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PRIVATE EQUITY WATERFALLS, CLAWBACKS, & GP CATCH-UPS EXPLAINED

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 * FNRP Editor
 * October 2, 2020


KEY TAKEAWAYS

 * The terms and conditions of a private equity real estate investment are
   governed by a document called the “Private Placement Memorandum” or “PPM” for
   short.
 * Investors not familiar with the typical language and deal structure outlined
   in a PPM may find it difficult to follow.  Specifically, there are three
   commonly used terms: “waterfall,” “clawback,” and “catch-up.”
 * By definition, an equity investment “waterfall” is the method used to
   allocate an investment’s income and profits between the General Partner and
   the Limited Partner(s).
 * There are two types of waterfalls that could be used in a private equity
   transaction, the European Waterfall and the American Waterfall.
 * Another clause that may be outlined in the PPM is the “Clawback,” which is an
   investor-friendly provision that entitles them to be repaid for any incentive
   fees improperly paid to the manager.
 * Finally, the catch-up clause is a legal provision meant to compensate the
   General Partner (GP) based on an investment’s total return, not just the
   return in excess of the pre-established hurdle.


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Whether allocating money to an investment fund or to an individual deal, the
terms and conditions of a private equity real estate investment are governed by
a document called the “Private Placement Memorandum” or “PPM” for short. 

Among other things, the PPM lays out two important aspects of the transaction:

 1. the fee(s) paid to the investment manager; and
 2. how income and profits generated by the underlying property are divided
    between the investment manager (sometimes called the Sponsor or General
    Partner) and the individual investors (sometimes referred to as the Limited
    Partners). 

Investors not familiar with the typical language and deal structure outlined in
a PPM may find it difficult to follow.  Specifically, there are three commonly
used terms: “waterfall”, “clawback”, and “catch-up,” that can be particularly
confusing.  Yet, a proper understanding of these terms is critical to assessing
the risk profile and relative merits of a commercial real estate investment
opportunity.

In this article, FNRP explains about the investment waterfall, including the
American and European waterfalls, the clawback provision, and the GP catch-up
clause.

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“THE INVESTMENT WATERFALL”

The basic structure of a private equity commercial real estate transaction is
such that there are two parties involved, the General Partner and the Limited
Partner(s).  


GENERAL PARTNER

The “General Partner” is the investment manager.  They are responsible for
identifying investment opportunities, arranging the financing, coordinating
transaction logistics, and managing the property once purchased.  In a typical
deal, they will put in a small part of the total equity needed to finance the
purchase, usually 10% – 20%.


LIMITED PARTNERS

The other party is the “Limited Partners” or “LPs.”  There may be one LP or
many, but they are accredited investors who place their capital with the General
Partner in the hope of earning a positive return.  The Limited Partnership role
is strictly passive and collectively, they contribute the difference between the
total equity needed and the amount contributed by the General Partner, usually
80% to 90%.

Because the General Partner is responsible for managing the asset once the
purchase is complete, a typical deal structure will incentivize them to deliver
a high return to the Limited Partners.  This is done by providing them with an
increasing share of the property’s income and profits once certain hurdles are
met.  Colloquially, this return structure is known as a “waterfall.”


EQUITY INVESTMENT WATERFALL DEFINITION

By definition, an equity investment “waterfall” is the method used to allocate
an investment’s income and profits between the General Partner and the Limited
Partner(s).  The exact methodology is described in the PPM, and it can vary
widely from one deal to another. However, each waterfall has a number of
features in common:

PREFERRED RETURN

As an incentive to invest, a General Partner may offer the Limited Partners a
“preferred return,” meaning that they will receive the first claim on the
property’s cash available for distribution until they have earned a certain
return on their investment.  For example, a deal may offer Limited Partners a
preferred return of 8%, which means that they will receive 100% of the
property’s cash available to distribute until they have earned a return of 8% on
their investment.

RETURN HURDLES

A return hurdle is a point at which the cash flow split between the GP and the
LPs changes.  For example, a waterfall could be structured that the GP gets 10%
of the cash flow available for distribution and the LP gets 90% until the LPs
earn a return of 12% (the return hurdle).  If the LPs earn more than 12%, the
split changes so that the GP gets 20% and the LPs get 80%. 

RETURN HURDLE MEASUREMENT

Depending on the deal, the return hurdle can be measured in a variety of
different ways.  Two popular methods are using the Internal Rate of Return or
the Equity Multiple.


EXAMPLE OF A TYPICAL WATERFALL STRUCTURE

To illustrate how these features work together, consider the following example
of a typical waterfall structure where the GP contributes 10% of the total
equity needed and the LPs contribute the remaining 90%:



In this structure, when the Limited Partners earn between 0% and 8%, the cash
flow split is “pro-rata,” meaning that the GP and LP shares, respectively, are
the same as what each party originally contributed.  But, if the LPs earn 8% on
their investment, but less than 12%, the cash flow split changes so that the GP
gets 20% and the LPs get 80%.  This extra share is meant to incentivize the GP
to deliver a strong return and it is known as a “promote.”  Finally, in the last
step, if the LPs earn more than 12% on their money, the cash flow split changes
again so that the GP gets 30% and the LPs get 70%.


