Preferred return tells you the floor. The waterfall tells you what happens after.
A waterfall is the order in which cash gets distributed between the sponsor (GP) and investors (LP) as a deal performs. It sounds complicated. It is really just a sequence.
Here is how ours runs on a recent industrial outdoor storage deal:
1. Return of capital. Investors get their principal back first.
2. Preferred return. Investors receive an 8% annual return before the sponsor sees a dollar of profit.
3. Promote tiers. Above the preferred return, profit splits shift in the sponsor's favor, but only as performance climbs.
What this structure tells you: the sponsor only gets paid meaningfully once investors are already doing well. If the deal is mediocre, investors keep almost all the upside. If the deal is a home run, the sponsor earns their share, because they have actually earned it.
What to watch for when you are reading someone else's waterfall: does the GP catch up to a bigger promote the moment the preferred return is hit, regardless of how the deal actually performs after that? That is a sign the structure rewards closing the deal, not compounding your capital.
The waterfall is where alignment either shows up or does not. Read it before you read anything else in the deck. What is the most aligned (or least aligned) fee structure you have seen in a deal?
Wednesday Real Estate 101: The waterfall
