When you start looking at syndications, you will hear a lot about “preferred returns” (also known as “prefs”), and “waterfalls”. These terms are thrown around a lot but not usually defined. So what do people mean when they are talking about them?

At the most basic, these terms are used to describe how the partners are compensated as part of a syndication deal. They define how the profits from the deal are split between the LPs and the GPs, after the expenses and fees have been paid.

The preferred return or pref is the return on your invested capital paid from profits before the GP gets anything outside of their fees (fees are part of the expenses of the business and not counted in profits). At a high level, this is the return that the GP is willing to pay you for use of your money. It is critical that you understand that this is not a guaranteed rate of return. If the deal has no profits, you will not get any money. As an equity partner in the deal, this is part of the risk you are taking. Unlike the holders of the debt, who can foreclose if they are not being paid, as a partner in the deal, you only get paid if the deal is profitable.

The pref can be either cumulative or non-cumulative (also known as simple). A cumulative return means that the amount owed under the pref continues to accumulate if it is not paid out while a simple return does not. For example, lets say you have a $100k invested in a deal with a 6% pref. In year 1, the profit amounts to only 5%, in year 2 it rises to 6%, in year 3 it hits 7% and stays there in year 4. In each year, you would be paid 6%, or $6k, before the GP gets any payout. However, in the first year, you only got 5% ($5k). If the pref is cumulative, that means you have an additional $1k owed before the GP gets their payment. Year 2, you get exactly what the pref rate is, so there is nothing additional accumulated on your return and nothing split with the GP. In year 3, your share of the profit is $7k, which is over the pref by $1k. If the pref is cumulative, that $1k would pay off the accumulated pref owed to you from year 1. If the pref was a simple pref, there wouldn’t have been any accumulated funds owed and you would be splitting this $1k with the GP according to the waterfall that you agreed upon (more details below).In year 4, you split the $1k with the GP according to the waterfall.

It is easy to think that having a higher preferred return makes a deal better than a lower pref, however that isn’t necessarily the case. The GP needs to make money on the deal as well, and the higher the pref the more the deal needs to return in order for them to get anything for their investment. This can lead to them making decisions that aren’t always in the long-term best interest of the investors. For example, if the deal doesn’t allow them to get cash flow for 3+ years, they could decide to sell early in order to close out the syndication and get paid. Or the GP’s split on any funds beyond the pref rate could be higher than if the pref rate is lower, for example they could arrange the deal to take 50% instead of 30% of the profit beyond the pref.

Overall, you want to make sure that you are getting a fair return on your money but that your goals and the GPs are closely aligned so that they work hard to make the deal successful for everyone. This usually means that the pref rate should fall somewhere between the rate of interest that you would get on a bank account or 10 year treasury (on the low end) and half of the IRR the deal is expected to return (on the high end).

Once your preferred return has been paid, the GP starts to benefit in the profits of the deal. Of course, they have already been awarded their fees, but those are usually applied against their expenses in the deal and should not be a major source of income for them (if they expect to get most of their money from fees, I would suggest running away from the deal). How the profits are split after the pref has been met (also called “meeting the hurdle”) is called “the waterfall”.

Waterfalls can be simple or complicated. A simple waterfall has all additional funds split in a consistent manner. I have seen (and invested in) deals where once the pref was met, the GP kept all of the funds. However, it is more common for there to be a split of the money after the pref. A typical split is for the LP to get 70% and the GP to get 30%. However, 80-20 and 50-50 splits are not uncommon either. A more complex waterfall typically includes multiple hurdles, with the split between LP and GP changing as different hurdles are met. For example, a deal may have a 6% pref, then an 80%-20% split until the profit reaches 10% in a year, then a 70%-30% split until the profit reaches 15%, then a 50%-50% split for the rest.

While the idea seems reasonable – the GP gets paid more the more successful the deal is – I tend not to be a big fan of these complicated waterfalls. The accounting becomes challenging and it is hard to understand what is going on as the profits are calculated on different quarters and the appropriate distributions based on quarterly or annual numbers. Trying to make sense of a complicated waterfall seems like a lot of paperwork and overhead for what would ultimately be very little difference in the final outcome.

Ultimately, you have to decide what pref and waterfall works for you. I believe the deal will only be successful if both the investors and the sponsor are aligned and both are able to get what they need out of the deal. However, as you see more deals, you can see how they vary based on sponsor and asset class. The biggest thing to keep in mind is to make sure that your interests and the sponsor’s are aligned so that you both succeed together.

If you have any questions about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.