Updated: Feb 17, 2022
Syndications typically have a waterfall structure when it comes to distributions. Since every sponsor is different, it’s important to understand how the way they structure their distributions. This article relates directly to the way we structure our deals.
In its essence a waterfall, as it relates to investments, is the process of dividing profits amongst partners unequally. 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 needs to be paid to the investor prior to the sponsor getting their management fee.
When you think of an investment waterfall, think about different pools needing to be filled up, each in a different order. Once a pool is filled, the water falls into the next pool in line. The pools are often referred to as hurdles. In syndication deals, your first pool is “Distributable Cash”, which is rental income that’s left over after the expenses and reserves are paid.
The second pool is your preferred return pool, which is only for the investors. Its capacity is between 6-8% of the investor unreturned capital. Once the capacity is reached, the water falls into the next pool.
The next pool is designated for the sponsors. This is where they receive their management fee; an investor can expect this fee to be between 1 and 2%. If the pool reaches its capacity, the 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 the asset management fee
doesn’t get filled, the sponsor’s management fee typically accrues and is distributed on a better quarter with less expense, at the sale, or after a refinance.
Here’s an illustration of how the waterfall looks:
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 commits $100,000 to the 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 you your 8% preferred return, $8,000, to fill the preferred return pool, AKA satisfying the preferred hurdle. That leaves $12,000, which falls over to 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% to the investor, $2,250 and 50% $2,250 to the sponsor.
Year 2: There is $20,000 of distributable cash, the sponsor pays an 8% preferred return of $7,180 on the unreturned capital, with a balance of $89,750. That leaves $12,820, which falls over to the asset management fee pool. Again, the asset management fee pool’s capacity is 1.5% of the asset’s value, $7,500.00. This leaves $5,320 to be distributed between the investor and sponsor;
77$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. That leaves $3,607.20, which falls over to 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 capital left over to fill the pool, in this case, it’s short by $3,892.80 the amount accrues for a better period. Since there isn’t enough to fill the pool, there would be no waterfall to the next level.
Year 4: There is $20,000 of distributable cash, the sponsor pays you your 8% preferred return of $5,881.38 on the unreturned capital, with a balance of $73,517.20. This leaves $14,118.62, like the previous years this amount falls into the asset management pool. Unlike the previous years, the capacity has increased to the accrual that happened in year three. 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.
Haydn Zeis - Principal
Lonicera Management, LLC