Waterfall structures in commercial real estate private equity deals can be complex. One element of a deal that can further complicate them is the structure of the sponsor’s General Partner (“GP”) co-investment relative to its limited partners (“LPs”) investments.
LPs can easily misinterpret cash flow splits and profit split between the GP and LPs and part of the reason for that is because profits in CRE private equity partnerships can be split in different ways. However, while the path to dividing up profits can be different, the final result may be very much the same in the end. Therefore, it is valuable for investors to understand the three most common organizational structures and how cash flows through them to gain clarity for GP vs. LP returns
In this article, we will walk through three different types of organizational structures and highlight how cash flow passes through them.
Structure 1: The Single LLC
The simplest structure that you will find in deals is one in which the GP forms a single LLC (commonly referred to as a Special Purpose Entity or “SPE”) and places all equity (an important distinction we will touch on below) into that entity, inclusive of its GP co-investment. From an organizational chart perspective, it looks like this:
In this structure, the GP or Sponsor contributes its co-investment into the same entity as all LPs. This is why you will often see the term “All Equity” applied to this structure because, in fact, all equity in the project is in the form of Class A membership of the a single LLC. In order to create the vehicle for receiving a disproportionate share of profits or a “promote” (for more information on promotes please see our previous article, “What is a Sponsor Promote?”), the sponsor will often create a Class B Member that it owns, whose purpose in the LLC is to receive the promote once earned. Typically, it will have a de minimis capitalization (perhaps $100).
Under this structure, it is easier for investors to understand cash flow splits since the sponsor’s co-investment is treated equally to LP equity since it is contributed into the same entity. Furthermore, the simplicity of creating a promote entity that is owned by the sponsor also helps to cleanly delineate what cash flows go to the sponsor as payment of its promote versus what cash flows go it as a co-investor in the deal.
Waterfall Example
Take for example, the following deal waterfall:
| First | An 8% preferred return to all equity |
| Second | A return of capital pro-rata to all equity |
| Third | Above the 8% preferred return and return of capital, then 80% of cash flow to Class A Members and 20% to the Class B Member until Class Members have earned a 17% cumulative internal rate of return (IRR) |
| Fourth | Above a 17% cumulative IRR earned by Class A Members, then 60% of cash flow to Class A Members and 40% to the Class B Member |
With this structure, it is easy for investors to see that profit splits are essentially, as advertised, due to the fact that the sponsor’s co-investment is contributed as a Class A Member. However, this structure is not always the case, which makes getting to an apples-to-apples form of comparison challenging for investors.
Structure 2: Sponsor Contribution as Class B Member
Sometimes a sponsor will contribute its co-investment into the Class B Member entity instead of contributing it alongside LPs as an additional Class A Member. From an organizational perspective, that structure looks like this:
The key distinction here is that the term “all equity” as a means to describe equal treatment of cash flow is no longer valid since we now have 90% of equity contributed as Class A Members and 10% of equity contributed as the Class B member with different treatment of those members. All equity is not treated equally and the differences will be noted in the waterfall structure.
Waterfall Example
If we adhere to the same treatment of cash flows as described above, namely a 20% true promote to the sponsor above an 8% preferred return to a 17% IRR and then a 40% promote to the sponsor above a 17% IRR, then we must revise the waterfall to read as follows:
| First | An 8% preferred return pro-rata to Class A Members and the Class B Member |
| Second | A return of capital pro-rata to Class A Members and the Class B Member |
| Third | Above the 8% preferred return and return of capital, then 70% of cash flow to Class A Members and 30% to the Class B Member until Class A Members have earned a 17% cumulative internal rate of return (IRR) |
| Fourth | Above a 17% cumulative IRR earned by Class A Members, then 50% of cash flow to Class A Members and 50% to the Class B Member |
In this waterfall structure there are two primary differences: 1) we must now give a portion of the preferred return and return of capital to the Class B Member because it is a co-investor and 2) we must increase the splits to the Class B Member to reflect the fact that the first 10% of cash flow above the preferred return is simply the Class B Member’s pro-rata share of equity – it’s only above 10% that a true promote is actually earned. Hence the need to set the splits at 30% and 50% respectively.
