Distribution Waterfalls: How You Get Paid in Alternative Investments
Are you curious about how you really earn from alternative investments? In this episode, you’ll learn all about the waterfall feature, the structure that tells you who gets paid, when, and how in private deals like real estate funds and other non-traditional investments.
From getting your original investment back, to earning your preferred return, and then splitting profits with the sponsor, understanding these layers is important to spotting good deals and protecting your interests. Plus, you’ll hear questions to ask sponsors and learn how to spot hidden fees and potential conflicts of interest.
If you’ve ever puzzled over terms like "preferred return," "catch up," or "carried interest," this episode is for you!
Key takeaways:
Understanding Waterfall Structures: Learn how profits flow from return of capital, to preferred return, through catch up, and finally carried interest.
Evaluating Sponsor Alignment: Learn which layers sponsors often don’t reach, how fees can eat into returns, and what information to request to help you make your assessment.
US vs. European Models: Discover why the American “by deal” and European “whole fund” approaches matter..
Fees, Transfers, and Market Rates: Recognize common issues like sponsors moving assets between their own funds or layering on avoidable fees.
Ready to learn how alternative investments really pay out? Listen to the latest episode and let’s grow your wealth, unconventionally.
Take the quiz - How Alternative Assets Can Fit in Your Portfolio
Time Stamps
01:13 Waterfall basics
01:30 Limited Partners vs General Partners
02:34 Return of Capital
03:00 Preferred Return
03:53 Catch Up
05:20 Carried Interest
05:46 Investment profit splitting
06:44 Evaluating private investment opportunities
07:59 European vs American way
10:43 Fee traps and deal transfers
13:05 Wrap up and next steps
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Waterfall Basics
Welcome to the Unconventional Investor, where strategy, mindset, and money come together to build lasting wealth beyond the numbers. I'm your host, Michelle Moses. Hello everyone, and thank you so much for tuning in. Today is gonna be a solo episode. I'm gonna be talking about how you get paid inside of alternative investments.
It's what's called a waterfall feature and so there's a lot of lingo going around, I think, when you're looking at alternatives. And what they deem as a waterfall feature is really just the way that you get paid. So it's just the structure of who gets paid when and how. And and so I'm gonna go over it so that there's no confusion, and then some things that you should look out for.
Because a lot of these deals, they can write out that they're gonna pay 8%, and then they're gonna do this, and then it's gonna be this after that. But who knows if they're even gonna get to that point, right? So if they're not that profitable, then, none of that really comes to fruition.
So we're gonna talk a little bit about what's on paper and then what you actually do get and then we're gonna talk about what a waterfall feature is. So a waterfall feature i- as I said, is w- how you get paid. Okay? What is the order in which you get paid inside of a deal?
GP vs LP Roles
So let's say that you put $100,000 into some apartment i- investment, and the people that are putting out this apartment investment, they're called the sponsor or the general partner.
Okay? You are a limited partner. So a general partner the sponsor, they are the ones that put the deal together. They're the ones that run it, and they are the ones that make the decisions about who or what apartments are gonna be put into that fund which ones to sell and when, and that's why they're called a general partner.
You would be a limited partner, and it's just exactly how it sounds, is that you're putting in your money, but you don't have any rights to, "Yes, we should buy that apartment and sell it when," all these. Obviously you do have some, there's some legal things, like if things went south, but on the day-to-day operations, you are not going to have the ability to make decisions, and that's why you're called a limited partner.
So let's go over the different buckets that there are, okay?
Return of Capital and Pref
So the first thing that you'll hear from different funds is that first you get your return of capital, and then you get what's called your preferred return, which is called the pref. So return of capital is pretty simple, right? You put in $100,000.
They are not allowed, the sponsor is not allowed to take any money from the profits of the fund until you get all your capital back, and then usually until you get your preferred return. So your preferred return is usually somewhere between seven and nine. Sometimes it's 10%. It just depends on the deal.
But if you if you invest and it says, first you have to get return of capital and then your pref back- That means that the sponsor does not take any profits until you get your return of capital and you get your preferred return. Now, that doesn't mean they don't make any money, because they might make some money on an origination, some real estate origination.
So there's disposition fees, origination fees, things they, fees that they get for buying and selling things. They might loan money to the fund, and so they would make money by loaning money to the fund, different things like that. So they usually are making money with all the different fees inside of the fund.
It's just that they haven't taken their share of profit.
Sponsor Catch Up Explained
Okay, so then the next level, so the third level is what's called catch-up, and this is specifically for the sponsor. So the general partner, the person that puts on the fund, they will get what's called a catch-up, and that is their share of the profit, and usually it's 20% of the profits.
So keep in mind, you have been getting your share of the profits, right? By getting your preferred return, by getting your your return of capital If when they're doing their catch-up, they want 20% of all the profits, not the fees, not, all the other things that are in the fund, of the profits.
