For many investments, especially private real estate or private equity investments, investors will form a partnership with the initiator of the investment (e.g. the Sponsor or Promoter) taking the lead in executing the investment while other investors will join as financing partners (the “Limited Partners”).
In most cases, Limited Partners will provide most of the financing which means that they will have most to lose in case something goes wrong and – due to their passive role – become dependent on the execution skills and motivation of the Promoter.
Therefore, when dealing with an investment partnership, an investor will have to negotiate terms and come up with an agreement on how the risk is shared and profits shall be distributed.
Such investment approach will require to define a private equity profit distribution scheme between Limited Partners and Promoters by mostly using the waterfall method. An effective investment waterfall protects the downside of LP investors and rewards financial performance by allocating profits depending on achieving certain return hurdles.
A waterfall model can be thought of a series of pools that fill up with profits and then once full, spillover excess profits into additional pools.
Basically, the total profit limited partners achieve is allotted according to a cascading structure made up of layers or ranks, therefore the reference to a waterfall method. The conditions for such profit-sharing scheme in form of an investment waterfall model normally is defined in a shareholder agreement or investment agreement which sets the rules how each layer of profit is shared and distributed among the participating investors.
The Components of an Investment Waterfall Model
An effective profit distribution waterfall model will need to address several important components in order to define how profits are allocated. The terms of such investment and the profit-sharing agreement will need to be negotiated between the Sponsor and the Limited Partners, therefore each waterfall model is custom made and needs to be analyzed in detail. Let’s take a glance on some basic building blocks of a waterfall model example.
- The Preferred Return. A common component in equity waterfall models is the preferred return. It is often just called the “pref”, is defined as the first claim on profits until a target return has been achieved. In other words, preferred investors in a project are first in line and will earn the preferred return before profit is split in a different manner. Once this “preference” return hurdle has been met, then any excess profits are split as agreed or as per additional return hurdles.
- The Return Hurdle(s). It is simply the rate return that must be achieved before moving on to the next hurdle. This is important to clearly define because the return hurdles (or tiers) are the triggering point of the disproportionate profit splits. In practice when using the waterfall method, the Internal Rate of Return (IRR) is commonly used as return hurdle as it can address the annual return targets of investors while also taking into account the time needed to achieve those return. However, using an IRR requires an exit event in the near term, therefore profit distribution schemes based on IRR only work for buy & sell strategies but not necessarily for buy & hold strategies since there will be no exit event in the foreseeable future.
- Profit Allocation: For each layer of profit and for achieving a certain return hurdle, the investment agreement needs to define how profits shall be split. Simple waterfall models will split profits evenly among Sponsor and Limited Partner upon achieving the preferred return (to keep it simple) while more complex models will use several tiers of hurdle rates in order to distribute profits in a way which provides optimal incentives to the Sponsor to excel with the financial performance of the investment while at the same time protecting the downside of the Limited Partners.
Lookback and Catch-up Provisions
Sometimes additional provisions are used to correct the incentive schemes and risk profile of the investment partnership. To mention are the following ones:
- The Lookback Provision provides that the sponsor and investor “look back” at the end of the deal and if the investor doesn’t achieve a pre-determined rate of return, then the sponsor will be required to give up a portion of its already distributed profits in order to provide the investor with the pre-determined return.
- The Catch-Up Provision is essentially a variation on the lookback provision and seeks to achieve the same goal. The key difference is that with the lookback provision, the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check. With the catch-up provision, the investor gets 100% of all profits until the required return is achieved and only then will the sponsor receive a distribution. Typically the sponsor prefers the lookback provision (since they get to utilize money even if they have to eventually give it back), while the investor prefers the catch-up provision (since they get paid first and won’t have to ask the sponsor to make them whole at the end of the deal).
European or American Waterfall Methods
Waterfall models can either be applied on a deal by deal basis or overall on the performance of a defined investment portfolio.
As per the terminology used, the American waterfall method applies the profit share waterfall on a deal-by-deal basis. This is normally in favor of the Sponsor since he gets rewarded earlier on and does not have to wait until the final results of the portfolio are obtained.
The European waterfall method instead focuses on the overall portfolio returns. Therefore portfolio returns by definition will include the average of good and bad deals. This arrangement normally is in the interest of the Limited Partner. However, it might not work when you work on a club-deal basis where you are teaming up with co-investors on a deal-by-deal basis.
For our purposes, we focus on the American Waterfall model as we want to show how a profit-sharing waterfall model works for a private Real Estate deal.
Waterfall Model Example for a Real Estate/Private Equity Investment
We will look at the following example where we have two investor groups, Promoters and Limited Partners, which jointly are invested in a real estate deal with the objective to renovate a commercial property and sell it within 6 years. Promoters will invest 10% in the deal while the Limited Partners will invest 90% of the equity financing required.
Both parties agree to use a multi-tier investment incentive structure, whereas a minimum 8% preferred IRR return shall be achieved and when exceeding this hurdle, an increasing share of profits shall be allocated to the Promoters with additional hurdles at 12% and 20% in between. At the maximum 40% of profits will be given to the Promoter when exceeding Hurdle 3 of 20% IRR achieved for the Limited Partner.
