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What is a distribution waterfall?

A distribution waterfall is a term used in finance to describe the way in which the profits or returns from an investment are distributed among different stakeholders, such as investors, fund managers, and general partners. It’s a term most often used in private equity situations, but also typical in commercial real estate syndications and other co-investment mediums.

How are distribution waterfalls structured?

Typically, the distribution waterfall is structured as a series of tiers, with each tier representing a different level of return or profit. The first tier typically covers the return of the initial investment, while subsequent tiers may distribute profits in a predetermined ratio among stakeholders, based on the terms of the investment agreement.

Who uses distribution waterfalls?

The distribution waterfall is often used in commercial real estate, private equity, and venture capital investments, where the structure of the investment may be complex and involve multiple stakeholders. The distribution waterfall helps to ensure that all parties receive their fair share of the profits, based on the agreed-upon terms of the investment agreement.

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Distribution waterfalls in commercial real estate

In commercial real estate (CRE) syndication, a distribution waterfall is used to determine how profits or cash flow are distributed to the various stakeholders in the investment. These stakeholders typically include the general partner (GP) who manages the investment and the limited partners (LPs) who contribute capital to the investment.

The distribution waterfall is typically structured in a series of tiers, with each tier representing a different level of return for the investors. The first tier is typically referred to as the “preferred return” or “pref” and represents the minimum amount of return that the LPs must receive before the GP is entitled to any profits. The pref is often set as a percentage of the initial investment and is paid out to the LPs on a regular basis, usually quarterly or annually.

Once the pref has been paid out, any remaining profits are typically split between the GP and the LPs in a predetermined ratio. This ratio is set out in the investment agreement and is often referred to as the “promote” or “carried interest”. For example, the agreement may state that profits will be split 80/20, with 80% going to the LPs and 20% going to the GP. The distribution waterfall may also include additional tiers, which may be triggered by certain events, such as the sale or refinancing of the property. These additional tiers may involve a different split of profits or may be subject to different terms and conditions.

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Distribution waterfall types & definitions

Return of Capital (ROC)

The Return of Capital (ROC) model is a simple distribution waterfall that focuses on returning the initial capital investment to the investors before any profits are distributed. In this model, the investors receive their full investment amount back before any profits are distributed. Once the initial investment is returned, any remaining profits are distributed among the investors based on a predetermined split, such as a 50/50 split between the investors and the fund managers.

Preferred Return

The Preferred Return model, also known as the Hurdle Rate model, is a distribution waterfall that aims to provide a certain minimum level of return to the investors before any profits are distributed to the fund managers. In this model, a preferred return rate is set, such as 8% or 10%, and the investors receive their preferred return before any profits are distributed to the fund managers. Once the preferred return has been paid, any remaining profits are typically distributed between the investors and the fund managers based on a predetermined split.

Catch-Up Tranche

The Catch-Up Tranche model is a distribution waterfall that allows the fund managers to catch up to a certain percentage of the profits before the distribution is split between the investors and the fund managers. In this model, the fund managers receive a predetermined percentage of the profits, such as 20%, until they have received a certain percentage of the total profits, such as 30% or 40%. Once the fund managers have received their catch-up percentage, any remaining profits are distributed between the investors and the fund managers based on a predetermined split.

Carried Interest

The Carried Interest model, also known as the Performance Fee model, is a distribution waterfall that allows fund managers to receive a percentage of the profits above a certain hurdle rate. In this model, the investors receive their preferred return first, and any remaining profits above the hurdle rate are split between the investors and the fund managers based on a predetermined split. The fund managers typically receive a percentage of the profits above the hurdle rate, such as 20% or 30%, which is known as the carried interest.

Lookback

The Lookback Model is a distribution waterfall that takes into account the overall performance of the investment over a certain period of time, typically several years. In this model, the preferred return is not paid out until the end of the period, and the overall performance of the investment is evaluated to determine the total amount of profits available for distribution. This model can be advantageous for investors if the investment underperforms in the early years but exceeds expectations later on.

Target Equity

The Target Equity Model is a distribution waterfall that aims to distribute profits based on achieving a certain target equity amount, rather than a specific percentage return. In this model, the investors receive their preferred return first, and any remaining profits are used to build up the equity value of the investment until it reaches the target equity amount. Once the target equity amount is achieved, any further profits are distributed between the investors and the fund managers based on a predetermined split.

