When you are syndicating a cash-flowing property, you must determine how you will distribute cash to your investors at various stages of your company. This is called a “waterfall”. At a minimum, you will need to determine the waterfall for cash flow derived from property operations, and from “capital transactions”, such as a refinance or sale of the property. There are many forms this may take, but below is one description of how you, as the syndicator, can preserve your rights to distributions from Day 1 of operations using a Manager or “Class B Catchup.”
Below are some examples of how a Class B Catchup works:
Waterfall showing an 8% Preferred Return with a 70/30 split and a Class B Catchup Distribution
Let’s say you have a waterfall during property operations that says the following:
- Distributable Cash generated from property operations will generally be split 70/30 between Class A and Class B Members, respectively, but it will be distributed in such a manner that the Class A Members will be paid all of the Distributable Cash until they have received a non-compounded, cumulative annualized return of 8% (the Preferred Return), determined quarterly and calculated against the Class A Unreturned Capital Contributions; then
- Class B will receive an annual, non-compounding, cumulative catchup distribution of 3.43% (the Class B Catchup Distribution), determined quarterly, calculated against the Unreturned Capital Contributions of the Class A Members; note that this is equivalent to a 70/30 split between Class A and Class B, as illustrated below:
- Any remaining Distributable Cash from Company operations will be split 70/30, with 70% paid to Class A and 30% paid to Class B.
To show how this works in numbers, let’s assume that Class A had contributed $10 Million and the property generated an annual cash flow return of $1,000,000 (or 10% calculated against the Capital Contributions of Class A Members). In this scenario, Class A would be entitled to an annual return of $800,000 ($200,000/quarter) and Class B would be entitled to an annual return of $343,000. However, since there was only $200,000 to pay to Class B in that year; Class B has a deficiency of $143,000.
Any arrearages (deficiencies) in either Class A Preferred Returns or Class B Catchup Distributions (meaning that either class didn’t receive the annual return calculated above) will be deferred and made up from future cash flow or proceeds from a Capital Transaction, at the Manager’s option.
Class B would be entitled to a look-back on occurrence of a Capital Transaction, and could make up the $143,000 deficiency from year 1, and any subsequent deficiencies.
The Capital Transaction waterfall with a Class B Catchup Distribution would look like this:
- First, repay the Unreturned Capital Contributions of Class A Members; then
- Make up arrearages in Class A Preferred Returns; then
- Make up arrearages in Class B Catchup Distributions; then
- Split any remaining cash 70/30 between Class A and Class B.
How is this different from a waterfall without a Class B Catchup?
Below is a typical waterfall without a Class B Catchup:
- First, Class A Members will be paid all of the Distributable Cash until they have received a non-compounded, cumulative annualized return of 8% (the Preferred Return), determined quarterly and calculated against the Class A Unreturned Capital Contributions; then
- Any remaining Distributable Cash from Company operations will be split 70/30, with 70% paid to Class A and 30% paid to Class B.
To show how this works in numbers, let’s assume that Class A had contributed $10 Million and the property generated an annual cash flow return of $1,000,000 (or 10% calculated against the Capital Contributions of Class A Members). In this scenario, Class A would be entitled to:
- An annual return of $800,000 ($200,000/quarter),
- Plus 70% of the remaining $200,000, or $140,000; and
- Class B would be entitled to 30% of the remaining $200,000, or $60,000.
Any arrearages (deficiencies) in Class A Preferred Returns will be deferred and made up from future cash flow or proceeds from a Capital Transaction, at the Manager’s option. There is no “catchup” for Class B, so whatever they get in any given year is all they ever get.
The Capital Transaction waterfall without a Class B Catchup Distribution would look like this:
- First, repay the Unreturned Capital Contributions of Class A Members; then
- Make up arrearages in Class A Preferred Returns; then
- Split any remaining cash 70/30 between Class A and Class B.
As you can see, without the Class B Catchup, you run the risk of paying all of the cash flow to your investors both from property operations and from a capital transaction, leaving little (or none) to distribute to your management team. Further, you may even be creating a disconnect between your interests and those of your investors. For instance, if your investors are receiving cash flow from property operations but you are not, they may want to keep the property long-term. However, because you aren’t making any money for all of the work you are doing as the syndicator (overseeing property operations on your investors’ behalf), you may have incentive to sell the property so you can get paid from your share of the equity realized on sale. Or alternatively, you may have to keep chasing acquisition fees from new deals to support your own financial needs; turning your attention away from this property to the detriment of your investors.
The best way to make sure you and your investors’ interests are aligned, is to create a waterfall scenario where both you, as the syndicator, and your investors make money from all phases of your property ownership.
We trust this explanation will help you understand the importance of this concept. We realize that not all deals will support this structure but it should always be considered when underwriting your deals.
