Distribution Waterfall Models – Private Equity, Real Estate and Equity Partners Returns

A distribution waterfall is a financial concept used to allocate profits among partners or investors in a hierarchical manner. It’s commonly used in investment structures such as private equity, venture capital, and real estate. The waterfall determines the order in which profits are distributed, ensuring that all parties receive their due share based on predefined agreements (cascading structure).

This structure ensures that the interests of both the GP and LPs are aligned, incentivizing the GP to maximize the fund’s performance while ensuring LPs receive a fair return on their investmen

The excel template includes four different examples of Distribution Waterfalls for Private Equity, Preferred Equity Partners, and Real Estate Investments.

Contents:

In private equity, the 80/20 distribution refers to the way profits are typically shared between the limited partners (LPs) and the general partner (GP).

• Private Equity – 80/20 Distribution

The 80/20 distribution model assumes that the Limited Partner (LP) contributes all equity investment and receives first the Principal and Preferred Return.

After that the remaining proceeds are distributed 80% to the LP and 20% to the GP (PE Firm).

• Private Equity – GP Catch Up with 80/20 Distribution

This structure ensures that the LPs get their capital back and a preferred return before the GP starts to share in the profits, aligning the interests of both parties.

Here’s a breakdown of how it works:

1. Return of Capital: First, the LPs receive their initial investment back.
2. Preferred Return: Next, the LPs receive a preferred return, often around 8% per annum, on their investment.
3. Catch-Up: After the preferred return is met, the GP receives a “catch-up” portion, which is usually 20% of the profits until the GP’s share matches the agreed-upon split.
4. Profit Split: Finally, any remaining profits are split 80% to the LPs and 20% to the GP

• Real Estate – 4-tier IRR hurdle Waterfall

This structure aligns the interests of the GP and the limited partners (LPs) by rewarding the GP for exceeding return expectations while ensuring the LPs receive their expected returns first.

A 4-tier IRR hurdle waterfall in real estate is a structured way to distribute profits among investors based on achieving specific internal rate of return (IRR) thresholds. Here’s a breakdown of how it typically works:

Tier 1: Return of Capital + Preferred Return

• Investors receive their initial capital back.
• Investors also receive a preferred return, often around 8% per annum.

Tier 2: 20% Promote Up to 12% IRR Hurdle

• Once the LP’s preferred return is met, the GP receives 28% of the profits and limited partners 72% of the profits.

Tier 3: 30% Promote Up to 15% IRR Hurdle

• After the LP’s 15% IRR hurdle is reached, the GP receives 37% of the profits and limited partners 63% of the profits.

Tier 4: Thereafter 60% – 40 % between GP and LP

• Beyond the 15% IRR, the GP receives 40% of the profits and limited partners 60% of the profits.

• Preferred Equity Returns

Preferred equity partners’ returns refer to the profits that preferred equity investors receive, which typically come with certain advantages over common equity. Here are the key aspects:

1. Preferred Return: Preferred equity investors receive a fixed return, often between 8% and 12% per annum, before any profits are distributed to common equity holders
2. Return of Capital: Preferred equity investors get their initial investment back before common equity investors receive any distributions
3. Priority in Cash Flow: Preferred equity holders have priority over common equity holders when it comes to receiving dividends and distributions from cash flow
4. Cumulative Returns: If the preferred return is not fully paid in a given period, it may accumulate and be paid out in future periods
5. Risk and Security: Preferred equity is generally considered less risky than common equity because of its priority in receiving returns and capital
6. Profit Sharing: After the preferred return and return of capital, any remaining profits may be shared between preferred equity holders and common equity holders, often based on a predetermined structure

Preferred equity provides a balance between the security of debt and the potential upside of equity, making it an attractive option for investors seeking stable returns with some level of protection.

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