Waterfall structure out of whack?

basementflat02's picture
Rank: Baboon | banana points 128

A developer just proposed to me a structure as follows:

  • 7% pref
  • 7-12% (overall return to equity) 50/50 split
  • 12-17% 25% to LP, 75% to GP
  • 17%+ 10% to LP, 90% to GP

As well, 5% development fee for GP, invested into the equity of the deal.

Does that seem unusually GP friendly?

Private Equity Interview Course

  • 2,447 questions across 203 private equity funds. Crowdsourced from over 500,000 mem.
  • 9 Detailed LBO Modeling Tests and 15+ hours of video solutions.
  • Trusted by over 1,000 aspiring private equity professionals just like you.

Comments (17)

Jan 26, 2019

What are your percentage interests? 50/50?
If so I'm reading pari-passu to 7% IRR + ROC, 75/25 to a 17%, and 90/10 over a 17%.

As a developer, I would kill to land a structure like that. I think your pref is far too low--as an LP I would want to see a 9-10%. Giving up 50% of your returns over a 12% IRR is crazy. If you are 50/50 on money in, I would again push for 60/40 or 65/35 above a 12%. That back end split is nuts though--very good for the developer. Again, if you are starting at 50/50, I think 70/30 or 75/25 is more appropriate. I would run returns around various scenarios.

Jan 26, 2019

In terms of cash invested? Probably 95/5.

I think anyone would kill for that as a developer. And I'm sensing that any LP would laugh that offer out of the room.

FMI, are you in real estate PE professionally?

They are targeting and have been hitting 30% ROE's, and if they hit that, it would be 12.2% to LP and 17.8% to GP. Uhhh, just me or is it crazy to have the GP take 62% of the cashflows??

I mean I am helping them raise funds, but I was thinking of coming back at them with something along the lines of "that's not going to fly with the people I'd intro you to, and if you can come back closer to
8% pref
-From 8-14% 70/30 LP/GP split
-After 14% 60/40 LP/GP split

If they are really confident about their returns and wanted to come back with something like this maybe it'd be entertainable, imho
8% pref
-From 8-14% 70/30 LP/GP split
-From 14-20% 60/40 LP/GP split
-After 20% 40/60 LP/GP split

But it sounds like I've gotten enough confirmation from here, and other forums that ppl are like "yeah thats way steep."

Jan 26, 2019

agreed - definitely isn't market for where we are now...maybe could have been passed off if the developer was institutional and the LP was a smaller shop who wanted the name brand in bed with them.

standard pref's now are more closer to 10%, 8% maybe if the deal is right. Return of equity hurdles are being played with mroe and more...in the sense that only a capital event can be used to return equity (i.e. a sale or refi)...meaning your pref never goes away during the deal hold. A lot of developers have been swallowing this.

the hurdles really just depend on what the trended yield on cost is coming in at, and what the deal is underwriting to depending on what type of debt is on the table. Hard to say what a reasonable hurdle is without that info. But even with that being said, "flipping" immediately after the ROE tier is pretty aggressive...and getting to a 90/10 split in a 3tier structure is pretty rich IMO. If I'm going to give a developer 90% of the cash flow for only putting up 5% of equity...it better be based off an IRR that is rich enough to essentially make me not care what the splits are...

Jan 26, 2019

If you are 95/5 percentage interests, there is no LP in the world that would give the developer 90% of the cash flows in the back end split. That's insane. I think 65/35 is seriously the best you offer up in the very last hurdle and taper your 2nd hurdle accordingly.

I failed to mention that a 5% development fee is the highest I've ever seen. Is that development fee AND GC fee combined (gross fee)? We charge 4% on total project costs less: fee itself and other G&A (depending on what our LPs permit us to include). Dev fee is guaranteed cash more or less, whereas the promote is not. If a developer is charging a high fee, they should take a hit on the waterfall, or vice versa (lower than market fee but better than market waterfall). Remember that you are paying 95% of his fee.

Also the levered IRR your capital source needs should drive the waterfall structure. Most of our LP's are trying to hit 16%+ LIRR over a 5 year window. 17% is preferred. The waterfall should ultimately be a factor of your target return. Sensitizing around the various deal-level inputs, and getting comfortable with your ability to achieve said target return, should provide direction as well.

Most Helpful
Jan 28, 2019

As others are saying, this is ludicrous. That is an enormous fee and that GP may as well ask you to make it an interest free, forgivable loan as to invest on those terms. Check the operating agreement to make sure you aren't also required to bend over and take a nice ass-fucking as long as they're giving you 3 days notice or something.

