Waterfall Tab

Article Contents

• Introduction to Waterfall Modeling
• Waterfall Tab Overview
• Fees (Paid to GP)
• Analysis Timing
• Waterfall Terms
• Warnings
• Return Summary
• Detailed Calculations
• Waterfall Examples
  • • Example 1: Two Entity Structure
    • Example 2: Three Entity Structure - No Catch-up
    • Example 3: Three Entity Structure - with Catch-up

Introduction to Waterfall Modeling

An investment waterfall is a method of splitting profits among partners in an equity transaction where the distribution of profits is uneven. The waterfall analogy represents the idea that profits fill up one pool and the excess spills into the next pool.

The benefit of waterfall modeling is the incentive to the operating partner. The operating partner (also known as the General Partner or Sponsor) will receive an extra, disproportionate share of returns (called the “promote”) if they exceed return expectations from the deal. Conversely, if the returns are lower than expected, the operating partner receives less.

Key Terms in Waterfall Modeling

General Partner / Sponsor – operating partner who manages the capital of the limited partners and has control of project decisions to drive investment return

Limited Partner / Investor – investors who provide capital to fund a project

Preferred Return – minimum return paid to the limited partners before the GP receives profits

Promote – increased share of the return given to the General Partner for exceeding return expectations

Return Hurdle – minimum rate of return required to achieve a specific compensation level. Waterfall investments typically have multiple tiers each with higher return hurdles and different compensation splits between partners.

Catch-up Hurdle – Once the preferred return hurdle (investor expected returns) is met, the GP / Sponsor receives all future profits until the GP catches up to the agreed upon percentage of amounts distributed to date.

Compounding – process of reinvesting earnings to generate additional earnings over time

Distribution – disbursement of earnings/profits to partners in a transaction

Waterfall Tab Overview

The rDCF Waterfall tab allows the user to enter a total of three partnership entities: Limited Partner 1, Limited Partner 2, and General Partner 1. Each entity can be subject to a combination of four Return Hurdles (tiers) as well as three optional Catch-Up Hurdles each with a specific set of inputs that accommodates a wide range of partnership structures.

The Waterfall tab uses monthly cash flows from Monthly CF (Lev) tab to create the initial Property Cash Flow that defines the profits and distributions.

At the top of the Waterfall tab there are three boxes for user inputs: Fees, Analysis Timing, and Waterfall Terms, and one Warnings indicator field, as well as a Return Summary box displaying calculated results. The bottom half contains calculated results in four sections: (1) Cash Flows & Fees, (2) Summary Distributions, (3) Detailed Distributions, and (4) Waterfall Calculation.

Note: the above example uses the Debt Inputs Example 1 as the starting point for the Waterfall model. 

Each box of user inputs is described below.

Fees (Paid to GP)

Input Field Category /  Name	Input Options	Description	Impact on Model
Asset Management Fee	% and drop down	Annual asset management Fee starting in Period 1 through sale date. Input percentage and choose from: (1) % of Purchase Price, (2) % of EGR, (3) % of NOI, or (4) % of Initial Equity.	Decreases the Fund Cash Flows After Fees
Acquisition Fee	% Entered as xx.xx	Upfront fee in Period 0. Enter as a Percent of the Purchase Price.	Decreases the Fund Cash Flows After Fees
Debt Fee (Initial)	% Entered as xx.xx	Upfront fee in Period 0. Enter as a Percent of the Initial Debt (Loans 1 and 2)	Decreases the Fund Cash Flows After Fees
Debt Fee (Refi)	% Entered as xx.xx	Fee occurs at the time of Refinance. Enter as a Percent of the Refinance Debt (Loan 3).	Decreases the Fund Cash Flows After Fees
Disposition Fee	% Entered as xx.xx	Fee occurs at the time of Sale. Enter as a Percent of the Gross Sale Price.	Decreases the Fund Cash Flows After Fees
Construction Fee	% Entered as xx.xx	Fee occurs as Capital Expenditures are realized. Enter as a Percent of any Capital Improvements (Excludes TIs and LCs).	Decreases the Fund Cash Flows After Fees
Tenant Improvement Fee	% Entered as xx.xx	Fee occurs as Tenant Improvement Costs are realized. Enter as a Percent of any Tenant Improvements.	Decreases the Fund Cash Flows After Fees
Leasing Commission Fee	% Entered as xx.xx	Fee occurs as Leasing Commission Costs are realized. Enter as a Percent of any Leasing Commissions.	Decreases the Fund Cash Flows After Fees

Analysis Timing

The Analysis Timing input box references the analysis start date and the hold period from the Unleveraged Cash Flow worksheet.

