I have seen the promote on the equity waterfall structure defined two ways. Although both ways benefit the sponsor, one way clearly favors the limited partner and the other benefits the general partner. I have included those two scenarios below. Which of these scenarios do you most commonly see in your practice, and which do you feel is more appropriate?
GP Equity: 10% of Total Equity
LP Equity: 90% of Total Equity
"20 Promote over a 10% Preferred Return"
$100,000 cash flow after preferred return
Scenario 1 (Benefits the Sponsor):
Sponsor 10%: $10,000
Sponsor Promote 20%: $20,000
LP 70%: $70,000
Scenario 2:
Sponsor Promote 20%: $20,000
Sponsor 8% (10% of remaining): $8,000
LP 72% (90% of remaining): $72,000
I ask because I am trying to gain clarity on best practices in the industry.
Scenario 2 pencils correctly, but it is explained wrong. The promote is based off of a percentage of equity split.
In a "20 over a X return" scenario, the following would happen: LP is promoted 20% of all cash flows after X return, meaning the LP gives 20% of 90% (18%) to GP.
If there is $100,000 left after all X pref hurdle is met and return of capital is met, then the following would be the result:
GP (10% + 18%): $28,000 LP (90% - 18%): $72,000
Also, "LP is promoted" is the correct way to phrase it. It does seem counter-intuitive that to be "promoted" means giving up a share of profit, but that is the correct phrasing.
scenario 2 looks right, scenario 1 looks fucked up/wrong to me
A couple things:
I'm not even sure that you can answer this at all since you haven't said how much capital has been invested in total - it's not just 10% of the cash flow, it's 10% of the return calculated off of the initial equity contributions. So depending on how much capital was invested, it may be $50,000 pari passu to get to the 10% hurdle.
Also, you say $100,000 cash flow after the preferred return, but then are saying that the 10% is the preferred return and are using that to calc on your $100,000.
EDIT: I just re-read the original post, I think I get it now - wasn't making sense to me at first the way you wrote it. I agree w/ TheWildMan on scenario 2.
At the risk of replying to my own comment, the other way that it can be structured (which is where I was getting confused as I originally thought this is what you meant) is that you can get 20% of the return on any CF remaining after the 10% pref return. So that would just be $20,000 to the sponsor in your example. This is different than your scenario 1 because the pref has already been taken into account and they wouldn't get another $10,000 - this would have already come as the pref. return disbursement in this instance.
can someone explain the difference in waterfall structures for preferred return versus an equity contribution?
If you guarantee a pref. return of 8% for example, is the sponsor entitled to tiers? Is this something that is different for every structure?
Transparency from Sponsor to Investor in many deals varies dependent upon the sophistication of the investor and their negotiating leverage with sponsor. What do I mean? "Dumb" money gets dumb returns in dumb structures which are obfuscated under industry lingo. Some deals I've seen (with dumb money, dr's attys dds') say we'll give Investor X% pref, by which the Sponsor only means I will give Investor X% times their total investment each period. The language sounds like the first piece of the waterfall deal you get working with a big institution (smart, lots of money), but its not the same structure at all. The institution requires that you square up against that X% investment return, or IRR which has time value built in through the annoying to build waterfall. The dumb money deal just compares the payout in a given period to that fixed target. Catchup is arithmetic without any TVOM.
I agree with 1901Monkey that your conceptual framework is of little use to seasoned professionals BECAUSE the seasoned professionals are trying to skew the deal in their own favor as much as possible (this is easier with dumb investors who are dumb and also greedy themselves). When you work with institutions, your conceptual framework should match the deal structure, there "pref" is exactly that, the investor is paid to their PREF or hurdle before the sponsor gets return on their capital.
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