Investment Waterfall Structure

You've probably heard the term waterfall, when someone was talking about an investment.  In this article, I'm going to outline how they can be structured. 

Syndications typically have a waterfall structure when it comes to distributions. Since every sponsor is different, it’s important to understand the way sponsors structure fund distributions. This article relates directly to the way Lonicera structures distributions from our real estate investment funds.

A waterfall, as it relates to investments, is the process of prioritizing the distribution of profits among passive investors and sponsors. One of the main functions of an investment waterfall is to give the sponsor an incentive to achieve a particular return for their investors. The cashflow from an investment can be split however the sponsor decides, but in general, there is a preferred return that must be paid to the investor prior to the sponsor getting a management fee.

When you think of an investment waterfall, think about a series of pools. Once a pool is filled, the water overflows into the next pool in line. The pools are often referred to as hurdles. In Lonicera syndication deals, the first pool is “distributable cash”, which is rental income that’s left over after expenses and reserves are paid.

The second pool is the “preferred return” for the passive investors. Its capacity is determined as a percentage (typically 6-8%) of unreturned capital. Once the capacity is reached, the water spills over into the next pool, the “asset management fee”.

The asset management fee is paid to the sponsors. An investor can expect this fee to be between 1% and 2% of the fair market value of fund assets. If there is enough cash flow for this pool to reach its capacity, the excess water falls to both the investor and sponsor. This is split somewhere between 50% and 80% going to the investor and the rest to the sponsor. If this pool doesn’t get filled, the sponsor’s management fee typically accrues and is distributed after a more profitable quarter, at the sale, or after a refinance.

Here’s an illustration of how our waterfall structure works:

Four Year Example

To further explain, I’d like to give an example of how distributions would be paid to investors over the course of 4 years (I’m using round numbers for easy calculations, everything from the preferred return to the equity splits will likely be different from sponsor to sponsor).

Let’s say the investor contributes $100,000 to a syndication with an 8% preferred return on unreturned capital and a 50/50 equity split on an asset that’s worth $500,000.

Year 1: There is $20,000 of distributable cash. The sponsor pays to investors an 8% preferred return, $8,000, filling the preferred return pool . That leaves $12,000, which falls over into the asset management fee pool. This pool has a capacity of 1.5% of the asset’s value, $7,500. Once the capacity is reached, this leaves $4,500 to be distributed; 50% or $2,250 to the investor and 50% or $2,250 to the sponsor.

Year 2: There is $20,000 of distributable cash. The sponsor pays to investors an 8% preferred return of $7,180 on the unreturned capital of $89,750 ($100,000-$8,000-$2,250). That leaves $12,820, which falls over into the asset management fee pool. Again, the asset management fee pool’s capacity is 1.5% of the asset’s value, $7,500. This leaves $5,320 to be distributed equally between the investor and sponsor; $2,660 going to the investor and $2,660 going to the sponsor.

Year 3: There is $10,000 of distributable cash due to major vacancies and capital expenditures. The sponsor owes the investor 8% preferred return of $6,392.80 on the unreturned capital balance of $79,910 ($89,750-$7,180-$2,660). That leaves $3,607.20, which falls over into the asset management fee pool. Remember, the capacity of this pool is 1.5% of the asset’s value, $7,500. When there isn’t enough cash to fill the pool, in this case it’s short by $3,892.80, the amount accrues. Since there isn’t enough to fill the pool, there would be no overflow to pay out the next level.

Year 4: There is $20,000 of distributable cash, the sponsor pays to investors the 8% preferred return of $5,881.38 on the unreturned capital of $73,517.20 ($79,910-$6,392.80). The remainder, $14,118.62, falls into the asset management pool. The capacity has increased to include the amount of unpaid asset management fee from Year 3. The pool’s capacity is now 1.5% of the asset’s value, $7,500, plus the $3,892.80 accrued amount, totaling $11,392.80. This leaves $2,725.82 to be distributed between the investor and sponsor; $1,362.91 going to each.

Overall, waterfall structures can vary from company to company.  It's important as a passive investor to understand the type of waterfall structure that's in a deal you're considering.