Introduction
If you are interviewing for anything on the equity side, the waterfall is the topic most likely to separate people who have built a model from people who have read about one. It is also the part of real estate finance that sounds far more complicated than it is.
Strip away the language and a waterfall answers one question. When the deal makes money, who gets paid, in what order, and how much?
The Definition
An equity waterfall is the agreed set of rules for distributing cash between the sponsor, also called the general partner, and the investors, also called the limited partners.
Cash flows down through a series of tiers. Each tier has to be filled before anything spills into the next one, which is where the name comes from.
Why Waterfalls Exist
The sponsor usually puts in a small share of the equity, often somewhere between 5 and 10 percent, and does all the work of finding, financing and operating the deal. The investors put in most of the money and do none of the work.
A straight split of profits by dollars invested would not compensate the sponsor for the work. A waterfall solves this by paying investors a minimum return first, then giving the sponsor a disproportionate share of everything above that. That extra share is called the promote, or carried interest.
The logic is simple. The sponsor only earns the promote once investors have been made whole and then some.
A Four-Tier Example
Let's say the LPs put in 90 percent of the equity and the GP puts in 10 percent. The waterfall is structured like this:
Tier 1: 8 percent preferred return to the LPs
Tier 2: Return of capital
Tier 3: 80 / 20 split until the LPs hit a 12 percent IRR
Tier 4: 70 / 30 split on everything above that
Now walk cash through it. Every dollar the deal distributes goes to tier one until the LPs have received an 8 percent annual return on their money. Nothing reaches tier two until that is done.
Once the preferred return is satisfied, cash goes to returning the LPs' original capital. Only after both of those are complete does the sponsor start earning a promote.
In tier three, cash splits 80 percent to the LPs and 20 percent to the GP until the LPs reach a 12 percent IRR. Notice the GP is now receiving 20 percent of the cash while having contributed only 10 percent of the equity. That extra 10 points is the promote.
Above a 12 percent IRR, the split moves to 70 / 30 and the sponsor's share increases again.
Cumulative vs Non-Cumulative Preferred Return
This is the detail that catches people out.
A cumulative preferred return accrues. If the deal cannot pay the full 8 percent in a given year, the shortfall carries forward and has to be paid later before anyone moves up the waterfall.
A non-cumulative preferred return does not. Miss it in a year, and that year is simply gone.
Most institutional deals use cumulative, and many compound the unpaid balance as well. If you are reading a term sheet, find out which one you are looking at, because in a deal with a slow first few years the difference is enormous.
IRR Hurdles vs Equity Multiple Hurdles
Tiers can be triggered by an IRR hurdle, as in the example above, or by an equity multiple hurdle, where the split changes once investors have received a certain multiple of their money back.
IRR hurdles are time sensitive, so a sponsor who sells quickly can clear them more easily. Equity multiple hurdles are not, so they reward total profit rather than speed. Plenty of deals use both together, requiring the higher of the two to be met.
If you want a refresher on the metric behind the hurdle, see what IRR is and how it works.
Where People Get Stuck
Forgetting that the GP also invested. The GP receives their share of every tier as an investor, plus the promote on top. Both, not just the promote.
Applying the promote before the preferred return is satisfied. The order is not optional.
Not checking the tiers. A model that ties will show the IRR at each hurdle landing exactly on the stated number. If your tier three check reads 12.4 percent instead of 12 percent, something in the schedule is off.
Where This Shows Up
Waterfalls come up constantly in private equity interviews and in almost any case study involving a partnership structure. Reading about one is not the same as building one. If you want to build a full four-tier waterfall with a preferred return and a working IRR check at every hurdle, that is chapter six of the real estate financial modeling course.