Equity Waterfall
Also called: Distribution waterfall, Promote structure, Carried interest
An equity waterfall is the contractual sequence of tiers that determines how a real estate deal's cash flow is split between limited partners and the general partner as return thresholds are met.
A waterfall converts a single pool of profit into a schedule of priorities. Cash flows down the tiers in order, and each tier has its own split. A typical structure returns the preferred return first, then returns invested capital, then splits residual profit on progressively more sponsor-favorable terms as hurdles are cleared.
The sponsor's disproportionate share above the hurdles is the promote, also called carried interest. It exists to align the sponsor with outperformance, since the promote is worth nothing until limited partners have received their pref and their capital back.
Waterfalls are computed either deal-level or on an IRR-lookback basis, and the choice materially changes sponsor economics in deals with uneven cash flow. The lookback recalculates at exit to ensure the realized split matches the agreed hurdles.
Worked example
A common three-tier structure:
- Tier 1
- 100% to LP until an 8% preferred return is met
- Tier 2
- 100% to LP until invested capital is returned
- Tier 3
- 70% LP / 30% GP on residual profit
Rules of thumb
- The number of hurdles matters less than where the first one sits. Most of the economic difference between structures is set by the pref and the first promote break.
- Check for a catch-up tier. A full catch-up can move a large share of profit to the sponsor immediately after the pref is satisfied.
Related terms
- Preferred Return
A preferred return is a threshold rate of return that limited partners must receive on their invested capital before the general partner participates in profits above their pro rata share.
- Internal Rate of Return (IRR)
The internal rate of return is the annualized discount rate at which the present value of a deal's cash flows equals zero, making it the time-weighted compound annual return on invested equity.
- Equity Multiple
The equity multiple is total cash distributed to investors divided by total equity invested, expressed as a multiple, and it measures how many times an investor gets their money back over the full hold.