Waterfall/Promote Nuance

1st Year Associate in Real Estate - Commercial

Hey WSO - I'm spending some time learning how to model waterfalls and I have come across two different approaches for calculating LP interest per tier/hurdle based on various promote %'s.

Can someone help explain the difference between the below examples?

Example A:
Assume 90%/10% LP/GP Split
Tier 1: Pro-rata up to some preferred return
Tier 2: 10% Promote up to X% IRR
LP Interest in Tier 2 = (90% - 10%) = 80%, such that 80% is used in the MIN/MAX function for the LP's distribution at the respective tier

Example B:
Assume 90%/10% LP/GP Split
Tier 1: Pro-rata up to some preferred return
Tier 2: 10% Promote up to X% IRR
LP Interest in Tier 2 = 1-([GP's Initial 10%]+[LP's Initial 90%]*10%) = 72%, such that 72% is used in the MIN/MAX function for the LP's distribution at the respective tier

Thank you!

Comments (6)

Most Helpful
Sep 9, 2019

The correct methodology for promoted interest is shown below. Alternatively, what we do is utilize a simple cash flow split so there is no confusion about profit CF distributions.

Promote:
Tier 1: 90%/10% LP/GP pari passu Capital Return and Preferred Return CF distribution
Tier 2 (1): (90%-(90%*10%)) = 81%/19% LP/GP CF split up to X% IRR

(1) LP is promoted 10% of all cash flows after pari passu Capital Return and Preferred Return up to X% IRR meaning the LP gives 10% of 90% (9%) of their base capital split to GP

CF Split
Tier 1: 90%/10% LP/GP pari passu Capital Return and Preferred Return CF distribution
Tier 2: 80%/20% LP/GP CF split up to X% IRR

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  • 1st Year Associate in Real Estate - Commercial
Sep 10, 2019

Isn't the GP promoted such that LP gives 10% of their 90% interest (9%) to the GP?

Sep 10, 2019
1st Year Associate in Real Estate - Commercial :

Isn't the GP promoted such that LP gives 10% of their 90% interest (9%) to the GP?

So that the GP is contributing essentially 1% of the equity? Doubtful. @InVinoVeritas has it right. Technically you can structure a promote waterfall however you want, but that is the most common way by far, in my experience.

Sep 10, 2019

No, the LP is the one "promoted" despite that this sounds counter-intuitive. This has been confirmed repeatedly by seasoned MD's in the industry. If you read my reply you can see that LP gives 9% of their base pari passu cash flow split to GP in Tier 2.

Sep 10, 2019

Yeah I always find it helpful to think of it as the more formal "promoted interest" rather than a simple promote. As in, the interest is being promoted off of the LP. Makes it slightly less confusing.

Sep 10, 2019
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