Last week, we looked at exemptions to registration under Regulation D itself in Part 1 of the blog series on private placements. Let’s continue our discussion of private placements by exploring distribution waterfalls in Reg D programs.
When reviewing private placements (or any investment program), three of the most important questions you need to ask are:
- How are investors being compensated for the risk they are taking on?
- How are investors’ interests aligned with management’s interests?
- As a necessary sub-question to number 2, are investors entitled to a return of their capital before management is receiving a percentage of the profits?
In order to answer these questions, it is critical to understand how investors and management are being compensated through the company’s distribution waterfall. While we often take a 20,000 foot look at the waterfall to determine how management and investors are splitting the profits, the most accurate answers to these questions can usually only be obtained through a detailed review of the waterfall’s features, including distribution escalators, aggregate versus per asset calculation methodologies, and clawback and subordination features.
Laddered waterfalls
Distribution waterfalls for private placements are commonly laddered. This means that management receives an increasing percentage of profits as the overall return to investors increases, for example as shown in the table below.
|
|
Investors |
Management |
|
Up to a 7% preferred return |
100% |
0% |
|
Return of invested capital |
100% |
0% |
|
Up to a 14% annual return to investors |
80% |
20% |
|
Thereafter |
70% |
30% |
In this example, investors receive a return of capital plus a 7% annual return before management has any distribution participation. Management then receives 20% of distributions until investors have received a 14% annual return, and 30% of distributions thereafter. These distribution hurdles appear to help align management’s interests with those of investors. However, even in instances when a waterfall appears to protect the interests of investors, it’s important to consider that the investment program may actually have different waterfalls for cash flow from operations versus cash flow from the sale of assets (not to mention that “cash flow from operations” eligible for distribution may be defined as including offering proceeds or other funds, the distribution of which could be dilutive to investors).
Waterfall methodology applied to asset sales
One of the most crucial elements that you should consider when evaluating a distribution waterfall is whether the company applies the waterfall on an aggregate basis or on a per property/per investment basis. The reason this is so important is that if a waterfall is applied on a per investment basis, management may receive profits from the sale of one asset, even though the company may experience a loss on the sale of other assets, or an aggregate loss on all of its assets once disposed. Of course, FactRight’s preferred treatment is for the waterfall to be calculated on an aggregate basis, where investors often receive a return of capital and a preferred return, before the management participates in the profits.
Subordination features
Some distribution waterfalls, particularly in the oil and gas space, have subordination provisions, for example as shown in the table below.
|
|
Investors |
Management |
|
Up to a return of invested capital |
85% |
15% subordinated to a 12% annual return for 5 years |
|
After a return of invested capital |
75% |
25% subordinated to a 12% annual return for 5 years |
In this example, investors receive 85% of distributions until they have received a return of their capital contributions, with management accruing the other 15% from the first dollar. Once payout occurs, investors receive 75% and management receives 25%. Of note in this example, management’s share of distributions is actually subordinated to investors receiving a 12% annual return for five years (which is why management’s share at this level accrues until this happens). However, to be clear, the above waterfall does not guarantee investors a 12% return—it only subordinates management’s interest until that hurdle is reached.
Clawback features
In some waterfalls, management may agree to return any distribution it receives if investors do not receive a specific level of return after the fund has been liquidated, commonly referred to as a clawback feature. At a quick glance, a clawback feature may appear to align management’s interests with those of investors. However, it’s important to remember that clawback features really only provide investors with protection if management actually has the financial resources to make the clawback payment upon liquidation of the investment program.
Alignment of Interests
As you work through the questions at the beginning of this post, keep in mind that the answers can often be found in the details of the company’s distribution waterfall. Of course, you’ll also want to consider other, related features in gauging risk/return and alignment of interest, like potential subordination of manager fees to current payment of preferred return, and management investment in the common equity/limited partner interests, which may place at least one of their feet into a common shoe with the investors.
Next time, we’ll look at specific differences between private direct participation programs and their public, non-traded counterparts, related to leverage, valuation, and number of investors.
