Are you a real estate investor looking to maximize your returns from investments? Then understanding waterfall performance fees should be at the top of your priority list! Waterfall performance fee structures are becoming increasingly popular amongst investment firms, so it’s important for investors to understand how these fees may impact their overall return on investment. In this article, we will dive deep into the complexities of waterfall performance fees, exploring what they are and how they work in order to help you make more informed decisions when selecting investments.
What is a Waterfall Performance Fee?
A waterfall performance fee is an incentive-based real estate syndication structure that allows real estate sponsors to collect additional profits from the investment’s success. It is an incredibly powerful tool in professional real estate investing, as it encourages real estate sponsors to stand strong on their projects and push for optimal results that benefit investors. A successful real estate syndication depends heavily upon both real estate sponsor and investor contributions, making a properly structured waterfall performance fee an essential component of any real estate deal for both parties. Real estate investors can rest assured that a successful sponsor will be incentivized to invest in their success, making a waterfall performance fee an essential aspect of investment security.
How does a Waterfall Performance Fee Work?
Waterfall performance fees are a powerful tool in incentivizing high performance throughout all syndication stages. It works by cascading cash flow returns waterfall distributions according to a defined waterfall matrix, which ties the achievement of specific performance milestones to providing more favorable financial returns to investors. The fees are structured as preferred returns with tiered hurdles and vesting periods, allowing investors to prioritize their returns before other partners receive any benefit. As such waterfall performance fees can be used by businesses to create alignment and reward the teams they partner with, ensuring that everyone is committed to achieving the greatest success possible.
Preferred Returns and Matrix Hurdles
Private equity has seen tremendous growth over the last decade, with many private companies and venture capitalists turning to private equity investments to maximize their returns. However, private equity investments come with a unique set of risks that depend greatly on the performance of the portfolio assets – this makes determining the preferred return rate a critical component of any private equity investment strategy. Private equity real estate portfolios rely heavily on waterfall performance fees where investors receive an agreed-upon return or IRR on their capital ‘waterfalling’ down through a tiered matrix until all other investors have been paid out. Crafting a preferred return number feasible for managers and investors alike isn’t easy – but considering risk mitigation measures and potential market volatility can help solidify success in achieving solid returns from private equity investments long-term.
Asset managers and syndication sponsors are passionate about ensuring investors receive optimal returns. That’s why they prioritize investor welfare until a certain return benchmark is achieved – known as the preferred return hurdle rate. Should performance surpass that point, asset managers will begin collecting their due with rewards increasing in proportion to continued successes. It’s an exciting way to guarantee both mutual benefit and long-term financial success!
| Return (IRR%) | Name | Investor Payout | Management Payout |
|---|---|---|---|
| 8% | Preferred Return | 100% | 0% |
| 10% | General Partner Catch-Up | 0% | 100% |
| Above | Profit Split | 80% | 20% |
The waterfall matrix example above is of one of the most common waterfall fee structures.
The table above is one of the most common waterfall structures in private equity real estate. Just like with the US tax code, waterfalls are progressive, meaning that the manager rate only applies to that range. If a 1-year project worth $10 million had a payout of $1.5 million, the total IRR is 15%. In this scenario, the investors would receive $1.2 million and the management team would receive $300 thousand.
Up to the 8% preferred return, investors keep everything which is $800 thousand. Next, the management receives a catch-up fee to level the playing field which is $200 thousand. The remainder is split 80/20 and the investors net a 12% return, 4-5% better than the average S&P 500 return.
Keep in mind that waterfall returns do not always follow this structure and are oftentimes custom built so be sure to check with your syndication sponsor.
Benefits of Using Waterfall Performance Fees
Increased Returns
Performance fees are often based on a percentage of the profits earned by a fund, which means that managers only receive them when investors make money. This provides an incentive for managers to focus on generating strong returns, as they will only be paid if they are successful. This can lead to increased returns for investors, as managers are more likely to take risks and invest in new opportunities that have the potential to generate high returns.
Improved Accountability
Performance fees also improve accountability, as managers are only paid when investors make money. This provides an incentive for managers to be more transparent and open about their investment strategies and decisions. Additionally, it gives investors the ability to hold managers accountable for poor performance, as they can simply choose not to invest in a fund that has charged performance fees.
Greater Incentive for Calculated Risk-Taking
Another benefit of performance fees is that they provide a greater incentive for risk-taking. Since managers only receive performance fees when investors make money, they are more likely to take risks to generate high returns. This can lead to greater innovation and growth within the fund, as managers are constantly searching for new opportunities that have the potential to generate high returns.
Aligns Investor and Manager Interests
Another benefit of performance fees is that they align the interests of the manager and the investor. Under a traditional fee structure, the manager is typically paid a fixed percentage of the assets under management regardless of how well the fund performs. This can create a misalignment of interests, as the manager may be more focused on growing the size of the fund rather than generating strong returns. Performance fees help to mitigate this by ensuring that the manager only earns a fee if they generate positive returns for investors.
