So how does a waterfall work in a syndication or a fund? What
are the steps? What are the different kinds of things that
can go on, that's what we're gonna talk about.
Thought it'd be helpful to have a visual representation of what
exactly happens in a waterfall and how to think about it. That
makes it real clear, because it really isn't very complicated.
And but seeing it on paper sometimes can make all the
difference in the world. So let's go to the handy
whiteboard. So let's talk first about a direct investment deal
where we know what it is, let's say it's a piece of real estate.
Most of my clients are real estate, but we have a number of
private equity firms, hedge funds, businesses, all sorts of
other people that raise capital, but most are in real estate. So
let's stick with that. So we've got a piece of real estate
we have a piece of real estate, and let's say let's talk about a
capital event first. So capital event is when the property
sells. Yay, capital event. All right, so capital event occurs.
So money comes down. And it hits this pool, right? So there's a
big pool of money here. pool money pool. Alright, so there's
big money pool. And now out of this pool, first what has to
happen? So before you give any money back to your investors,
the next step that happens is expenses. These are expenses
that happened before so that we can end up with net profits at
the end, and that those net funds, so expenses, I mean, the
big one obviously would be something if it was real estate
is to pay back the loans, oh, my goodness. The other one, the one
that's matters most to you is payment of fees.
To you, Manager. Now, important side, note the payment of fees,
most of the time these fees portion is going to be treated
as income on your taxes. So keep that in mind when you're doing
your tax planning. So this happens first, right, so we pay
off those, we pay out all the expenses, the loan, the whatever
there is left, sometimes there's taxes, I've got other videos on
that. But most of the time, it's you know, you got to pay your
loans, you got to pay your fees, whatever else is owing, which
ends you up at the end of the day with your net proceeds.
So you've got your net proceeds that's supposed to look like $
sign, there you go. So you end up with your net proceeds now
from the net proceeds. This is where we really start thinking
about waterfalls. The most common first step out of the out
of a waterfall is a return of capital. This goes to your
investors. Right so that that money goes to your investors,
it's returning the amount of money that they have. So you're
probably paying out all those Class A units, that amount of
their initial capital contribution 99% of the time,
this is what what is in the operating agreement and the PPM
and it's described accordingly. So after Return of the capital,
what happens next? So a lot of times there'll be a step here,
that is the preferred return. So the preferred return let's say
it's 6%. That goes to the investors. Okay, this return of
capital here as long as it is a return of capital to your
investors is not taxed
as long as it's not at tax to the point of which is this their
basis, of course, cost segregation, other things like
that can adjust that but I just giving you that brief like idea
just so that you know. So your preferred return is coming to
your investors. Now the preferred return probably is
taxed, and it would be taxed as long as you've held the asset
for more than one The year it's going to be taxed your investors
as a capital gain after the payment of the preferred return,
sometimes and this isn't very common, especially in a real
estate deal, but it certainly does happen and maybe 20 to 30%
of the of the formations that are right the structures that
are right. And that is what's called a catch up. And that
catch up will be normally it will be to the whatever that
percentage is of the preferred return. And this gets paid to
manager. So that catch up to the manager is a amount of money
that is to bring them to this 6%. So what you're basically
saying is, okay, investor, here's all your money back, I'm
also going to give you a preferred return, which means
I'm going to make sure that you get 6% of your money back before
anybody else gets any money. And so we give you 6% of the money
back. But what that actually has done is it's decreased the size
of this pool here. It's decreased that size of the pool
such that now it's not in line with whatever buddy wouldn't
necessarily think it is. So you can do the preferred return as a
pure catch up of 6%, to the manager to make everybody fair,
but that alone would essentially be a 50/50 split, right? So that
first 12% of profits would basically be okay, we're going
to split that 12% 50/51, we're going to pay the investor, then
we're going to pay the manager. But that's probably not what
your investors are normally thinking that a catch up should
be. Because if you're doing, for example, an 80/20 split, maybe
it should be something different. Let's use a
different, different math here so that I don't have to do the
math. But let's say we do a catch up, up to an additional
say, say we're doing a split of 75. So that would be to the
manager, we do a catch up of hey, manager, we're gonna catch
you up a little bit because you didn't get to participate in
that first 6%. And so we're gonna give it make sure that you
get some profits, as you would expect from that next pool.
After this now we're in splitsville. So here, we might
say something like, okay, split, we're gonna give 80% Actually,
since we were doing 75, let's do, we're gonna give 75% to the
investor. And we're gonna give 25% to the manager. After, let's
say that we want to do a more complex waterfall than then
would be normal. So we're going to say, we're going to split
that pool of money, but we're not going to split all that
money, we're going to say, let's split the profits that way for
just the next up to 20% of profit. And then after that,
we're going to say, we're going to split the remaining profit
5050. And that's it. Right? So let's put some actual numbers to
it. I think that might be useful as well. So let's say at the end
of the day, our net proceeds equals $5 million. Right? And
for that 5 million, let's say our investors invested two and a
half million, so two and a half million goes into this category,
right? So that leaves us with an additional now we've got here
we'll write it here. So now we've got 2.5 million left to
divide. Right. Okay, so now we've got to make a division of
other preferred return. Typically, you'll do that
preferred return of 6% on the amount that they invested, which
works out fine here. So the next 150,000 goes to your investors,
which leaves us with 2 million 350. Right. Now we've got this
catch up piece here. And so that is equal to just an additional
35.25k. That leaves us with With 2,000,003 852 50. Okay, so now
we're going to divide that pool up, just up to 20%. And because
of my math, it's much easier to do this in Excel. I'm not going
to do that here. And let's just say, we're going to do this
simple waterfall here, because you'll get the point. So, so
we've got that admission additional to $2,385,250. So of
that, now, we give to the investor we're giving 1,000,007
88 937. And the remaining there we go. The manager gets
$596,313. Not bad, right? So the manager on this deal alone, just
from the capital transaction is made that 596313 plus the 35 to
50. Plus plus whatever amount that they made to in the in the
fees, which means that outside of fees, they've made a good
$631,000 So this is the way that a that a waterfall works. Now if
my name is Tilden Moschetti, I am a syndication attorney with
the Moschetti syndication Law Group. If we can help you put a
syndication or fund together, we'd be happy to talk about it.
We work exclusively under Regulation D Rule 506b or Rule
506c. That's what we do every day and make sure we can help
you be successful.