After reading through these forums and some job posts, I have came across the waterfall scenario. Does anyone have a good grasp on what this is. Can you explain it in further detail and the ins and outs of the scenario. Any help would be appreciated.
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You derive an end value to something, say a valuation or an earnings figure, for the purposes of this illustration I'll say earnings.
Let's assume in t0 you earned 100. You could then create a chart with your base earnings of 100 at the far left, then various adjustments (i.e. sector incomes such as investment banking fees (+12), trading gains (+7), mortgage defaults (-9) and net interest (-3) which will take you to your end earnings number of 107.
Waterfall distribution is designed to encourage confidence from the investor in the PE fund. Once the investor receives his/her money back, plus a preferred return, the general partners (i.e. PE fund) then participate in the profits. The kicker, is that general partners typically invest a small a share of the initial equity (20%), but can receive a higher share of the profits
This is a little different from what I'm used to, but it came up on Google and should give you an idea: www.exinfm.com/excel%20files/Cash%20Flow%20Waterfall.xls
This is my understanding of a waterfall analysis in Real Estate. The developer won't be able to put nearly as much equity into the project but as the project attains a higher IRR and surpasses a new IRR hurdle the developer will receive more cash flow than their pro-rata share would normally provide them.
What Gene basically said. You have general partners that have a very small stake, say 10%. Even though they invested 10%, that's not the portion they are receiving now. The PE firm or fund will take mostly everything and then the general partner will slowly begin to see profits. This is mainly done by general partners who dont want to allocate alot of capital to a project. 10% of a 25% equity interest(assuming 75% debt) in a project means the GP only had to put up 2.5% of the total project cost. Hope this helps.
Waterfall is an allusion to capital flowing down the cap table in a liquidation event. Different investment tranches have different terms and you need to model how that impacts investor payouts in different scenarios (usually date and valuation are your different scenarios, also terms of the new tranche if this is growth capital instead of just liquidating). It's too complicated to explain coherently in a post on here. If you have to do waterfall analysis for a job, your employer will almost certainly train you on how to model one.
As other posters have mentioned, same rationale can be applied to the fund level too, it's the same concept (when at fund level it's usually just the LPs and GPs as two separate tranches). It's common when the GPs don't have enough to invest their pro-rata share.
I did a lot of waterfall scenario analysis when I was in PE and we were considering selling or investing in a company. They are not fun, especially when you have multiple tranches with vastly differing terms. You're talking tons of nested ifs in your formulas, tons of testing to make sure they work properly, etc. They're one of the hardest things within financial modeling (now some douche quant person is going to come and chime in about modeling complicated options, swaps, etc. and how waterfalls are a joke haha).
Thanks for the heads up. I would like to mess around with some models on my own time to get a better knowledge of the process.
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