The key attributes of a distribution waterfall that determine investor returns for a private investment program might appear self-evident on first blush. However, they are open to misinterpretation on closer inspection. In this post, we’ll walk through a few of the most important structural nuances that will have significant bearing on how investors will ultimately fare.

**What is the return calculated on?**

Most fundamentally, the key to understanding distribution waterfalls is to never assume you know the meaning of a legal term until you review the program-specific definition. For example, what does “Net Capital” mean? Does it mean net of selling commissions, net of prior distributions, or something else?

If Net Capital is defined as gross capital less underwriting fees (e.g., selling commission, MDB fee, placement agent fee, etc.), investor returns are based on only somewhere between 85% and 91% of their gross invested capital. For example, a 6% cumulative, non-compounded preferred return on gross capital less underwriting fees (i.e., “net capital”) is really only a 5.5% cumulative, non-compounded return on gross capital, assuming 10% in underwriting expenses.

**An example, with simple math**

Let’s say an investor contributes $100,000 to a program and receives a 6% cumulative, non-compounded annual preferred return on gross offering proceeds. This equals $6,000 a year; this is simple enough math. Now suppose the 6% return is payable on the $100,000 investment less 10.0% in underwriting fees, or $90,000. A 6% return on $90,000 equals $5,400, which equates to a 5.4% return of the full $100,000.

Another definition of Net Capital is gross offering proceeds less prior distributions, or more likely prior distributions in excess of the preferred return,* if* the preferred return is payable first. Let’s see what that looks like, based upon the same information as above, but assuming the program distributes 8% rather than 6%, and the preferred return is payable before a return of capital.

The calculation for the first year is straightforward. The investor receives $8,000, which is the 6% preferred return plus a $2,000 return of capital. For the second year’s returns, however, the investor’s capital account has been reduced by $2,000. The remaining capital account balance is $98,000, and the preferred return in year two is $5,880 (i.e., 6% times $98,000). Assuming the same annual distribution amount of $8,000 in year 2, the capital account balance in year 2 will be reduced by $2,120 (or $8,000 less $5,880). And so on, and so on. Over a five-year hold period, a declining capital balance will result in $1,274 less in preferred return than if the net capital had not been reduced by distributions in excess of the preferred return.

**Carried interests and catch ups**

This calculation wouldn’t matter if investors received all net cash flow generated in the program. However, the manager’s carried interest will kick in at a certain point, typically after an investor receives the preferred return and a return of capital. The key elements in assessing a manager’s carried interest are the magnitude of the carried interest (or, hurdle) and whether a catch-up provision applies:

- The appropriateness of the level of the carried interest is dependent upon the appropriate risk-return trade-off of the investment. If the carried interest is set to high, the manager might be disincentivized to perform, or conversely incentivized to take additional risk, in the form of additional leverage or otherwise, to try and reach higher performance threshold levels.
- The catch-up provision typically provides for the manager to receive all distributions, after the first threshold, until the manager has effectively received a certain percent of total distribution in excess of original investor capital, or in some rare cases, a percentage of total distributions. In the second case, the manager is effectively being compensated on the amount of investor capital as well as growth in investor capital.

Looking at our example, barring a carried interest, an investment generating 8% cashflow and 8% growth in NOI, assuming no underwriting fees, will generate an IRR to investors of 16.75%. With a carried interest for the manager equal to 20% of total distributions in excess of investor capital after a 6% preferred return and a return of capital, investor IRR would decline to 13.3%. Without the catch-up, the 20% carried interest would provide investors with a 14.1% IRR.

As you can see, the basis of the investor return (gross vs. net capital), the carried interest, and catch-up provisions can have a material impact on investor returns.

Now that we’ve discussed some of the idiosyncrasies of distribution waterfalls, let’s consider another wrinkle. What happens when a program is investing through a joint venture that has a distribution waterfall that is distinct from the program’s waterfall? We’ll discuss that in the next blog post.