Input Field Category /  Name	Input Options	Description	Impact on Model
Distribution Period	Drop down	Selection establishes how the Partner Cash Flows will be presented, but more importantly, also determines how the IRRs are calculated in the Waterfall worksheet. Options are 1) Monthly, 2) Quarterly, or 3) Annually	See notes for Waterfall Terms – Compounding below for more information regarding the impact of this selection.

Waterfall Terms

The Waterfall Terms inputs are broken into eight sections. The first contains the Entity Names, Equity Percentages and corresponding Equity Amounts. The remaining seven sections contain inputs for each Waterfall Tier or Catch-up Level.

Input Field Category /  Name	Input Options	Description	Impact on Model
Entity Names	Text	Enter names for the three partnership entities: Limited Partner 1, Limited Partner 2, and General Partner. Note: Limited Partner 2 is assumed to be associated with the GP.	Does not affect financial results
Equity %	% Entered as xx.xx	Enter the desired percent of Equity for each LP Entity. If less than 100% of the equity is split between the LP entities, the remainder will be allocated to the GP entity.	Affects the Detailed Distributions to each partner for Tier 1.
Tiers, Catch-Up Levels, and Remainder
Apply Hurdle (row)	Drop Down	Yes – select for as many hurdles as are needed to model the waterfall. Selecting “Yes” opens subsequent input fields for modeling the Tier or Catch-Up level. No - section will be grayed out; any inputs for that tier or catch-up will not be applied in the calculations. Tier 1 is assumed active and set to “Yes.”	Affects distribution of cash flow (Detailed Distributions) after all prior hurdles are achieved.
Compounding Applies to Tiers Only	Drop Down	For Tiers 1, 2 and 3, select from three compounding intervals: Monthly, Quarterly, or Annually. This is different from the “Distribution Period” in the Analysis Timing input box. The compounding input is specific to the Return Rate for a tier as determined by the partnership agreement. For example, a partnership agreement may indicate a cash flow split of 75% up to an 8.0% IRR on a Monthly Compounded basis. Select Monthly compounding in this case Note: Compounding is only available for Tiers, not the Catch-Up levels or Remainder. *See note below	Compounding selection will affect IRR and Profits. Compounding will affect each Tier’s return but will not affect the Catch-up Distribution. *See note below
LP Preferred Return		Yes - Return Hurdle for Tier 1 will be paid to LP Entities before it is paid to the GP Entity. Note: This option is only available (1) if the GP Entity is assumed to contribute equity (if GP Equity % = 0 then the LP Preferred Return field is hidden); (2) for Tier 1 returns. All other Tiers are assumed to be pari passu.	Affects Detailed Distributions to each partner
Return Hurdle		For Tiers 1, 2 and 3, enter the percent return for the LP 1 Entity as applicable. The LP 2 Return Hurdle is assumed to be the same.	Affects Detailed Distributions to each partner
Cash Flow Split Applies to Tiers Only		For Tier 1, the Cash Flow Split is the same as the initial Equity Percentages. For Tiers 2, 3 and Remainder, enter the percent of cash flow to be allocated to the GP Entity. The remaining percent of cash flow is applied to the LP Entities based their initial Equity Percent. For all Tiers, once the LP 1 Entity achieves the desired Return Hurdle Rate, calculations move to the next Tier or Catch-Up Level.	Affects Detailed Distributions to each partner
Catch-Up Hurdle		For Catch-Up 1, 2, 3, enter the percent of Total Profit that is to be accumulated by the GP Entity as applicable. The percent of Total Profit means Distributed Profit up to that point and does not include any cash flow that may be distributed in subsequent calculations	Affects Detailed Distributions to each partner
Cash Flow Split Applies to Catch-up		For Catch-Up 1, 2, 3, enter the percent of cash flow to be distributed to the GP until the Catch-Up Hurdle has been achieved.	Affects Detailed Distributions to each partner

Note: Compounding - Selecting different Compounding Intervals produces different Annual IRRs for the same Rate of Return and, therefore, affects the return calculations. For example:

Rate of Return	Compounding Interval	Resulting Annual IRR
10.00%	Annual	10.00%
10.00%	Quarterly	10.38%
10.00%	Monthly	10.47%

When the Distribution Period is less frequent than Compounding, returns will be compounded over the distribution period. Thus, the returns in each period will be higher than the rates of return entered.

