favor.

Brian Burke · Answer

“Market” waterfalls vary based on the business plan and type of investment (and a lot of other factors), so without knowing what the underlying strategy is, it’s difficult to say if this is out of market, or how far out of market.

Having said that, a first hurdle starting at 50% is pretty unusual, and an ending hurdle of 10/90 is almost unheard of.

I’ve seen development deals with a first hurdle after the pref at 50/50, even house flipping deals, because the sponsor/developer is doing a lot of heavy lifting.  But for a value-add or stabilized income property there is a lot less heavy lifting and the promote structure typically reflects that with a first hurdle in the range of 20% to 30% promote and an ending tier at 40% or 50% to the GP.

The waterfall you described is a somewhat modified version of a preferred equity structure and if that’s what it is it might actually be a bit rich to the LP because preferred equity tends to have far less profit participation, usually none beyond a 12% to 16% IRR.

Brian Burke · Answer

I can't comment with authority on the market waterfall terms for boutique hotel development projects because the only time I did one it was with my own resources and no investor money.  But nevertheless the waterfall terms, even for this specialty type of project, seem out of market.  And to have LPs sign on loan guarantees is very unusual unless the investor owns greater than a threshold percentage set by the lender, which could be 10%, 20% or 25% ownership (or actually it could be any number at the discretion of the lender but these are the most common that I've seen).  By "ownership" I mean percentage of the capital commitments.

Anders Jax · Answer

@Brian Burke

Boutique luxury hotel developments.

4% development fee

Then that waterfall structure

And also asking for a personal guarantee from the LP.

I just don’t think I can bring this to my contacts. I think they will be offended and dismayed at me. But RE isn’t my main field, but certainly this sounds unusual.

The management fee for the property (which they would do as they have a management business) would be 13%. That seems high. They are citing airbnb managers that charge 15%, but those are for individual properties and I’m not so sure those rates won’t come down anyway, and these are boutique hotels, not airbnb properties. 13% on a property that has 20 beds and does $1.1M in revenue is $154k. That seems like a rather large management fee for a property that has no concierge, restaurant etc. Just cleaning service on request and repairmen as needed, etc.

Anders Jax · Answer

@Greg Dickerson

Whats your standard structure

8% pref and 60/40 thereafter or something?

Greg Dickerson · Answer

I always like to keep it as simple as possible. No waterfalls. Just a simple preferred return for LP and equity split.

Matt Nusbaum · Answer

@Anders Jax I have not seen that type of waterfall structure before. Seems a little rich for the GP to me.

Is this waterfall structure a non-starter for an LP?

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