Sage-Tips

How does a private equity waterfall work?

Private equity waterfalls are a method of dividing capital gains or investment returns between all participants. The term “waterfall” defines how the profits from an investment make their way down to everyone involved in the venture.

What is a waterfall fee?

The waterfall defines the way in which cash distributions will be allocated between the sponsor and the investor. For example, a sponsor may only put in 5\% of the investment capital but be entitled to 20\% of the profits. The typical performance fee is between 20\% and 30\%, subject to a preferred return hurdle.

What is a funding waterfall?

A distribution waterfall describes the method by which capital is distributed to a fund’s various investors as underlying investments are sold for gains. Essentially, the total capital gains earned are distributed according to a cascading structure made up of sequential tiers, hence the reference to a waterfall.

What is an 80/20 catch-up?

The catchup is defined by two elements: an allocation (usually 80\% for the LP, 20\% for the GP), and a target (in relation to the carried interest). Example: First, 100\% to the investors (LPs) until they receive their Preferred Return; Finally, allocate funds based on the carried interest allocation.

How is waterfall calculated?

The realized waterfall is calculated at the time of an actual distribution and allocates the actual cash proceeds from investments. It may include written-down and written-off investments. The carried interest includes the actual carried interest paid.

What is a promote in private equity?

The key term to a real estate private equity deal is the sponsor “promote”. – for the sponsor’s disproportionate share of profits in a real estate deal, provided the project hits certain return benchmarks. The promote is often expressed in the form of a waterfall.

What is waterfall development methodology?

The waterfall methodology is a project management approach that emphasizes a linear progression from beginning to end of a project. This methodology, often used by engineers, is front-loaded to rely on careful planning, detailed documentation, and consecutive execution.

What is waterfall structure?

Waterfall structure refers to the order in which a private equity fund pays out distributions after investments have been liquidated.

What is incentive fee in private equity?

An incentive fee is a fee charged by a fund manager based on a fund’s performance over a given period. For instance, a fund manager may receive an incentive fee if their fund outperforms the S&P 500 Index over a calendar year, and may increase as the level of outperformance grows.

What is the waterfall approach to project management?

Waterfall project management maps out a project into distinct, sequential phases, with each new phase beginning only when the previous one has been completed. The Waterfall system is the most traditional method for managing a project, with team members working linearly towards a set end goal.

What a promote structure is also known as a waterfall for sponsors and investors in real estate?

In practice, most private equity real estate deals have a multitiered sponsor promote structure, also known as the distribution waterfall. As an example, you might see a structure that looks like this: 100\% of returns go to investors (or members) until each investor has received an 8\% internal rate of return, or IRR.

What are waterfalls with institutional real estate investors?

Waterfalls with Institutional Real Estate Investors commonly have multiple tiers (preferred return and one or more hurdles) and involve complex calculations to accurately match the requirements of their overall investment portfolio.

Should you use a waterfall approach to manage your investments?

In certain investment products, such as debt or income, this waterfall may actually be more suitable, as the end goal is to hold the asset for income and there is very little risk to principal. In the case of income funds, it’s not uncommon for managers to participate in the income stream from day one.

What do HNWI investors look for in a private equity investment?

High Net Worth Individuals (HNWIs) are common investors in private equity real estate deals and they typically look for more straightforward equity waterfall investment structures. This can lead to a simple split of cash flows between the GP and LP once the preferred return has been satisfied.

What is the typical performance fee for a waterfall sponsor?

In most waterfalls, a sponsor receives a disproportionate amount of the total profits relative to their co-investment. For example, a sponsor may only put in 5\% of the investment capital but be entitled to 20\% of the profits. The typical performance fee is between 20\% and 30\%, subject to a preferred return hurdle.