Warnings

The Warnings field provides the user with two warning messages:

1. The first indicates that the Return Hurdle rate in Tier 2 is less than the actual IRR achieved in the Catch-up Level 1 distribution.
2. The other indicates that the Return Hurdle in Tier 3 is less than the actual IRR achieved in the Catch-up Level 2 distribution.

These warning messages do not indicate the model is malfunctioning. Rather they indicate that subsequent Return thresholds are too low compared to previous distributions. The Tier 2 and/or Tier 3 distributions will be negative in order to achieve the desired Hurdle Rates.

Return Summary

The Return Summary box presents calculated returns at the Project, LP and GP levels displaying Initial Investment, Total Profit and IRR for the Waterfall analysis period with or without fees, or for any tier, as selected by the user. The default is to display the Return Summary for Total Returns with Fees.

Detailed Calculations

Below the Waterfall Terms section, you will find Fund Cash Flows, Summary Distribution and Detailed Distribution calculations based on the Distribution Period selected in the Analysis Timing box. Below the Detailed Distributions you will find the Waterfall Calculations by Tier and LP / GP in gray rows detailing the beginning and ending capital balances for each period with the detailed paid preferences and capital contributions and distributions. Samples are shown below.

Note: Waterfall Calculations displayed above are for Tier 1 and Catch-up Level 1 only. All tiers are shown in the Underwriting Workbook.

Waterfall Examples

Example 1: Two Entity Structure

JV Partner is ABC Fund that contributes 75% of the Equity, XYZ Company is the GP contributing 25% of the Equity. Initial Equity for project is $10 million.

Cash Distributions

1. The JV Partner will receive a 10% annual return compounded monthly and the return of equity; then
2. The GP will receive a 10% annual return compounded monthly and their return of equity; then
3. The JV Partner and GP will split remaining cash 70%/ 30% until the JV Partner achieves a 15.0% annual IRR; then
4. The JV Partner and GP will split remaining cash 60%/ 40% until the JV Partner achieves a 20.0% annual IRR; then
5. The JV Partner and GP will split remaining cash 50%/ 50%.

The screenshots below represent the inputs for this example. Since there are no Catch-Up provisions in the agreement, we have not applied the Hurdle and those sections are grayed out. Due to the Cash Distribution verbiage, it was assumed that the LP 1 Entity’s 10% return was Preferred.

Example 2: Three Entity Structure - No Catch-up

JV Partner is ABC Fund that contributes 75% of the Equity, XYZ Company is the LP and GP. XYZ Company - LP contributes 25% of the Equity. Initial Equity for project is $10 million.

Cash Distributions

1. The limited partners receive a 12% annual return compounded quarterly and the return of equity; then
2. The XYZ Company LP and GP will split remaining cash 70%/ 30% until the ABC Fund achieves an 18.0% annual IRR; then
3. The LP and GP will split remaining cash 50%/ 50%.

The screenshots below represent the inputs for partnership model with three entities, two LPs and one GP. The GP is separated from the LP to isolate the “Promote”. Since there are no Catch-Up provisions in the agreement, we have not applied the catch-up hurdle and those sections are grayed out. Additionally, the Tier 3 calculations were not applied since they were not applicable to this structure.

 

Example 3: Three Entity Structure - with Catch-up

JV Partner is ABC Fund that contributes 75% of the Equity, XYZ Company is the LP and GP. XYZ Company - LP contributes 25% of the Equity. Initial Equity for project is $10 million.

Cash Distributions

1. The Limited Partners receive a 10% annual return compounded quarterly and the return of equity; then
2. The LP and GP will split remaining cash 70%/ 30% until the LP 1 Entity achieves an 15.0% annual IRR; then
3. The LP and GP will split remaining cash 60%/ 40% until the GP Entity receives 20.0% total profits (Catch-up"); then
4. The LP and GP will split remaining cash 50%/ 50%.

The screenshots below represent the inputs for partnership model with three entities, two LPs and on GP.

Waterfall Tab Conclusion

The UW Waterfall Tab allows you to model sophisticated equity structures, including multi-tiered waterfalls and fees while leveraging your underwriting data. The power of the UW lies in the ability to flex all aspects of the transaction in one model: the cash flow and valuation, the debt financing and the equity structure.