    • 9
Learn More

Side-by-side comparison of top modeling training courses + exclusive discount through WSO here.

Jan 26, 2019

If the LP is using WSO to gauge how market his term sheet is, the GP may not be as stupid as we make him out be...

Jan 26, 2019
cpgame:

If the LP is using WSO to gauge how market his term sheet is, the GP may not be as stupid as we make him out be...

The LP is definitely not. I am a friend of some LP's and the GP wanted me to propose that. FYI, my response was "there is no way I am presenting that, they will laugh at me and never talk to you again."

I'm just wondering whether anyone has really ever seen anything that audacious offered. It seemed incredibly insulting and just absurd, but I'm not in real estate PE, so I just wanted a final sanity check to make sure it wasn't just me thinking it was batshit crazy.

Jan 28, 2019

I actually thought about it a bit and I can imagine a couple scenarios in which this could maybe barely possibly pass the smell test.

For example, if I'm an LP looking to transfer my money out of another asset and need a 1031 option real quick, and you've got an unimpeachable asset with effectively no downside and limited upside, then I might take this deal if I have major decision rights. For example, buying PBS8 at a 7.50% cap or something like that.

I guess the point is that if I'm looking to shelter my money for the long term, and I'm making the "GP" come along for the ride in order to manage my asset for me for an indefinite period, then I might consider a deal where they get the rewards of an upfront fee (or more likely some kind of asset management fee) and mos of any possible market appreciation. IDK, there would have to be some kind of covenant by which I know they're managing the asset well... again, it would only be for a timing reason, because they had an asset that met my 1031 exchange deployment timeline, because otherwise I could obviously hold out for better term sheet.

Jan 30, 2019

Notwithstanding the foregoing, Sponsor shall have a continuous Right of First Refusal (the "ROFR") to deliver non-lubricated penetration of the Limited Partners, provided that Sponsor indicates an intent to elect the ROFR no fewer than three (3) business days prior.

    • 8
Jan 30, 2019
Ricky Rosay:

non-lubricated penetration of the Limited Partners

Quoting this for posterity

    • 2
Jan 26, 2019
Ricky Rosay:

Notwithstanding the foregoing, Sponsor shall have a continuous Right of First Refusal (the "ROFR") to deliver non-lubricated penetration of the Limited Partners, provided that Sponsor indicates an intent to elect the ROFR no fewer than three (3) business days prior.

HAHAHA. Good one.

Jan 28, 2019

If you find anyone to go along with this please send me over their details...I've some great business opportunities to discuss.

Jan 26, 2019
Capital360:

If you find anyone to go along with this please send me over their details...I've some great business opportunities to discuss.

Believe me, if I could find anyone who would take an offer half this aggressive, I'd sell them on a new dial up modem company that's about to launch.

I just am so baffled at what the GP proposed I'm almost looking for anyone who's even seen anything like this. WTF!! I'm so glad I asked them to show me their terms first.

Feb 2, 2019
basementflat02:
Capital360:

If you find anyone to go along with this please send me over their details...I've some great business opportunities to discuss.

Believe me, if I could find anyone who would take an offer half this aggressive, I'd sell them on a new dial up modem company that's about to launch.

I just am so baffled at what the GP proposed I'm almost looking for anyone who's even seen anything like this. WTF!! I'm so glad I asked them to show me their terms first.

I've seen GP get 60 and even 70 in the final tier, can't remember what the hurdle was though

Jan 26, 2019

I just posted my waterfall template as a post 'WSO Waterfall example'. In it I use a calculation based on the weighted average splits on a 90/10 deal. The idea is the formula auto updates based on the change in equity contribution. MAybe take a look, enter the equity you plan on using, and see how the splits in that model compare to what you are seeing. I can say those splits are from about 1-2B of executed MF development deals from institutional and well known smaller development shops...so probably a decent barometer of what's "market" as I just made it 2 months ago.

Feb 5, 2019

This is a joke if the equity split is typical (80%/20%, 90%/10%, or 95%/5%).

Typical structure is something like pari passu return of capital, 8-12% preferred return (pari passu or GP subordinated / cumulative and compounded monthly), 75%/25% CF distribution split up to a 15-20% project IRR, and 50%/50% CF distribution split thereafter. Preferred return and IRR will vary based on project risk.

We pay a 3% development fee on all development costs per the budget (we don't pay anything on cost overruns). 3-5% is a typical reasonable range dependent upon project complexity.

    • 1