Investors often ask us to explain the “waterfall” structure that is common in private placement projects.
A waterfall structure is a sequential set of rules or conditions that dictate the order in which capital is allocated among various parties involved in a private placement project. The purpose is to determine the distribution of profits or losses from the transaction, with each step of the waterfall taking effect only after the previous one is met.
The steps of the waterfall structure typically follow this type of sequence:
- Return of capital: The first step is to return the invested capital to the parties involved, such as lenders, investors, or sponsors.
- Preferred returns: The next step is to allocate returns to specific parties, such as investors, at a predetermined rate or amount.
- Participation or profit sharing: Once the preferred returns have been paid, the remaining profits are split among the remaining parties according to predetermined ratios or agreements.
- Residual profits: If there are still profits after the participation step, they are distributed according to the residual profits agreement.
Each step in the waterfall structure takes effect only if the previous step has been fully met, meaning that the structure ensures that capital is distributed in a logical and efficient manner.
Waterfall structures can be very simple to immensely complex depending on the nature and size of the project and the level of risk carried by the investors and sponsors.
Investors with more risk usually get higher returns on the waterfall. Conversely, projects requiring sponsors to take higher than common risks (such as recourse loan guarantees) will get profit sharing earlier in the waterfall.
Here is a simple illustration of a waterfall structure for a Multifamily private placement project:
- 100% of all cash is distributed to investors until all of their original invested capital is returned.
- Let’s say the original capital was $1m.
- So, the investors would receive $1m back in this step.
- From the remaining profits, cash is distributed to investors until they have received at least 6% on their invested capital for each year of investment. This is the preferred return to investors.
- Let’s say the total profits were $2.5m, then after step 1 we have $1.5m remaining. Also, let’s say the project was held for 3 years.
- So, the preferred return of ($1m x 6% x 3) = $180k is now distributed to investors.
- After preferred returns have been paid, cash is split so that 50% of the remaining profits are distributed to investors and 50% is distributed to sponsors.
- After steps 1 and 2, the remaining profits are $1.32m.
- So, $660k is distributed to investors and sponsors each.
At the end of this waterfall, investors have received ($1m + $180k + $660k) = $1.840m. This represents a 1.84x equity multiple and a 28% average annual return on invested capital in 3 years.
Pretty solid returns!