In our waterfall calculation private equity example, the following graphic demonstrates that there is a clear incentive given to the Promoters to maximize the financial performance of the deal as then they get their maximum share of profits from Limited partner investors.
Based on a more detailed financial model which analyzes the property deal in detail, we obtain the net cash flow forecast of the deal. Here we focus on the levered cash flows available to equity investors, which will include the required equity investments and the proceeds available to investors. The deal itself shows a 42.3% IRR based on refinancing in year 3 and exit in year 6.
Hurdle 1 of our Waterfall Calculation Example
We now start our waterfall calculation private equity example by modeling the required return of Hurdle 1 for the Limited Partners. For this, we forecast the invested capital account of the Limited Partners (90% of the invested capital) by increasing its balance by the required 8% return by year. Available cash to distribute is used to pay for the required return and also pay back the invested capital until the capital account reaches zero and is fully paid back.
The calculation for the Promoters is easy to perform as we simply allocate pro-rata cash flows as per the profit-sharing agreement up to the hurdle 1 which are 10% of the profits (corresponding to the 10% equity investment).
The result of this waterfall calculation is that we can determine how much cash of the yearly cash flows remains available for distribution after fulfilling the requirements of hurdle 1.
Hurdle 2 and Hurdle 3 of our Waterfall Calculation Example
The investment waterfall now flows into Hurdle 2 and 3. Here we apply the same procedure as for Hurdle 1 only that we project the capital balance by adding higher accrued interest (12% and 20% instead of 8%) and we deduct all prior distributions made. We first use the remaining cash s to service the requirements of hurdle 2 and afterward also the requirements of hurdle 3.
Whatever is left in cash flows to be distributed above reaching hurdle 3 can now be distributed as per the profit-sharing scheme for any profits recorded above hurdle 3. This methodology is at the core of the waterfall modeling technique.
All we have to do now to complete the waterfall method is to summarize the cash distributions made to the Limited Partners and to the Sponsors. We do this by adding up all distributions received throughout the various tiers and double-check that the cash flows received by the Limited Partners plus Sponsors equal the deal cash flows.
Key Financial Metrics of a Waterfall calculation Private Equity Example
The investment waterfall now is built and cash flows are allocated. We now can summarize the key financial metrics for Promoters and Limited Partners based on our waterfall model example. As you can see in the below table, the deal shows an IRR of 42.3%. Given the IRR exceeds the maximum hurdle rate, the Limited Partners have to share up to 40% of their profit. This leads to the situation where the profit is transferred from the Limited Partner to the Promoters, therefore the IRR for Promoters lies above the deal IRR while the IRR for Limited Partners lies below the deal IRR.
Another important aspect for our waterfall calculation private equity example to look at is the risk/return equation. How much of the downside and upside will be shared among the parties? Obviously risk and return will be different and depends on the deal cash flow scenario. Therefore, normally it is very helpful to look at different scenarios and see how they impact the risk and return balance.
Whenever such profit-sharing agreements are in place, it pays to model such investment waterfalls in Excel to see what is the resulting expected IRR for Limited Partners investors. Limited Partners investors should only invest if their own circumstances allow it, they are comfortable with the risks and the expected profit and IRR meets their return requirements. As such the waterfall method becomes an essential tool to understand for each investor.
Waterfall Model – Advantages and Limitations
Obviously every profit share agreement via the waterfall model has its advantages and disadvantages. Here some common advantages and limitations to consider when dealing with investment waterfalls techniques.
- Focus on returns achieved by the Limited Partners
- Allows to distribute profits based on financial performance achieved
- Rewards financial performance and therefore incentives the Promoter to perform at his best
- Creates a sense of ownership since the Promoter will also have to invest funds and needs to protect his expected profits
- Protects the downside as profits are only shared if certain hurdles can be met and capital invested is repaid
- Waterfall models can either include only 1 hurdle or several hurdles which allow for flexibility in designing effective incentive and performance participation schemes
- In general, waterfall models are difficult to understand and require complex shareholder agreements.
- Most waterfall models require an exit
- For buy & hold investments, standard waterfall models based on IRR hurdles will not work for the Sponsor (since there is no exit and he will never see a share of profits). Therefore, the focus of a profit share agreement will need to be shifted on alternative financial metrics (e.g. Levered Cash on Cash Yield).
Conclusion: Waterfall Modeling is essential to understand the Deal
Our waterfall model example defines who gets paid first and shows the allocation of profits based on meeting certain return hurdles. The waterfall method allows structuring profit-sharing agreements in a flexible manner, whereas the Promoter needs to maximize the return of the Limited Partners in order to also maximize his own return, which normally aligns the interests among the two different parties.
Waterfall modeling is an essential tool for investors to understand the terms of their investment agreement with the Sponsor and how risk and reward are shared in a variety of deal scenarios. On the one hand, the waterfall model needs to incentivize Promoters to perform at their best while, on the other hand, it needs to protect the downside of the Limited Partner in case the performance falls short of expectations.
Looking for Waterfall Model Example Templates that you can use as a reference or a base to start with your own financial model? If you are, then check out our list of Waterfall Models below:
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