Private real estate sponsors, such as Timberland Partners, often include a “waterfall” structure in their deal terms when raising private capital. However, there is no standard waterfall, and the specific components that comprise it are unique to the sponsor and, oftentimes, to the deal itself within the sponsors’ various offerings. Thus, understanding why sponsors use this tool and how a particular structure functions is critical to deciding which sponsor to invest with when investing in private real estate.

At a fundamental level, waterfalls are a tool used to align the interests of limited partner investors and general partners (or managers/sponsors) of investment offerings. Interests are aligned by disproportionately splitting profits according to the performance of an investment. Sponsors’ earned profits above their respective interest in an investment are also known as promoted interest or carried interest. Limited partners (passive investors) want their investment to perform well but have no control over the day-to-day operations. Therefore, they will incent the general partner (sponsor) by allocating a disproportionate share of the proceeds after certain investment performance metrics are met. This motivates the sponsor to ensure the deal performs as well as possible because the better it performs, the more they earn. While the collective waterfall structure is unique to each deal, most share a variety of common components.

First, to incent limited partners (passive investors) to participate in an offering, the general partner (sponsor) will frequently offer a preferred return, or “pref.”

The preferred return is the base return the sponsor must payout to the limited partners prior to sharing in any profits. Investors should also inquire whether the “pref” is cumulative or not. Under a cumulative “pref,” the preferred return accrues to the investor, and the sponsor must pay out all of the accrued return before sharing in any profits. Timberland Partners offers a 7 percent cumulative preferred rate of return.

After the “pref” the sponsor will often have a catch-up period whereby a certain portion of distributions above the “pref” is paid out to the sponsor to compensate them for the paying out the preferred rate to the limited partners.

Some sponsors have a 100 percent split up to a certain return or payout, such that above the “pref” the sponsor is entitled to every dollar of distribution until the subsequent hurdle. At Timberland Partners, within our catch-up period, profits above the “pref” are split 50/50 between preferred unitholders (passive investors) and common unitholders (Timberland as a sponsor) until the sponsor has received 20 percent of the cumulative distributions. That way, the preferred unitholders will always share in the profits, no matter the amount.

Hurdles are the return levels beyond which the distributions are split at different levels between the limited partners and the sponsor.

Oftentimes, the subsequent hurdle after the catch-up period will either be an internal rate of return (IRR) based metric, or a cumulative distributions-based metric. As long-term holders of real estate Timberland Partners is not an IRR-based investor. Accordingly, our hurdle after the catch-up period is a distribution-based split. Once the sponsor (Timberland Partners) receives 20 percent of all distributions, every future dollar of proceeds above the pref will be split 80 percent to the preferred unitholders (passive investors) and 20 percent to the sponsor. Again, this profit sharing can only take place with the proceeds above the preferred rate of return.

The final hurdle in our waterfall is an IRR-based split, which is appropriate, as this return would only be achieved after an equity event, such as a sale or refinance of an asset.

After an investment achieves a 12 percent IRR, which is roughly equivalent to a 12 percent annual return on investment, 70 percent of the proceeds (again, only those above the preferred rate of return) will go to the preferred unitholders (passive investors), and 30 percent will go to the sponsor (Timberland Partners). Passive investors are satisfied with sharing profits here as they are still receiving substantial profits above a 12 percent rate of return.

Waterfalls are a great mechanism to align the interests of passive investors with those sponsoring the investment.

While it should now be clear how the sponsor can earn increasing proportions of the profits the better an investment performs, preferred unitholders (passive investors) should always ensure that the sponsor also has skin in the game! In the scenario above, sponsors share in proceeds above the 7 percent pref, ultimately earning 30 percent of those profits after the investment achieves a 12 percent IRR. But what keeps the sponsor from essentially giving up on an underperforming investment? If the sponsor has no money invested alongside the passive investors, then though they may never earn a promoted interest, they also don’t care about an investment not performing. They may even lose value because in that scenario they have no money at stake and nothing to lose. For that reason, Timberland Partners has always invested a minimum of 10 percent of the cash equity in every new investment. Skin in the game, combined with a waterfall distribution, is the best way to ensure a sponsor truly acts in the best interest of their passive investors.