The key takeaway in this structure is that we refer to these splits as a cash flow waterfall rather than a promote waterfall. Only after you account for the 10% Class B Member co-investment do you get to the promote. This aspect of the structure can be confusing to investors and lead them to believe that promote is larger than it actually is. As a final note on this structure, the control provisions of Class A Members and Class B Members are encased within the LLC Agreement. This is still a matter of two share classes within the same entity.
Structure 3: The JV LLC
The final structure we discuss in this article is the JV LLC structure. From a cashflow perspective, it is nearly identical to the Class B co-investment contribution structure outlined above but with the following changes:
This structure employs a total of three LLCs with a JV LLC taking title to the property.
- The GP and LP each join the JV LLC via its own LLC. LPs are now housed in their own distinct LLC.
- All control provisions between GP’s and LP’s are now encased in the JV LLC Agreement. There are no longer Class A or Class B Members.
Waterfall Example
As mentioned above, the waterfall of the JV LLC structure is similar to the Class B co-investment structure. We simply need to address the structure correctly in the waterfall:
| First | An 8% preferred return pro-rata to the LP LLC and the GP LLC |
| Second | A return of capital pro-rata to the LP LLC and the GP LLC |
| Third | Above the 8% preferred return and return of capital, then 70% of cash flow to the LP LLC and 30% to the GP LLC until the LP LLC has earned a 17% cumulative internal rate of return (IRR) |
| Fourth | Above a 17% cumulative IRR earned by the LP LLC, then 50% of cash flow to the LP LLC and 50% to the GP LLC |
Investors may wonder why the JV LLC structure would be employed over either the previous two structures? The answer is that it is a more formal structure that keeps the GP and LP in their own entities and does not co-mingle them as members of the same entity. An entity has a Manager and that Manager has powers. If the LP wants more control of the deal and does not want to allow the GP to be the Manager of the controlling entity then the JV LLC structure is superior.
This is why JV LLC structures are typically utilized in scenarios where an operator has an institutional capital provider as an LP. The institutional LP is willing to give day-to-day authority to the GP but it is usually unwilling to give it sole discretion over major decisions such as when and for how much to sell the asset or if the entity can declare bankruptcy. The JV LLC structure addresses a sharing of control better than a single LLC structure which, in contrast, vests the GP with more power and major decisions being either a) at the discretion of the GP or b) subject to a vote of all equity partners.
Tips to Remember:
- In true promote scenarios the sponsor’s equity is a part of all equity. In a waterfall structure, it will say that all equity gets an equal X% return of capital to a certain specified level, and then once a hurdle is achieved the sponsor/general partner/manager will receive Y% and limited partners Z% of profits.
- In some cases, a sponsor/general partner/manager is contributed as a separate class of shares than LP equity. In that scenario, the offering will be structured as a split of cash flows and keep in mind that you must deduct the percentage of the sponsor’s co-investment to derive the true promote.
- In a JV LLC, the treatment of cash flows is similar to that of the sponsor’s equity being contributed as a separate class of shares. The GP and LP equity are now in distinct entities and the JV LLC Agreement dictates how cash flow is divided between the two entities as well as how control is allocated.
The Takeaway
The difference between cash flow splits versus true promotes is a topic that often raises questions for retail investors, and for good reason. Most sponsors do a good job of outlining waterfall structures in offering documents. That said, sometimes sponsors think investors understand waterfall structures as well as they do, which in actuality, is rarely the case. As a result, unwinding exactly how much a sponsor gets paid, how, when and why can, at times, be confusing and easily misconstrued. By better understanding how a true promote on all equity differs from a split of cash flows when the sponsor co-investment is contributed via a separate class of shares or entity, investors can quickly discern true promotes in any of the three scenarios.
The CrowdStreet Marketplace will always reference the true promote since that is the percentage of profits that are paid to the sponsor above each hurdle. Whenever a sponsor uses a cash flow split, CrowdStreet makes a point of identifying the cash flow split (e.g. 60% / 40%) but then also showing the true promote percentage (e.g. 70% / 30% assuming a 10% sponsor co-investment).
