All About Equity Waterfalls, Part 2

By Jay Maddox, Principal, Avison Young

The first part of this two-part series provided a general overview of the “equity waterfall,” which included the key components of a typical profit sharing arrangement for a real estate joint venture equity investment. Part two addresses some of the key structural elements and the trade-offs for both investors and developer/sponsors. 

Roles of JV Partners

In a typical real estate joint venture, the passive investor is a limited partner or LLC member that puts up the majority of the equity and looks to recover that capital plus a minimum threshold return on a priority basis. The developer/sponsor—typically in a general partner position—is responsible for all operational aspects of the project, and receives a disproportionate share of cash distributions (the “promote”) once the investor’s minimum return threshold is met. The developer is also responsible for providing any required loan guaranties, and earns acquisition and development fees that are paid out of cash flow prior to debt service and investor distributions.

JV Operating Agreement

The joint venture operating agreement spells out the responsibilities, rights and remedies of the partners, as well as the elements of the waterfall structure. Major decisions on the project will require consent of the limited partner. The agreement usually includes provisions on complex matters such as resolving partner disputes, funding of project cost over-runs, and buy-out or buy-sell provisions designed to address situations in which one partner desires to sell its interest or buy out the other partners.

Minimum Return Hurdles

Waterfall structures vary widely with no one-size-fits-all structure. The waterfall is intended to provide the developer/sponsor incentive to maximize returns for the limited partners, and it will typically include several return hurdles that, once satisfied, enable the developer/sponsor to earn an increased promote. For example, the developer may earn 50 percent of profits before the hurdle is met, then 70 percent above that hurdle. These return hurdles are usually defined as a specified minimum internal rate of return (IRR) or multiple of equity (MOC), and are both calculated over the duration of the investment. In a typical development joint venture, the IRR hurdle can be 15 percent or higher, or the MOC can be 1.5x or higher. In most cases only one of these hurdles is utilized.

Make-Whole Provisions

Some waterfall structures include make-whole provisions that are intended to ensure the limited partner receives a minimum pre-determined IRR or MOC. A “look back” provision at the end of the deal requires the developer/sponsor to give up a portion of its previously collected profits in order to meet the investor’s minimum hurdle. A more common “catch up” provision permits the investor to collect 100 percent of profit distributions until its investment hurdle is achieved.

These make-whole provisions may seem reasonable when the deal is first cut, but can end up being especially burdensome for the developer. The IRR hurdle can consume the developer/sponsor’s promote entirely if the project is not completed in the early years. On the other hand, the MOC target is generally easier to achieve if the project is held for a longer term, and depending upon the circumstances, may be the less burdensome option of the two.

Profit distribution waterfalls and joint venture structures are among the most complex and customized investments in commercial real estate. Participants would be wise to consult with experts when negotiating and documenting such transactions.