Reading a waterfall before you agree to it

A deal summary says the split is eighty-twenty in favour of investors. It sounds settled. It is actually the last line of a sequence, and the lines above it decide how much reaches that split at all.

The sequence is called a waterfall, because money fills one level before spilling into the next.

A common arrangement runs in four steps. Return of capital first, meaning investors get their original money back. Then the preferred return, a stated annual rate paid to investors before the sponsor shares in profit. Then a catch-up, where the sponsor receives a run of profit to bring their share up to the agreed ratio. Then the residual split, the eighty-twenty that was in the headline.

Numbers make the shape clear. This is an illustration, not a real transaction. Investors put in $3,000,000. The preferred return is eight percent. The hold is three years and the property sells, leaving $4,500,000 to distribute.

Return of capital takes $3,000,000, leaving $1,500,000. The preference is eight percent of $3,000,000, which is $240,000 a year, and across three years that is $720,000. Now $780,000 remains. Split eighty-twenty, investors take $624,000 and the sponsor takes $156,000.

Add it up. Investors receive $3,000,000 plus $720,000 plus $624,000, which is $4,344,000. The sponsor receives $156,000. On the total profit of $1,500,000, the sponsor's share is about ten percent, not twenty.

Now change one thing. Add a catch-up tier that pays the sponsor until they have received twenty percent of all profit above the return of capital. Twenty percent of $1,500,000 is $300,000. The sponsor now takes $300,000 instead of $156,000, and investors take $1,200,000 instead of $1,344,000. The headline split did not change. The answer moved by $144,000.

Two structural details decide a great deal. Whether the preference compounds, meaning unpaid preference accrues and grows rather than simply waiting. And whether it is cumulative, meaning a year that pays nothing still adds to what must be paid later. A non-cumulative preference in a weak year is a year the sponsor never has to make up.

There is also the question of what the percentages are measured against. A split applied to profit after return of capital is a different instrument from a split applied to every dollar distributed.

Three questions for the sponsor. Is the preferred return cumulative, and does it compound? Is there a catch-up tier, and at what rate does it pay? Can you walk me through the distribution in a case where the property sells for exactly what we paid for it?

The last question is the one that reveals the most, because it has no upside to hide behind.

In the structure you were last shown, at what sale price does the sponsor start earning more than a fee?