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How Distribution Waterfall Structures Affect Investor Returns in Private Placements: Part 2

by Gail Schneck

In our last post, we looked at how the nuances of seemingly straightforward distribution waterfalls in private investment programs can materially impact investor returns. 

The complexity of distribution waterfall are magnified when an investment program is structuring its development or renovation projects through joint ventures (JVs). In this case, property cashflows are often subject to more than one level of fees and participation interests.  In this post, we’ll walk through the impact that structuring programs through joint venture agreements (with their own waterfalls) can have on Investor returns.

What should you know about joint venture arrangements?

So, let’s say the sponsor’s business plan is to co-invest in development projects with established developers/operators. This makes sense on the surface, especially if the sponsor is more experienced at raising money than deploying it. JV arrangements can provide investors with the best of both worlds: capital raising and property development expertise. But at what cost? When you see a joint venture structure referenced in the PPM:

  • The first set of questions you might want to ask are: “Who is the JV partner? What are their qualifications and experience?”
  • The second type of questions you might want to ask are: “Does the JV partner share in the risk of the project? Are they contributing cash equity rather than sweat equity?
  • The third line of questions you might want to ask relate to: How is the JV partner (and sponsor) being compensated? Let’s explore these inquires in a bit more detail, with an emphasis on how waterfalls that will compensate the JV partner will impact net investor returns.

What are the costs of joint venture arrangements?

Just as a private placement program provides its manager with a carried interests as determined by the distribution waterfall, so does a joint venture even if the terms are not explicitly stated the PPM, which is often the case for blind pool programs. Another element to look out for that is often not addressed in the PPM is whether the sponsor or its affiliates participate in JV fees or the JV distribution waterfall. Given the program’s role in providing oversight of the JV on behalf of Investors, FactRight looks disfavorably on a non-operating sponsor that is compensated at both the company and JV level.

What should you look for in a joint venture agreement?

The distribution waterfalls at the program and JV level share many similar characteristics, except that the participation hurdle is often expressed as an internal rate of return, rather than a cumulative, non-compounded return, which is included in most private placement programs that FactRight has reviewed. The threshold level for manager participation is a balancing act between incentivizing the JV Partner to perform without incentivizing it to take on too much risk, typically in the form of leverage. You should review any leverage limits at the JV level. FactRight prefers to see 10% to 20% JV equity contributions, in the form or cash, or at the very least in the form of property with a reasonable basis for valuation (a recent appraisal or valuation opinion). Remember, the equity participation is typically pari-passu with investor equity and should not receive special treatment, unless there is no carried interest. The carried interest is the JV partner’s reward for performing.

How do JV waterfalls impact returns?

Let’s revisit our example in part 1 of this blog series. An investor contributes $100,000 to a program and is entitled to a 6% cumulative, non-compounded annual preferred return and a return of capital based on gross offering proceeds before the manager receives 20% of distributions subject to a catch-up provision. To simplify the math, let’s say that the front-end load on the offering is 10%, which means to program is contributing $90,000 to the JV. The JV partner receives 30% of distributions after a 12% IRR to the program. Let’s assume the property generates a 15% IRR over three-year hold period, with no distributions prior to the sale of the property. What type of returns will investors receive?

The JV will pay the program a 12% return on $90,000, which equals an 8.14% IRR on the $100,000 in gross offering proceeds. The JV partner retains the remaining 3% IRR on capital contributed to the JV. Note that if the catch-up amount was 20%, rather than 30%, of the preferred distribution, the IRR to the program would have been 12.74% and the JV partner would have received 2.26% IRR on investor capital.

Next comes the distribution waterfall at the program level itself. Investors receive their accrued preferred return and return of capital in Year 3. With a 20% catch-up, investors receive an 6.82% IRR and the manager receives a 1.32% IRR on investor capital (or 7.40% and 1.45% if the JV catch-up is 20%). These examples use a simple catch-up provision based on a percent of the preferred return. Catch-up provisions are typically calculated on distributions in excess of a return of investor capital, which provides the manager with even greater returns.

This example excludes other fees that are typically charged at the company and JV level, such as management fees, development fees, etc. Such fees would further reduce investor returns.

As you can see, the terms of the joint venture waterfall can have as significant of an impact on overall returns to investors as program-level provisions. More retail private programs are investing in joint ventures. We hope you are now better prepared to assess waterfalls at two levels.

 

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Filed Under: Due Diligence, Regulation D