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Hey, everyone! Today I want to answer this vital question: Which waterfall structure should I use?
The preferred rate of return, or “pref” is 6 to 8%. The pref determines where the first (6 to 8%) of the money will go.
The usual “catch up” is 2%. And the rest of the money is split 80% to the investors, 20% to management.
Depending on the fund, you may need to avoid this traditional set-up…
For example, the preferred rate of return for a hedge fund would not work!
You may not want to use a pref for a PE fund either, because you are focusing more on equity than cashflow.
However, a pref would work nicely with a real estate fund because the reoccurring rental payments make it possible.
If a pref rate is not appropriate, use a hurdle rate.
The standard hurdle rate is 8%.
This means that the general partnership (GP) doesn’t get the 20% (of an 80/20 split) until they achieve an 8% gross return.
So, if the fund grosses 7%, the GP doesn’t get any performance fees, but if it gets 9%, then GP gets 20% of that 9%.
So, PE and RE funds get the pref rate, and venture capital and hedge funds get hurdle rate.
Make sure to have a high-water mark term set up in your hedge funds.
Check out this video if you don’t know what that means, but it basically ensures that investors aren’t cheated when the fund is volatile.
Real estate fund managers often ask me…
“Shouldn’t I do a 50/50 split instead of an 80/20 so that I can actually find investors?”
We tell them that if they syndicate 20, 50, or 100 deals in their fund, then they can find investors, leverage people’s money, and make way more money splitting it 80/20.
So, if you’re still asking yourself, “Which waterfall structure should I use?”
Check out my video and remember that every fund/situation is different!
That’s it for today!
Thanks,
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DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.
