An IRR waterfall is a commonly used method to distribute returns in real estate investments between General Partners (GPs) and Limited Partners (LPs). In short, it outlines how profits from the investment will be shared between these two groups in a structured way.
This article will explain how an IRR waterfall works and how it can benefit both GPs and LPs in a real estate investment.
What is an IRR Waterfall?
An IRR (Internal Rate of Return) waterfall is a distribution method that outlines how profits will be divided among the GP and LPs in a real estate investment. The waterfall is designed to incentivize the GP to perform well by giving them a more significant share of profits once specific performance benchmarks have been reached.
The waterfall is based on a tiered structure where different return rates trigger different levels of profit sharing between the GP and LPs. The system usually includes three tiers, but it can be more or less depending on the complexity of the investment.
The three tiers of an IRR waterfall are:
Preferred Return Tier
Catch-up Tier
GP Promote Tier
The Preferred Return Tier
The first tier of an IRR waterfall is the preferred return tier. This tier is designed to ensure that the LPs receive a minimum return on their investment before any significant profits are shared with the GP.
Typically, the preferred return is set at around 8-10%, which is paid to the LPs first. Once this desired return has been achieved, the profits are split between the GP and LPs according to a predetermined ratio.
For example, let's say that the investment generates a 12% return. The preferred return of 8% is paid to the LPs, and the remaining 4% is split between the GP and LPs in a pre-determined ratio; for example, it may be around 80/20 in favor of the LPs.
Catch-Up Tier
The second tier of the IRR waterfall is the catch-up tier. This tier is designed to give the GP a more significant share of profits once the investment has surpassed the preferred return.
The catch-up tier allows the GP to "catch up" to the LPs and receive a larger share of profits until the GP has received a predetermined percentage of the profits. This percentage can vary depending on the terms of the investment.
For example, let's say that the investment generates a 15% return. The preferred return of 8% is paid to the LPs, and the remaining 7% is split between the GP and LPs in a pre-determined ratio, usually around 70/30 in favor of the LPs until the GP has received a predetermined percentage of the profits.
GP Promote Tier
The third and final tier of the IRR waterfall is the GP promote tier. This tier is designed to give the GP an even larger share of the profits once the investment has exceeded specific performance benchmarks.
The GP promote tier usually applies once the investment has achieved a certain IRR threshold, such as 15-20%. At this point, the GP will receive a more significant share of profits, usually around 30-40% of the total profits.
For example, let's say that the investment generates a 25% return. The preferred return of 8% is paid to the LPs; the remaining 17% is split between the GP and LPs in a pre-determined ratio, usually around 60/40, in favor of the LPs. Any additional profits above the predetermined threshold would be split 70/30 in favor of the GP.
Benefits for Limited Partners
An IRR waterfall structure can provide several benefits for Limited Partners (LPs) in a real estate investment. Here are some of the ways that an IRR waterfall can benefit LPs:
Protection of Capital: The preferred return tier of the IRR waterfall provides LPs with a minimum return on their investment, ensuring that they receive their capital back plus an agreed-upon rate of return before the GP receives any profits. This protects the LPs from losses and provides them with a predictable return on their investment.
Aligning Interests: The IRR waterfall structure aligns the interests of the GP and LPs by incentivizing the GP to achieve a higher return on the investment. The GP only receives additional profits after the LPs have received their preferred return, encouraging the GP to work hard to achieve a higher return on the investment.
Greater Transparency: The IRR waterfall structure provides greater transparency to LPs about how profits are distributed between the GP and LPs. The structure outlines the percentage of profits that the GP and LPs receive at each investment stage. It provides LPs with a clear understanding of the investment's profitability and how their returns are calculated.
Higher Returns: The catch-up and GP promote tiers of the IRR waterfall can provide LPs with the potential for higher returns on their investment. Once the investment surpasses the preferred return tier, LPs receive a higher percentage of the profits until the GP has caught up to them. After that point, the GP gets a larger percentage of profits, but the LPs still receive a significant share of any additional returns above the IRR threshold. This can result in higher overall returns for LPs.
Overall, an IRR waterfall can provide LPs with several benefits in a real estate investment. It offers greater transparency, aligns interests between the GP and LPs, protects the LPs' capital, incentivizes performance from the GP, and can potentially result in higher overall returns for the LPs. As such, the IRR waterfall is a popular method for structuring real estate investments and is often used in private equity and real estate investment trusts.
* All figures in this article are example structures only and do not reflect actual structured deals provided by Above 8 Capital LLC.
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