American or European Waterfall?

Question

For deal sponsors, what kind of waterfall do you typically underwrite your deals with - American or European?

For LPs, which waterfall do you prefer to see in a deal? I'm assuming an LP would prefer a European waterfall because all LP money is returned and their pref is achieved before the promote kicks in, but curious to see if there's a different take on this.

Evan Polaski · Answer

@Parker Stone on both the sponsor side and the investor side, I believe every offering I have seen had an American waterfall.  Granted some of this goes back 14 years, so I am only 80% confident about some of the offerings in the 07/08 era, and includes offerings marketed to accredited investors and institutional investors.

Paul Moore · Answer

Hi @Parker Stone. I could be wrong, but I think the math works out the same in the end either way.  In reading up on this concept online, it seems that the European model is more investor friendly.

My firm has invested with operators that do both types and our investors get an American waterfall from us as of now at least.  We are going to look at the European model in the future since it seems like a viable alternative. We had not heard of that model years ago when we got started and we’ve just stay with what we have.  Good luck!

Rick Martin · Answer

@Parker Stone in our last two deals we had an 8 pref, and as returns rise above this, those cash flows go towards paying the LP's back their original investment. Then at a refi or sale, the first proceeds are paid back to the LP's to pay them back in full, and that is when the split occurs, and the promote kicks in. Thus, the GP's do not share any of the proceeds until the LPs have their original investment back. So I guess we are European! Of course the GP's do earn an aquisition fee, and asset managment fee.

Greg Scott · Answer

Personally, I won't invest in, or offer as an investment, any deal structured as a waterfall.

Waterfalls create a misalignment of risk / reward for the GPs and LPs.  If the deal is doing poorly, the GP can lose interest because the LPs are making the bulk of the money.  If the deal is a home run, the LPs can feel like they got the short end of the stick because they put more money at risk but did not get anywhere near the payout as the GP.  In addition, some waterfall structures are complicated enough that the LPs can't easily track what they should be receiving which can cause some mistrust between GP and LP.

I prefer a much simpler structure where the  GP takes a flat percentage of profits.  I also like to see them have some skin in the game net of any acquisition fees.  Only then are the GP and LP interests fully aligned.

American or European Waterfall?

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