Understanding Waterfall Fairness Constructions In Multifamily Actual Property
Posted On February 27, 2023
Founder of Vive Funds, a unique multifamily investment firm specializing in curating high-quality assets for our investors.
A waterfall equity structure is a system for allocating profits, losses and expenses for a business venture or investment members. The real estate industry commonly uses it, but you can also apply it to other types of businesses or investments. The investors in a waterfall equity structure receive profits and losses according to their agreed-upon return on investment. This is known as the “preferred return.” Preferred returns are often distributed first; any remaining profits are then distributed to investors based on their agreed-upon terms and then to the project’s sponsor. The latter distribution is known as the “promote.”
A waterfall equity structure has the potential to align the interests of the investors with those of the company. By providing a guaranteed return to investors, the company can ensure that the investors are motivated to support the business’s success and incentivized to work toward the business’s long-term success. There are several variations of the waterfall equity structure, and each has unique features. For example, some structures may include a “hurdle rate,” which is a minimum rate of return on a project or investment. Others may have a “catch-up provision,” which stipulates that all distributions go to the sponsor of a project or fund until it receives a designated percentage of the profits. It is essential to carefully consider the terms of a waterfall equity structure, as they can have significant implications for the distribution of profits and losses among investors.
Waterfall equity structures can have many advantages. But it’s also important to evaluate some disadvantages to determine whether they fit your investment needs.
Advantages Of Waterfall Equity Structures
• They can provide a clear framework for distributing profits: Waterfall equity structures establish a clear hierarchy for distributing profits, which may help reduce investor disputes and uncertainty.
• They can align incentives: Because investors in a waterfall equity structure are rewarded in a specific order, the structure can help to align the incentives of different investors and ensure that everyone is working toward the same goal.
• They facilitate risk-sharing: Waterfall equity structures can allow investors to share risk and reward in a fair and transparent way.
Disadvantages Of Waterfall Equity Structures
• They can be complex and difficult to understand: Waterfall equity structures can be complicated for some investors. Investors need to be sure they understand where they fall within the waterfall to assess the risks and benefits.
• They can have limited flexibility: Because the distribution of profits is predetermined in a waterfall equity structure, investors may have limited flexibility to negotiate different terms or adjust the distribution of profits.
• They can create tension among investors: In some cases, the hierarchy of a waterfall equity structure may create tension among investors, particularly if some investors feel that they are not fairly compensated.
It is also essential to consult with legal and financial advisors to ensure that the structure is appropriate for the specific business or investment.
Overall, a clear understanding of the waterfall equity structure is critical for all stakeholders involved in a multifamily real estate syndication to ensure that everyone’s interests are aligned and support the success of the investment.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.