Evaluating Real Estate Investments -- Waterfalls

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Theatre Graslin in Nantes opened in 1788 and quickly became a major opera house. Constructed in the Italian style based upon the design of architect Mathurin Crucy, the theatre features seven imposing Corinthian pillars across the front above wide stairs spanning the front of the building. But in August and September 2020, art, rather than opera, drew people to Theatre Graslin.

Artist Stephane Thidet’s installation, Rideau, which translates to “curtain” in English, was on public display. Thidet’s “curtain” wasn’t made of fabric but rather was a waterfall. Life-size statues of the nine muses stood on the edge of the roof while water flowed from Theatre Graslin’s roof and cascaded in front of the Corinthian pillars before plunging down the front stairs into a newly constructed basin where the water would be captured and recycled for a repeat journey.

Although the waterfall prevented entrance through Theatre Graslin’s front entrance, dedicated operagoers could enter through the artists’ entrance to view live opera. Perhaps it was no coincidence that the opera being performed, Monteverdi’s L’Orfeo, was a transformational composition, which created the opera genre and helped move classical music into the Baroque period.

Although a waterfall at an opera house may be unusual and transformational, “waterfalls” of cash flow are common in real estate and other financial investments. This article is part of a series on evaluating real estate investments and discusses those investment waterfalls.

What is a Waterfall?

In real estate and other financial investments, a waterfall is the distribution of cash out of the investment to investors and the sponsor or founder (which I will call the sponsor). It can be thought of how funds flow (like water in a waterfall) to various parties to the investment.

At a minimum, two groups receive part of the cash flow in the waterfall: investors and the sponsor. In more complicated structures, there may be multiple investor classes, each having different rights. But the two fundamental groups receiving money in a waterfall are still investors and the sponsor.

Investor cash flow is tied to their equity investments. Sponsor cash flow is due to a “carried interest.” That’s a right to receive cash flow given to the sponsor as part of its compensation for putting together and managing the fund.

Many investments have at least two waterfalls, one for cash from operations and a second for cash flow from liquidity events, such as sales, refinances, or recapitalizations. Differences between these waterfalls are often based on the concept that investor capital return is a priority upon liquidity events.

Elements of a Waterfall

Graslin’s waterfall included several stages of water flow – down the roof, freefall to the top of the stairs, flow down the stairs, and collection in a reservoir at the bottom. Fund waterfalls also consist of two or more stages of cash flow to both investors and the sponsor. Possible elements of a waterfall include (NOTE: some of these phrases aren’t “official” terms):

Return of Capital A return of capital is return of the Investors’ cash investment. Since investors don’t want to lose money, return of capital is critical.

Preferred Return – A preferred return usually operates much like interest on debt and is generally described as a percentage per annum on investors' unreturned capital. The purpose of a preferred return is to ensure that investors receive a return on their capital investment before the sponsor makes a profit. However, since preferred returns frequently are cumulative and non-compounding, an investor's actual return may be lower than the stated preferred return percentage.

SplitsSplits are what they sound like – they are a split of cash flow between the investors and the sponsor. The sponsor's share of the splits is its "profits share" and is called a carried interest.

BenchmarksBenchmarks, which frequently are stated in terms of internal rate of return (IRR), are breakpoints at which the waterfall moves to a new level.

Sponsor Catch UpsSometimes, sponsors will delay their return until after investors receive a stated return. When this happens, the sponsor may receive a catch-up payment to bring the return on their carried interest more in line with the investors’ return.

ClawbackIf the sponsor receives money from the splits before investors receive a specified return, frequently return of their capital investments, they may agree to return that money if the investors still haven't gotten their capital back at the end of the investment. This arrangement is called a sponsor "clawback."

Sponsor FeesSponsors frequently receive fees for services rendered. Asset Management Fees, Disposition Fees, and other Sponsor fees typically aren’t part of the waterfall. Most Sponsor fees are paid BEFORE the waterfall, although sometimes a Sponsor will defer it until investors receive a specified return.

