3 Factors when picking an equity waterfall structure.

Equity waterfall structures offer a great chance for real estate investors who gather equity from external investors to boost their returns significantly.

However, as lucrative as this strategy can be, picking the ideal structure for your particular deal or investor group isn't always as simple as it appears. The process can become complex, with many options available and numerous factors to weigh in.

This newsletter will guide you through three key considerations to select the most suitable equity waterfall structure for you and your investors. We'll also explore how to craft a mutually beneficial scenario for everyone involved in the deal.

But first, what is a waterfall in Private Equity?

You're diving into an article about the "best" equity waterfall structure, so I'm guessing you've got a handle on the basics of real estate equity waterfall structures

But just in case, a real estate equity waterfall structure is all about how cash flow gets divided in a real estate partnership.

When certain financial targets are met, the General Partner (or the one managing the show) gets a bigger slice of the cash flow pie, proportional to their initial equity investment. This is often referred to as promoted interest.

At first glance, this seems like a sweet arrangement for the General Partner. And usually, it is. They're rewarded for their efforts in piecing the deal together, with the chance of extra perks if they surpass investor return expectations.

But, the specifics of these financial targets (and their calculations) can vary widely from one deal to another.

If you're navigating your first deal with investors, figuring out the perfect structure can be daunting. You've got to balance what works for you, the nature of the deal, and the expectations of your investors.

Let's explore three key strategies to help you pick the ideal waterfall structure for your unique scenario, considering all the essential elements to crafting a successful deal structure.

1) Keep it simple

First, when picking an equity waterfall structure, it's key to keep it straightforward and user-friendly. This is particularly important for smaller deals and when you're teaming up with non-institutional investors.

A lot of folks who invest passively in real estate aren't fully versed in the nitty-gritty of partnership structures or the broader world of commercial real estate finance. The more complicated you make your structure, the higher the chance of intimidating potential investors. Keeping things simple can be a real game-changer.

We're in an era where investors are more informed and savvy than ever before. The shadow of Ponzi schemes and intricate, fee-heavy investment strategies has cast a bit of a dark cloud over investment managers. Nowadays, if investors can't wrap their heads around an investment's structure, chances are they won't be keen on putting their money into it.

So, while it might seem impressive to include terms like clawback or catch-up provisions in your agreement, these can actually make it tougher for the average investor to understand the nitty-gritty of cash flows and the impact on their returns.

However, when you're dealing with large-scale deals involving sophisticated, institutional capital partners, a bit of complexity can be justified. But when your goal is to gather investments ranging from $25,000 to $100,000 from friends, family, and high net worth individuals outside the industry, keeping things straightforward is usually the best approach.

2) Incentive Alignment

Keeping it straightforward is key, but equally important is ensuring your waterfall structure aligns with both your and your investors' investment objectives.

Moreover, when picking a waterfall structure, it's crucial to choose one that motivates the General Partner to make choices that resonate with the initial investment aims of the investors.

For instance, if your aim, along with your investors, is to buy a property to create steady cash flow and keep it indefinitely, then the equity waterfall structure should be designed to encourage the General Partner to achieve this specific goal.

In such a case, a structure based on cash-on-cash returns could be ideal. It would incentivize the sponsor to focus on long-term property management and enhance cash flow, thereby boosting investor payouts. This approach aligns perfectly with the interests of everyone involved in the deal.

If that same investor group is looking to quickly turn a profit and recycle their capital, an IRR (Internal Rate of Return)-based structure could be the way to go. This would encourage the General Partner to enhance the property's value, sell it swiftly, and realize a profit in a shorter timeframe.

Conversely, if the group's focus is on long-term growth and wealth preservation, an equity multiple-based structure might be more suitable. This would motivate the General Partner to sustain cash flow over an extended period and delay selling the property until it yields a substantial gain.

It's also possible to combine different structures. For example, you could have a waterfall structure that includes both IRR and equity multiple benchmarks, or cash-on-cash returns coupled with a distinct cash flow division upon sale. Essentially, any combination that ensures the General Partner's decisions align with the core objectives of the real estate investment can be considered but again, keep it simple.

Real estate investment strategies may evolve to suit market dynamics, but starting with a structure that aligns the General Partner's compensation with the partnership's overall investment goals can simplify decision-making and prove more advantageous for everyone involved.

3) Current Market Rates

Finally, in addition to keeping your terms straightforward and ensuring your interests are aligned with your investors, it's crucial to set your equity waterfall terms at competitive market rates.

As mentioned earlier, today's real estate investors, especially those interested in passive investments, have more choices than ever. This abundance of options also means they're better informed about what they should and shouldn't concede in terms of cash flow.

The rise in popularity of real estate as an alternative investment avenue is undeniable.

Building a solid investor base is a tricky business. You need to ensure you are not over-promising but also keeping in line with competitive options investors have at their hands.

Start small and figure out your sweet spot regarding ROI and the terms you offer to the investors.

Sure, other firms might mimic your strategies or become your rivals in the markets you're eyeing, and honestly, there's not a whole lot you can do about that. However, there's one thing they can't replicate: the trust of your investors. This trust is a precious asset, painstakingly built over a long period, yet it can vanish in the blink of an eye.

If the structure you're pitching doesn't hold water, my advice is to tweak it until it's rock-solid.

Tempting as it may be to snag a few investors quickly with half-baked strategies, it's a short-term win that could cost you in the long run. If you're playing the long game, remember: short-sighted tactics will likely see your investor pool shrink as they catch on and move towards more cost-effective, similar investment opportunities.

The Crux

An equity waterfall structure is all about giving the General Partner a pat on the back for knocking it out of the park with investor returns, especially when they do better than what investors might have gotten with other investments of a similar risk level.

Investors are always eyeing different options, like stocks, bonds, or other private equity stuff, to see where their money can grow best.

Now, if I'm just kicking back and letting my money do the work (aka a passive investor), I'm not exactly thrilled if the sponsor grabs a slice of my profits for just so-so results. I mean, I could have put my cash in something less risky or more liquid and maybe done just as well, if not better.

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That's a wrap.

To summarize, a straightforward waterfall structure that's really dialed into what investors are looking for and that offers fair, market-standard rates works best.

It's the kind of setup that'll keep investors coming back for more. It's a win-win for everyone involved – both the General Partner and the Limited Partners get a fair shake in the deal.

Hope it was helpful. :)

Cheers,

Vidit

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