Family & Friends Waterfall - Advice Needed
Hey WSO,
I’m in a fortunate position of having access to some friendly LP capital. I plan on purchasing a small/mid size Multifamily investment, where I will contribute 3-5% of the equity. Our target deal size ranges from 3-5mm in total value. I plan on proposing an 80/20 split over an 8% pref but would like to hear input from WSO users who have structured personal deals with hurdles before. Would a 10% pref be more appropriate? I want to propose a fair structure that benefits both parties, this LP has my interests in mind and wouldn’t be opposed to giving me a favorable hurdle.
Thank you
7 or 8% sounds fair, why would you increase the pref to make things harder for yourself? You should also include a tier of even higher GP % once all principal is returned
Adding onto this, you could do 80/20 at 8%, 75/25 or 70/30 at 12%, and another step at 15% if you so choose. I would stay away from splits once capital is returned if it's your first deal because you want everyone to be thrilled with their returns and while you're taking on most of the risk and should be rewarded appropriately, if the LP is family or friends then you want them to be rewarded in trusting you to run a deal too.
In the long run you would want them to be excited for your next deal and happily invest again since they got 20% IRR and you got a measly 25% IRR after disposition than your LPs being more hesitant because they got a 15% IRR and you got 30% IRR. With interest rates going down in the next 2-3 years it would mean you would get a higher % of leverage for a lower interest rate when you refinanced and would pull out equity in the deal sooner than expected which would hit that higher split sooner and "hurt" their returns.
What do you mean by splits once capital is returned, are you saying a return of capital prior, then pari to a pref hurdle, then promote? Why would this be detrimental to the LPs return, would view this as a risk mitigant to the LPs.
If a long term hold, where you don't plan or need to exit a successful investment, I might also structure it at an 8% pref, and above that and crystallization at a capital event such as a refi/sale/ If you are going to hold long term, then that is when language such as the above takes effect, where LP get their money back. Because the LP would get repaid at a capital event, then the proceeds are split 80/20, and all cash flow going forward at an 80/20 split.
Thanks, wasn’t thinking in a crystallization context in a long term hold but that makes a lot of sense now, appreciate it.
I just want to make sure I'm 100% clear-- 'crystallization' references maintaining the 80/20 split, even after returning capital via refi/sale (thus reducing the denominator in your CoC% calculation)? In this scenario, the only way to hit the higher pref hurdles (75/25 @ 12%, 70/30 @ 15%), would be through increasing cash flow, not through a sale/refi?
It depends, typically once crystallization occurs, then there are no more hurdles, and the split is "crystalized" going forward, 80/20 in this case. Essentially the gp is promoted, but just on cash flow and capital events going forward. This is typically not a close ended fund structure as they look to exit their investments in 5-7 years.
What's the goal of your investments? Fix and flip? Long-term hold? If the latter, I would seriously consider an American waterfall over a European. Your partners receive a preferred return on an annual basis and anything above that pref is spilt between you and your LP's. Allows you to receive some compensation for the value you create w/o having to sell. The longer I'm in real estate, the more I realize how many bad real estate decisions are made b/c a GP is meaningfully compensated only after a sale/refi. Some investors want the high octane, short term holds, but most don't.
The intention is for a long term hold. Having a yearly cash out after hitting a set pref makes sense.. I certainly don't want to be in a position in the future where I feel the need to force a capital event just to hit some form of distribution. In summary, the terms I plan on proposing are an 80/20 over 7% pref, to be calculated yearly on the anniversary of acquisition. Promote will be crystallized at 80/20 in the event of a recap and subsequent return of capital.
Just make sure the 20% over a 7% is enough dollars to make it worth your while. In an American waterfall, you don't even necessarily need to do a promote crystallization, you would just use any refi proceeds to pay off the pref. In theory, at some point the pref is fully paid off and every single dollar that comes in the door is split 80/20 (or 70/30 or whatever you end up using as the split).
a fucking waterfall over a $3MM to $5MM deal....getting a little too cute here.
how many "friends and families" even would understand what a pref or a promote is anyway.
Why don't u just knock it out of the park here with the first deal and establish a track record instead of worrying about a pref / promote on such a small deal.
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