Using Waterfall Structures in Your Deals?
As a GP with a private equity firm or other industry organization, you’re likely working with a variety of limited partners (LPs) to raise capital beyond your own investment to help fund new commercial real estate opportunities. As a result, a waterfall structure is likely in place that specifies how returns are managed. Because of your role in securing, funding, and overseeing the property as well as generating strong cash flow over time, you’ll receive a GP promote — an incentive for strong performance.
You’re likely already well familiar with GP promotes and have such incentives built into the operating agreements of the properties you manage. However, navigating waterfall structures that include them can be complex and time-consuming for you and your team. Here’s why:
- Managing LP Returns — If the property has a preferred return for limited partners, those individuals will likely receive 100% of the returns until they’ve hit a certain ROI. This is often measured using a metric called internal rate of return (IRR), the calculation of which can vary by transaction. This adds complexity to managing those returns.
- Different Tiers and Buckets — One of the reasons waterfalls are so complex is because the returns for LPs as well as the GP promote changes as the property performs better. As you reach different tiers, the calculation for LP returns decreases and the GP promote increases. Manually calculating and monitoring this adds even greater complexity as well as risk to your daily operations.
- Operating Agreement Variances — You likely have your own operating agreement preferences for your properties, but LPs will likely want input. Additional partners involved with the deal may also have a say in the final terms of the agreement and thus how returns are split. And the inclusion of clauses and provisions further complicates the process. All of this is more detail that has to be managed on a consistent basis.
- Administrative Burden — As we’ve noted already, many firms tend to manage this process manually, often using tools such as spreadsheets. The industry itself has a well known aversion to technology adoption, but this creates a heavy workload on your team and increases the chance of human error. And when there’s this kind of money being moved around, mistakes are the last thing you want to be dealing with.
These are just some of the many challenges GPs face with their promote incentives. The promote is critical, however, because it’s one of the ways professionals create long-term cash flow for their firms (e.g. eventually, the promote % becomes larger than the LP return). How can you make this process more efficient for long-term success?
Ensure Accuracy and Improve Operational Efficiency with GP Promote Calculations
Private equity firms and other commercial real estate professionals involved with GP promote calculations and management must offset the risks and inefficiencies outlined above. Even if you already have a process and tools in place that have served your firm well for years, that is no guarantee that they’ll continue to work well as you grow. In fact, the more assets under management that you have, the greater the complexity and risk.
Value is another consideration here as well — if you were an investor in a large commercial real estate deal, how would you feel if the firm responsible for your returns told you that someone on their team popped open a spreadsheet every quarter to calculate your return? Would that give you confidence in their accuracy? Is there a sufficient history and backlog for you or them to identify errors? Do you have any reporting or tracking tied to that? Most likely not on all fronts.
It’s time for GPs and their teams to consider switching this important process to an automated technology solution. While the GP promote calculation must still be determined and set up front, it’s a one-time effort that is then run automatically each quarter or at a cadence of your choosing.
- Go deeper: Learn more about the value and impact of automation distribution payments to LPs, vendors, and other partners.
Use Covercy to Streamline Returns for Your Investors — and Your Firm
At Covercy, we’ve built the first real estate syndication platform where banking meets investment management. One of the key features of our platform is the ability to build waterfall distribution models for your assets and automate those payments as you see fit. Revenue and profitability are monitored in the system, and at any time you can initiate a payment for your investors and have those funds deposited directly into their bank accounts. The same goes for your GP promote incentive. No more paper checks. No more time consuming calculations. Just fast payments add value for you and those you serve.
Connect with us today to see our platform in action.