TYPES OF WATERFALLS IN PRIVATE EQUITY TRANSACTIONS

To further complicate matters, there are two types of waterfalls that could be
used in a private equity transaction, the European Waterfall and the American
Waterfall.

EUROPEAN WATERFALL

In a European Waterfall structure, 100% of property cash flow is paid to the LPs
on a pro-rata basis until the preferred return hurdle is met and 100% of LP
capital is returned.  Above the hurdle, the General Partner’s share of the
income rises. This structure is commonly seen in private equity funds where
investor capital may be deployed into multiple investments.

From an investor standpoint, the biggest advantage of the European Model is that
the General Partner doesn’t get any profits until investor capital, plus their
preferred return, is given back. The idea behind this structure is that the
manager is incentivized to create a strong return, otherwise, they may not see
any profits during the investment period. 

The drawback of the European Model is that it may take many years for the
General Partner to return investor capital and realize their share of the
profits. As such, they may be incentivized to maximize short term profits to
reduce the amount of time until they get paid, rather than focusing on creating
long term value.

AMERICAN WATERFALL

The American Waterfall model addresses the primary weakness of its European
counterpart – that it takes a long time for the General Partner to receive their
management fees.  In the American structure, the General Partner is entitled to
their fee(s), regardless of whether or not investor capital has been completely
returned.

The American waterfall structure benefits smaller private equity firms that
don’t have the resources to wait many years for their fee and it benefits
investors because it doesn’t incentivize the manager to sell an asset just to
generate a return. Conversely, the downside to the American Waterfall is that
while the investor is still due their return of capital, it may allow a
manager/General Partner to take a performance fee, even if the deal
underperforms. 

Regarding waterfalls, the key point is this, the actual structure includes
multiple variables and changes from one deal to the next.  The details of the
hurdles, splits, and other key terms are outlined in the Private Placement
Memorandum (PPM) and it is absolutely critical to read it – and understand it –
prior to making an investment decision.


“THE CLAWBACK PROVISION”

Another clause that may be outlined in the PPM is the “Clawback,” which is an
investor-friendly provision that entitles the investor to be repaid for any
incentive fees improperly paid to the manager. Whether it is the result of an
accounting error or negligent behavior, if it is determined that the General
Partner received a fee they shouldn’t have, a clawback provision allows the
investor to seek its return.  

It should be noted though, that a strong clawback provision doesn’t mean
anything unless the General Partner has the ability to pay it.  As such, it’s
important to review the GP’s financial strength prior to making an investment
decision.


“THE GP CATCH-UP CLAUSE”

Finally, the private equity catch-up clause is a legal provision meant to
compensate the General Partner (GP) based on an investment’s total return, not
just the return in excess of the pre-established hurdle.  

In practice, in a deal with a GP Catch-Up clause, the LP receives 100% of the
property’s cash flow until their preferred return hurdle is reached.  Above the
hurdle, the manager/General Partner receives 100% of the income and profits
until they are “caught up” to their performance fee.  


CATCH-UP CLAUSE EXAMPLE

To illustrate this concept, assume that the Limited Partners are entitled to a
10% preferred return and the General Partner is entitled to a 15% performance
fee, with a catch-up provision.  Here’s how property income/profits would be
allocated:

 * First, the LPs would get 100% of the income and profits until their 10%
   return hurdle has been reached.
 * Next, the General Partner would get 100% of the income and profits until
   they’ve received the entirety of their 15% performance fee (the catch up)
 * Lastly, any remaining funds would be split between the general and limited
   partners according to a predetermined schedule.


SUMMARY & CONCLUSION

Investment waterfalls, clawbacks, and catch-up clauses determine how a
property’s income and profits are split between the General and Limited
Partners.  The specifics of these clauses are laid out in the Private Placement
Memorandum. The PPM is a document that potential investors should read in its
entirety to ensure that they are comfortable with the risk profile and financial
compensation involved with their capital contribution. 


INTERESTED IN LEARNING MORE?

First National Realty Partners is one of the country’s leading private equity
commercial real estate investment firms. With an intentional focus on finding
world-class, multi-tenanted assets, including middle-market service-oriented
retail shopping centers, well below intrinsic value, we seek to create superior
long-term, risk-adjusted returns for our investors while creating strong
economic assets for the communities we invest in.

To learn more about our investment opportunities, contact us at (800) 605-4966
or info@fnrpusa.com for more information.


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Red Bank, NJ 07701
 * 800-605-4966
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NOTICE: As with all investments, an investment in commercial real estate is
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