Attract Top Talent
In addition to incentivizing existing managers to perform well, performance fees can also help to attract top talent to a fund. When prospective managers see that a fund is willing to pay performance fees, it signals that the fund is serious about generating strong returns. This can attract some of the best and brightest managers in the industry, which can further improve returns for investors.
Associated Risks of Waterfall Structures
Short-Term Thinking
RISK: Performance fees can incentivize managers to take risks in order to achieve short-term gains, rather than focusing on long-term value creation. This can lead to poor decision-making and ultimately result in losses for investors. The manager’s interests are aligned with achieving short-term gains, while the investor’s interests are aligned with achieving long-term value. This conflict of interest can ultimately result in the manager making decisions that are not in the best interests of the investor.
SOLUTION: Investing with an aim toward long-term success is a core component of successful asset management. To ensure your committed managers are up to the task, take time to assess their strategy and market insights through questions that probe into how they plan for sustained performance over time – making sure short-term strategies aren’t prioritized or rewarded more than those built for longevity and success. Additionally, look beyond one year’s cash flow metrics; be sure performance fees correlate with key long-term financial indicators including equity multiple or internal rates of return for demonstrable returns that weather any economic storm.
Complexity
RISK: Another issue with performance fees is that they can be complex and difficult for investors to understand. This complexity can make it difficult for investors to know how much they are paying in fees, which makes it harder for them to make informed investment decisions. Additionally, this complexity can also lead to confusion and frustration on the part of investors.
SOLUTION: When it comes to investing, there’s no substitute for doing your due diligence – so make sure you understand the waterfall matrix and payout structure before diving in. A reputable investment manager should be able to provide a clear explanation of the payouts; if they can’t, that may serve as an early warning sign about their trustworthiness. Before proceeding further with any type of financial plan or asset allocation strategy, seek professional advice from qualified advisors like accountants and attorneys who specialize in these matters.
Underperformance
RISK: Finally, performance fees can reduce returns for investors, as a portion of the profits generated by the investment will go towards paying the fee. This is particularly problematic in cases where the investment under-performs, and the investor will not only lose money but will also have to pay a fee for the privilege.
SOLUTION: At Eikon Investments, we ensure that our investments have a preferred return rate to protect the asset from under-performance risk. We provide returns for all of our deals that are either comparable or exceed those on offer in other funds with similar risks and potential upside – meaning your investment is safe at minimum levels but still has room to grow! By choosing funds with a preferred return you’re protecting yourself against potential losses while simultaneously leaving open possibilities for high-performance outcomes.
The Future of Waterfall Performance Fees
The increasing democratization of investments has been largely beneficial for the financial community, but has also posed an interesting question – what will be the future of waterfall performance fees? Despite these changes, this fee structure is still a core component and a valuable tool within any investment portfolio. However, improved access to and availability of software can offer more sophisticated risk management which would be greater transparency on performance fee structures could significantly impact the market. Waterfall performance fees should continue to remain a key part in investment management and the challenge going forward lies in finding a balance between increasing flexibility while simultaneously safeguarding optimal security for investors.
When to Avoid Waterfall Structures
Real estate is a powerful asset class, and investors have used waterfall performance fees to their great advantage. For clients, these fees are advantageous because they create an incentive for asset managers to deliver outsized returns on investments. On the other hand, asset managers benefit from these fees since they get rewarded with higher relative payouts when their strategies deliver above-average returns. This creates a win-win situation for asset managers and their clients alike – asset managers are incentivized to perform better, which in turn leads to greater success for the client. When it comes to group real estate investing specifically, waterfall performance fees can be even more beneficial because investors can spread out the risks between themselves and enjoy sharing the profits should they be realized.
Ready to Begin?
Waterfall performance fees are an important part of the real estate industry and can benefit both investors and managers. By aligning incentives, these fees encourage high performance and can create a win-win situation for all parties involved. If you’re interested in learning more about how to structure a waterfall fee or want help creating the right matrix for your business, get in contact with one of our team members today. We’ll be happy to help you navigate this complex topic and find the best solution for your needs. If you are ready to begin your real estate syndication journey, you can always reach out to us at invest@eikoninvestments.com or register as an investor to start being notified of our investment opportunities.
Happy Growth.
Related
Jordan Moore | Investments Director
Armed with a passion for client success, Jordan leads Eikon Investment Group to become the ultimate financial ally. As Managing Partner and Investments Director he develops innovative strategies that prioritize needs first; offering clients an unparalleled opportunity to unlock life’s full potential with their investments. With his guidance, he emphasizes efficiency across all fronts: Investor Relations, Capital Markets and Project Operations alike – putting Eikon in prime position for enduring organic growth.
Articles:13