When an investor places their money with us, they do so with the expectation that they will get it back – plus interest – upon the conclusion of an investment. We take this fiduciary responsibility very seriously and make every effort to ensure it happens.
Before closing on any deal, we create a cash flow projection called a “pro forma” and use it to estimate the property’s potential return. We use those estimates to create something called an “equity waterfall” that will dictate the return parameters for our investors and ourselves. The “waterfall” concept is often new for our investors and can be confusing when seeing it for the first time. Still, it is essential to understand when trying to assess an investment’s return potential. There are four considerations that our investors should review in each deal:
- The Private Placement Memorandum
- The Return Metric(s)
- The Waterfall Structure
- Fees
Let’s review each in detail.
The Private Placement Memorandum
The Private Placement Memorandum (PPM) is a legal document that we provide to potential investors when raising money for a particular property. It contains the legal language that outlines the structure of the investment and the specific parameters. As it relates to returns, there are three particular things to look for: (1) The metric used to measure the return; (2) The waterfall is structure; and (3) The fees associated. These should be reviewed carefully before investing with us.
Return Metrics
There are many ways to measure a property’s return, and we evaluate several of them before making an investment decision, including the cash on cash return and equity multiple. But, as it relates to the creation of our “equity waterfall,” we use a metric called “Internal Rate of Return” or “IRR.” By definition, it is the compound annual rate of return that sets the net present value of all estimated cash flows equal to zero.
The math used to calculate the IRR can be complicated, and we won’t review it here. The important point to remember is that it represents two things: (1) The estimated annual return that an investor can expect; and (2) it creates the basis for determining the “cash flow split” between our investors and us. Here is where the equity waterfall comes into play.
The Equity Waterfall
The “waterfall” is a term that we use to describe how a property’s cash flow will split between ourselves and our investors. An easy way to think about it is to imagine that a property’s cash flow is a “waterfall.” As the property generates income, the income falls into “pools,” and when each pool gets filled up, it disproportionately spills into other pools. The IRR is the trigger that dictates how the cash flow splits in each pool.
In every deal, we act as the General Partner or the “GP.” It is our job to find the deal, underwrite it, and to assemble the capital to get it closed. As part of that effort, we work with investors who will contribute “equity” to bridge the gap between the purchase price and the loan amount. In a typical deal, we will contribute our own money as a small portion of the overall equity needed (usually ~10-25%), and the rest will come from our investors.
Once the initial contribution percentages are set, we define the IRR “hurdles” that trigger changes in how cash flow is split. This is where it can get a little bit confusing, so let’s look at an example.
Assume that we needed to raise $1,000,000 in equity capital. We would contribute 20% or $200,000, and we would raise the remaining 80% or $800,000 from investors. This is the starting point for the waterfall. The rest of it may look something like this:
Return Hurdle GP Share LP Share
0% – 8% 20% 80%
8% – 15% 30% 70%
15% + 40% 60%
This structure means that when the cash flows from the property produce an IRR in the range of 0% – 8%; property cash flow is split “pro-rata” between ourselves and our investors, meaning we would split it in proportion to the amount of money that we put in (we get 20% and the LP gets 80%).
But, when we do a good job managing the property, and the IRR exceeds 8%, we would get an extra share of the pie as an incentive for producing a good return. From 8% -15%, we would get 30% of the cash flows, and the investors would get 70%. The additional 10% share is commonly referred to as a “promote,” and it acts as a bonus for profitable management.
But, if we do an excellent job managing the property and we can achieve an IRR above 15%, our share of the cash flow rises to 40% – meaning we get another 10% ‘promote’ – and the investors would get the remaining 60%.
The idea behind this waterfall structure is to align our incentives with those of the investor(s). We both want a high return, but as the GP, we have direct operational control over the property, and if we can deliver it, we stand to benefit alongside our investors.
Fees
As a General Partner, it is our job to find, screen, and present the most profitable deals to our investors. Often, this may mean doing research and performing analysis on 50 different deals before we find one that meets our criteria. There is a cost associated with this as we have to support a team of analysts and fund the cost of third party reports and research to validate our assumptions. As such, we charge a series of fees in our deals to offset the expense of these activities.
We charge an “Acquisition Fee” that helps recoup some of the upfront research, analysis investment, and earnest money required to find an investment opportunity. We also set an “Asset Management Fee” to offset the overhead cost of complying with all legal and reporting requirements associated with our stewardship of the investment. Finally, we charge a property disposition fee to recoup the expenses associated with preparing the property for sale or refinance. These fees are not designed to be a profit center, only to cover our overhead costs associated with finding, operating, and selling these investment opportunities while attempting to achieve max returns for our investors.
Summary & Conclusions
When our investors place their money with us, it is a true partnership, and it can last for 5 – 10 years. As the lead partner, we strive to be transparent and straightforward about all aspects of the investment. We understand that we have a fiduciary responsibility to protect our investor’s capital, and we work hard to create a return structure that aligns our financial incentives with those of our investors. One of the ways this is done is to create a “waterfall” structure.
The Private Placement Memorandum, which is the legal document that governs the investment, details the outline of the waterfall structure. We encourage our investors to read the document carefully and to retain the services of an expert if necessary. In doing so, there are three things to look for: (1) The metric used to measure the return; (2) The waterfall is structure; and (3) The fees associated. We want our investors to be as informed as possible before committing funds to a project.