Whether allocating money to an investment fund or to an individual deal, the terms and conditions of a private equity real estate investment are governed by a document called the “Private Placement Memorandum” or “PPM” for short.  Among other things, the PPM lays out two important aspects of the transaction: (1) the fee paid to the investment manager; and (2) how income and profits from the underlying property are divided between the investment manager (sometimes called the Sponsor or the General Partner) and the individual investors (sometimes referred to as the Limited Partners). The profits for the fund manager outside of the acquisition fees are typically known as “carried interest”. 

Investors not familiar with PPMs may find their language difficult to follow. Yet, a proper understanding of it is critical to assessing the risk profile and relative merits of an investment opportunity. Specifically, there are three PPM clauses – waterfalls, clawbacks, and catch-ups – that should be evaluated thoroughly because their structure has a material impact on the rate of return.


The Investment Waterfall

The term “waterfall” refers to the method used to allocate an investment’s income and profits. In order to fully digest the concept, it’s first important to understand how a typical private equity real estate transaction is structured.  In most cases, the private equity firm acts as the “General Partner” or “Sponsor” and may contribute a small portion of the equity needed to consummate a transaction.  Their primary role is to find deals, analyze them, line up financing, and manage them once closed.  The remainder – and majority – of the equity is pooled from investors or “Limited Partners” and their role is largely passive.

The “waterfall” language in a PPM describes how money is split between the General Partner and Limited Partner(s) in the investment and there are two components:  the return “hurdle” and the income “split.” For example, the PPM may state that the Limited Partners are entitled to a 10% preferred return on their invested capital, this is the “hurdle rate.” Once it has been met, any profits above the hurdle rate are “split” with 20% allocated to the General Partner and 80% to the limited partner. This extra share of returns for the General Partner is known as the “promote” and is designed to incentivize them to achieve elevated levels of return. Distribution waterfall structures can – and do – vary significantly from one transaction to the next, but there are two that are most common:  the European Model and the American Model.

The European Waterfall

Under the typical terms for a European Model, 100% of investment cash flow is paid to investors on a pro-rata basis until the preferred return hurdle is met and 100% of investor capital is returned.  Above the hurdle, the manager/General Partner’s portion of the profits rises. This structure is commonly seen in private equity funds where investor capital may be deployed across multiple investments.


From an investor standpoint, the biggest advantage of the European Model is that the manager/General Partner doesn’t get any profits until investor capital, plus their preferred return, is given back. The idea behind this structure is that the manager is incentivized to create a strong return, otherwise, they may not see any profits during the investment period. 

The drawback of the European Model is that it may take 6+ years for the manager/General Partner to return investor capital and realize their share of the profits. As such, they may be incentivized to maximize short term profits to reduce the amount of time until they get paid, rather than focusing on creating value for the long haul.

American Waterfall – Strengths and Weaknesses

The American Waterfall model addresses the primary weakness of its European counterpart – that it takes a long time for the manager/General Partner to receive their management fees. With this structure, the manager/General Partner is entitled to their fee(s), regardless of whether or not investor capital has been completely returned.

The American Waterfall structure benefits smaller private equity firms that don’t have the resources to wait six years for their fee and it benefits investors because it doesn’t incentivize the manager to sell an asset just to generate a return. Conversely, the downside to the American Waterfall is that while the investor is still due their return of capital, it may allow a manager/General Partner to take a performance fee, even if the deal underperforms. 

The key point is this, the actual structure of the investment waterfall includes multiple variables and changes from one deal to the next.  The details of the hurdles, splits, and other key terms are outlined in the Private Placement Memorandum (PPM) and it’s absolutely critical to read it – and understand it – prior to making an investment decision.


The Clawback Provision

Another clause that may be outlined in the PPM is the “Clawback,” which is an investor-friendly provision that entitles them to be repaid for any incentive fees improperly paid to the manager. Whether it’s the result of an accounting error or negligent behavior, if it is determined that the manager/General Partner received a fee they shouldn’t have, a clawback provision allows the investor to seek its return.  It should be noted though, that a strong clawback provision doesn’t mean anything unless the manager has the ability to pay it.  As such, it’s important to review the manager’s financial strength prior to making an investment decision.

Catch-Up Clause

Finally, the catch-up clause is a legal provision meant to compensate the manager/General partner based on an investment’s total return, not just the return in excess of the pre-established hurdle.  In practice, the investors/Limited Partners would receive 100% income and profits until their preferred return hurdle is reached.  Above the hurdle, the manager/General Partner receives 100% of the income and profits until they are “caught up” to their performance fee.  To illustrate this concept, assume that the investors/Limited Partners are entitled to a 10% preferred return and the manager/General Partner is entitled to a 15% performance fee, with a catch-up provision.  Here’s how property income/profits would be allocated:

  • First, the investors would get 100% of the income and profits until their 10% return hurdle has been reached.
  • Next, the manager/General Partner would get 100% of the income and profits until they’ve received the entirety of their 15% performance fee (the catch up)
  • Lastly, any remaining funds would be split between the general and limited partners.

Interested in Learning More?

Investment waterfalls, clawbacks, and catch-up clauses determine how a property’s income and profits are split between the investment manager and the investors.  The specifics of these clauses are laid out in the Private Placement Memorandum and it is a document that potential investors should read in its entirety to ensure that they are comfortable with the risk profile and financial compensation involved with their capital contribution. 

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets – including middle-market service-oriented retail shopping centers – well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.