Places Of Interest

Explaining The Effects of a Waterfall Model with Multiple IRR Hurdles

This is all about financial incentives. Everyone wants to make the best returns possible over time. The best measure of that is IRR or internal rate of return. This model shows and explains the way this is done so that a joint venture real estate deal with investors and sponsors results in an equitable and max profit focused result.

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I would suggest you watch the entire video in order to gain a full understanding of what is going on.

The goal of a promotion based model is to give the sponsor a reason to maximize returns for investors. It can be done in a fair way by using the logic here within.

What happens is the cash flow returned to investors (based on the initial % splits, often called the preferred return) will be measured each new month. As soon as the total cash flows result in an IRR for the investor that is past the defined preferred return hurdle, there is a change in the share of profit between the sponsor and investors. If the preferred return is never met, there is never a change in the % share and it could mean the sponsor gets no share of the profits depending on how the hurdles are set up.

The change in share will be in favor of the sponsor for each new hurdle that is reached for the investor. What ends up happening is that the sponsor wants to achieve the highest possible IRR to the investor so that the sponsor can earn a higher share of profits themselves. The splits / promotes / hurdle rates are all pre-defined before the deal happens so everyone knows what 'should' happen in different scenarios of cash flow made by the project.

Having 2 or 3 hurdles is fairly common and often times the result is to split cash flows 50/50 after the final hurdle is surpassed. This is assuming the sponsor's share is below 50% up to that point.

The 'waterfall' name comes from how the cash is split between the hurdles. It is similar to how you pay taxes. The first x\$ made is taxed at a certain rate. Any earnings past that bracket the cash is taxed at a new rate and so on. This is very similar to what is happening in a real estate waterfall model with IRR hurdles. Each hurdle splits the cash that was generated within that IRR range at a given rate for the sponsor and investor. The rate that each gets is based on the promote schedule.

Let's say that there are 2 hurdles. The first is 10% and the second is 15%. What that means is the cash earned to result in an IRR to date of less than 10% will be split based on the initial preferred return or whatever you start the cash flow splits at in the beginning.

Then, any cash distributed to investors that results in their total IRR being between 10% and 15% is split to sponsors and investors based on the rate defined for that hurdle. Then, any cash flows the result in an IRR for the investor that is over 15% results in those cash flows to be split by whatever is defined after 15%.

Over the course of 10 years, the share of profits between sponsors and investors is likely to change based on the results of the cash flow.

This is often applied to real estate deals because they have regular monthly cash flows but it could apply to other situations that distribute regular cash flows.

The nice thing about using this method is that there is no going back to figure out the returns in the past. You don't have to wait until the entire deal is done to know what the cash flows should be. You will know at the end of every month, assuming there were no errors in calculating what the average cash flow to distribute is and the historical cash flows.