When evaluating a private real estate offering, an investor should take a detailed look into the investment return structure, or how the investors share in the profits of an investment relative to how the deal sponsor or operator shares in those same profits.

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Should the European Equity Waterfall be the new standard?

By Jorjio Hopkins, Associate, MLG Capital

When evaluating a private real estate offering, an investor should take a detailed look into the investment return structure, or in other words, how you, the investor, gets paid. Alternative investments in real estate typically compensate the General Partner, sponsor or manager (like us, MLG Capital) in a form of profit participation, called a “promote”. Limited partners, (you, the investors) are typically compensated by a preferred return and a share in profits.

As seen throughout the private real estate industry, return structures for investors can vary but are typically set up in two ways: American waterfall structure and European waterfall structure.

What do these mean to you as an investor? How is the investment manager getting paid? Great questions. First, let’s define the basic stages of these waterfall structures.

PREFERRED RETURNS

Not all managers offer a preferred return (pref), but as an investor, investing in an asset with a preferred return is generally considered to be in your best interest. Pref is a return-on-investment that a private offering distributes to investors out of cash flow.

The preferred return is generally paid to investors first, before a manager shares in the profits or “promote” of an investment. Most managers offering pref will provide investors between 5-8%. Pref can be cumulative, followed by an equity split.

For example, you might come across an offering that provides investors with 6% pref, and a 60/40 promote or profit split to investors/sponsors, respectively.

PROFIT or PROMOTE SPLITS

So, why do the sponsors receive a share of the profits? This is a great question.

Sponsors often rifle through dozens of potential deals and put in hundreds of hours of analysis and research just to secure one deal in preparation of a private offering for their investors. This hard work deserves some level of compensation. Especially, when it comes to the ongoing management of the investment. However, the level of compensation should absolutely be reasonable and aligned between sponsors and investors.

How do investment managers earn their “promotes” or share of profits? Waterfall structures. The two most common are:

AMERICAN EQUITY WATERFALL

The American equity waterfall has two tiers of returns. First, providing investors with a preferred return, then a profit split. Early on, the profit split percentages would favor investors. After meeting certain thresholds, the percentages shift, and profits would flow more heavily towards sponsors. Here’s the kicker: within these structures, the sponsors participate in the profits early in the life cycle of an investment, and, at times, before investors receive a return of all their original capital.

EUROPEAN EQUITY WATERFALL

The European equity waterfall has three tiers of returns. First, it provides investors with a preferred return, followed by a return of 100% of their invested capital. As an investor, the return of your invested capital first is the key difference between the American and European equity waterfalls. Finally, there’s a share of the additional profits split between investors and sponsors.

Why the European Equity Waterfall is better than the American Equity Waterfall

For example, MLG Capital typically offers investors an 8% cumulative preferred return on their invested capital. After this pref is paid, we continue to distribute 100% of the cash flows to investors until every investor has received 100% of their original capital contributions back. Then and only then, do we participate in the upside with a 70/30 split.

Every additional dollar of profit goes 70% to investors and 30% to MLG. MLG is rewarded on the backend for the years and years of hard work and successful execution of investment business plans for all assets held.  The 70/30 equity split is held throughout the remaining life of the investment and does not increase in MLG’s favor even as higher and higher investment returns are generated.

Ultimately, we view the European equity waterfall as the industry gold standard for showing alignment of interest between managers and investors.

 

Jorjio Hopkins is an Associate at MLG Capital, with a master’s in real estate and passion for service. He served for a number of years as a Marine Corps officer and as a dance lead for his high school show choir. Connect with Jorjio on LinkedIn. Or, if you’re an accredited investor, invest with us.

 

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