Hybrid

The Hybrid Model is a distribution waterfall that combines elements of several different models to create a custom distribution structure that meets the specific needs and goals of the investment. For example, the Hybrid Model may include a preferred return, a catch-up tranche, a carried interest, or any other combination of elements that are deemed appropriate for the investment.

Multi-Level

The Multi-Level Model is a distribution waterfall that includes multiple tiers of returns or profits, each with its own preferred return and split between the investors and the fund managers. This model can be useful for more complex investments with multiple properties or projects, as it allows for a more nuanced distribution of profits based on the performance of each tier.

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Waterfall distributions vs.
standard pro rata distributions

A standard pro rata model is a different way to distribute profits or returns from an investment compared to a distribution waterfall.

In a pro rata model, each investor receives a proportionate share of the profits or returns based on their ownership percentage in the investment. For example, if an investor owns 10% of the investment, they would receive 10% of the profits or returns.

In contrast, a distribution waterfall typically involves a more complex structure with multiple tiers determining the distribution of profits or returns among different stakeholders. The waterfall may include a preferred return, a promote or carried interest, and other tiers that are triggered by specific events or milestones.

The main difference between the two models is the level of complexity and the way that profits or returns are allocated. A pro rata model is simpler and more straightforward, as each investor’s share of the profits is based solely on their ownership percentage. On the other hand, a distribution waterfall is more complex and may involve a more nuanced distribution of profits based on specific terms and conditions set out in the investment agreement.

In commercial real estate syndication, a distribution waterfall is often preferred over a pro rata model because it allows for a more flexible and tailored distribution of profits that can take into account the different roles and contributions of the various stakeholders in the investment.

Learn more about commercial real estate syndication

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Automate Calculations

With Covercy, you can automate the complex calculations involved in determining the distribution of profits or returns to investors based on the specific terms of the investment agreement. This can help reduce errors and save time compared to manual calculations.

Track Distributions

Covercy can track the distributions made to investors and maintain a record of each payment made, ensuring that each investor receives their fair share of the profits in accordance with the terms of the investment agreement. Because Covercy integrates with third-party banking partners, GPs and LPs can transfer money instantly. No need for wires, paper checks, NACHA files, or other delayed and manual payment methods.

Customize Reporting

Covercy can generate customized reports that provide detailed information about the distribution of profits or returns to investors, including the amount and timing of each payment made. This information can be used to provide investors with transparency and insight into the performance of their property investments.

Manage Investor Communications

Covercy can also manage investor communications related to the distribution of profits or returns, including sending out notifications to investors when distributions are made, providing performance reports, and handling investor inquiries.

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Automate Calculations

With Covercy, you can automate the complex calculations involved in determining the distribution of profits or returns to investors based on the specific terms of the investment agreement. This can help reduce errors and save time compared to manual calculations.

Track Distributions

Covercy can track the distributions made to investors and maintain a record of each payment made, ensuring that each investor receives their fair share of the profits in accordance with the terms of the investment agreement. Because Covercy integrates with third-party banking partners, GPs and LPs can transfer money instantly. No need for wires, paper checks, NACHA files, or other delayed and manual payment methods.

Customize Reporting

Covercy can generate customized reports that provide detailed information about the distribution of profits or returns to investors, including the amount and timing of each payment made. This information can be used to provide investors with transparency and insight into the performance of their property investments.

Manage Investor Communications

Covercy can also manage investor communications related to the distribution of profits or returns, including sending out notifications to investors when distributions are made, providing performance reports, and handling investor inquiries.

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Bringing together investment management & end-to-end waterfall distribution payments

Covercy is the first real estate platform where banking meets investment management.

Covercy is the only investment management platform on the market with end-to-end customizable waterfall distribution models built for each firm’s individual needs. With Covercy, GPs can streamline the complex process of managing waterfall distribution payments to investors, saving time, reducing errors, and providing investors with greater transparency and insight into the performance of their investments.

Bringing capabilities such as investor management, fundraising, automated distributions, and more into a single platform, Covercy also provides GPs and their teams with the ability to open, manage, track, and report on bank accounts and activity tied to their assets, funds, investors, and more. GPs and LPs who open accounts through Covercy are eligible for high-yield APYs on all cash held, generating a whole new revenue stream for real estate firms.

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Everything you need to know about distribution waterfalls

Distribution waterfall types & definitions