Basic Waterfall Structures

Real estate and many other financial investments are risky. Although investors hope for a terrific return on their investments (ROI), their most fundamental concern is that they not lose money.

It’s common for the sponsor to receive fees for services rendered in organizing and managing the fund before investors get their entire investment back. However, since the purpose of the carried interest is to incentivize sponsor performance, the waterfall needs to be aligned with that incentive.

To accomplish this, for a company with one class of investor units plus the sponsor’s carried interest, I usually recommend one of three simple waterfall structures:

Option 1 - Investor preferred return, followed by return of investor capital, followed by splits

Option 2 - Return of investor capital, followed by splits

Option 3 – Investors receive all funds until a target IRR is attained, followed by splits

Although the first structure is the most popular, all three structures are easy to manage and ensure that the investors' investments are returned before the sponsor receives its carried interest. Options 1 and 3 ensure that investors not only receive return of their investment but that they also receive a stated profit before the sponsor receives its carried interest.

More Complicated Waterfall Structures

Some waterfalls include additional elements. The following modification to Option 1 provides for a sponsor “catch-up” designed to replicate the investors’ return:

Option 1A – Investor preferred return, followed by investor return of capital, followed by a sponsor catch-up (designed to replicate the investor preferred return on an assigned value of the carried interest), followed by splits

Option 3A – Investors receive all funds until a target IRR is attained, then the sponsor receives all funds until an amount designed to replicate the investor target IRR is achieved, then splits

It’s easier for investors to understand and the fund’s accountants to calculate to modify the splits to be more favorable to the sponsor. Exact percentages require reference to the fund proforma. But for example, an 80%/20% investor/sponsor split in Option 1 might be changed to a 70%/30% investor/sponsor split to replicate the catch up.

Some sponsors don't want to wait to receive their carried interest, particularly where the sponsor does not receive significant fees during the hold period. They might elect these options:

Option 1B - Investor preferred return, followed by splits, with a sponsor clawback if the investors don’t receive return of their capital when the fund closes

Option 2B – Splits, with a sponsor clawback to ensure investors receive return of their capital before the fund closes

These options, particularly the first one, might be acceptable for an established sponsor with many holdings and significant net worth backing the clawback. However, with a new sponsor, these structures present considerable risk to investors since the sponsor has little backing its clawback obligation.

As a sponsor becomes more experienced and offers larger funds, there may be multiple classes of equity (e.g., preferred equity that gets paid back first but does not receive a split, and common equity that receives a split).

With larger funds, IRR benchmarks can be used to increase the sponsor’s share of the splits as profitability increases. For instance, a sponsor may receive a 20% split until the investors receive a 12% IRR, then a 30% split until investors receive a 15% IRR, and then a 50% split. While this can be complicated to track, an established sponsor and larger fund usually can support the additional accounting burden.

Best Practices

Investors Come First -- Reputable sponsors put their investors first. Sponsors deserve fees for their services and hope to benefit from their carried interest. But sponsors’ top concern should be return of investor capital and investor ROI. And with a well-structured waterfall, investor ROI will translate to sponsor ROI from its carried interest.

Keep it Simple – Waterfalls should not be more complicated than necessary. Complex structures can be difficult for investors to understand and for sponsors to manage. And complicated financial calculations can tax a sponsor’s infrastructure and increase accounting costs.

Model Financial Results -- Sometimes, waterfalls and models feel like a chicken or egg situation. Some sponsors develop a waterfall without reference to the model based upon what they think will impress investors and then try to force the model to support that waterfall. The waterfall should yield to modeled financial results, not the other way around.

Under Promise and Over DeliverReal estate investments are risky, and financial models are, by necessity, based upon speculative financial assumptions. Aggressive waterfalls that depend upon every penny of forecasted net cash flow to achieve high preferred return percentages or IRR targets are more likely to fail than more conservative, easily attainable structures. High forecasted returns might attract investors, but investors will be disappointed if the forecasts turn out to have been overly aggressive.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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