Investment Waterfall Distribution – Building a Waterfall Model
Waterfall modelling is known as one of the methods when it comes to profit distribution arrangements used in investment schemes. It is a method where the profit is split among partners in a deal that allows profit to adhere an uneven distribution. The arrangement under the waterfall structure is when the operating partner gets rewarded and receive a higher share of profits in cases where the project’s return turns out more than the expected return. The same principle is applied too when the project’s return is lower thus, the share of profit given is lower. Essentially, the total capital gained is distributed according to a cascading structure made up of tiers, hence the reference to a waterfall.
Though you may think that Waterfall Modelling sounds simple, it is actually more complex and also considered as one of the most difficult concepts to understand in cases of real estate finance. This is due to how the cash flow is split in many ways thus, making a waterfall model confusing and hard to understand. The waterfall structure itself consist of a series of funds being filled by cash flow and once it overflows, the excess will then be pooled over into another additional fund.
Though the series of funds may be customized, generally, there are four tiers in a distribution waterfall schedule method such as:
1. Return of Capital – 100% of the distributions go to the investors until all of the initial capital contributions are recovered.
2. Preferred Return – 100% of the further distributions go to the investors until they receive the preferred return on their investment (approx. 7-9%).
3. Catch-up Tranche – 100% of the distributions go to the sponsor of the fund until he/she receives a certain percentage of profits only.
4. Carried Interest – The sponsor will only receive a stated percentage out of all the distributions which matches the stated percentage in the third tier.
One of the rates that can also be tiered is the Hurdle Rates depending on the total amount of carried interest of all the general partners. Basically, the carried interest goes hand in hand with the hurdle rate as it is considered that the more carried interest is determined, the higher the hurdle rate will be.
If you are planning to build a waterfall model, you can visit eFinancialModels, a platform which offers a wide range of financial model templates, to download Waterfall Model Templates and other industry-specific financial model templates which utilize the Waterfall Method.