So you've been getting 100% of the profits, and now they have to make up what would be 20% of that. And so my question is always, how many of your funds, like when I'm interviewing a sponsor, have made it past the catch-up provision? Because, it's great that you get your return on capital and that you make your 7 or 8% as your preferred return, but w- are we able to get past that hurdle to make more than that 7 or 8%?
How many times have you done that? Because sometimes you see like in a mediocre fund that has a lot of fees, right? They... it... they're... they don't have a ton of profit, then the catch-up might be where it stops, right? So you want to think of the, these are like stacking on top of each other, and you've got your return of capital, and then on top of that is your preferred return, and then on top of that is your catch-up.
Carried Interest Splits
And then after that is what's called your carried interest or we just call it the split, usually it's 80/20. Sometimes it's 70/30. It just really depends on what you were getting at the beginning. Like I've seen some where the preferred return is pretty small, but then it's 90/10 that is the split later on just to make up for it.
So you do see those kind of run the gamut, but a lot of times they're 80/20. And so basically what that means is the rest of the profits after they have that catch-up provision is split 80% to you, the investor, and 20% to the sponsor. And then a lot of times even past that if the return is between 12 and 15%, then we split it, 70/30, and then if it's even higher than that, then it'll go to 60/40 so that the sponsor has incentive to go higher, right?
They're gonna make a bigger percentage of that split if they can make more and more. And so that is where your interests are aligned. Those Are pretty standard.
Sponsor Track Record Checks
I think more of what's important when you're reviewing a lot of these is you really wanna ask, like, how many of your f- deals have gone past the catch-up provision.
'Cause again, it's like that layered thing, and so are they able to go up to that top layer? Have they had deals where they haven't had a lot of fees or they have made a lot, and so you have been able to split the 80/20? Because you have to consider these Reg D private, they're private placements.
It's not like mutual funds where they go, "Oh, my 10-year return is this," and then it's logged into the system where we can all look it up on, whatever platform that we're using. That's not like that with alternatives. So you really are reviewing the sponsor because when you're investing money, you are investing with these people.
Yeah you're trusting "Hey, I trust you guys to manage this, and I trust you to make a return." And so you just wanna make sure that they've done that in the past, and this is why I always like to have their interests aligned with your own and have their own money in the fund, so that they aren't just, nickel-and-diming you with a bunch of fees and not able to get get past that third layer of the catch-up so and then there's other ways that you can look at it too is so let's say that if you look all of this stuff up online, you'll see that there's like a European way to do it and an American way to do it.
European vs American Waterfalls
An American way to do it is by the deal itself, and a lot of times, I don't know if it's better. I like the European way. I like a lot of things European better, but that's a whole another story for another time. But the European way is like the whole fund itself. If you've got 10 apartments in one thing, and then, there's always gonna be one or two that aren't profitable.
But if you've got 10 and the first one is super profitable, and you're doing it by deal, right? And that one had a return of 25%, so they could make your capital, j- for that specific deal whole. They could give you your preferred return. They could take 20%, and then they could split it 80/20, right?
They're going up to the steps, the one, two, three, and four. The European way is that it's all lumped into one big, fund, and then overall profits are taken if the entire fund is profitable. It's 20% ... their catch-up is 20% of the entire fund and what they make. And I that because, you have some where it's a home run, and then the next deal, makes 8%, and then the next one makes 1%.
Not all of them. You might even lose money on another one. So if that was the case, you would want them all averaged out because you don't wanna have to claw back your profits. But, in America, they do have escrow accounts so that they keep all those profits, so that if there, the subsequent apartments are not profitable, then they're able to take the profits from the first apartment that they have in escrow, and then they can make you whole with your investment plus your preferred return.
Because no matter what, if they're making money, y- you have to get your prof- your, the return of your capital plus your preferred return before they're gonna make any money, besides the fees. So I ... a lot of times there's just a lot of lingo with what's called the waterfall feature, and that's why it's called waterfall is because you've got the different layers, right?
And you want ... I feel like it should be something about going up, but, whatever. It's fine. Waterfall goes down. And the, you wanna try to hit each one of those categories so that it's more profitable. And then the more that it makes, obviously, then you're more in line with the sponsor and what they're making, and you're in the same boat because they wanna make more so that they can make 20% of the profits.
So I'm not sure I have anything else that I wanna say about this.
Fee Traps and Deal Transfers
I mean, I think just it couples with, this particular topic couples a lot with what are the fees and how are my interests aligned with the sponsor. Because as I've said in some of my other episodes some of the sponsors just have loans to the funds.
They're moving one apartment from one fund to the next, and if they do that, then y- So let's say in your fund they have an apartment that's not really performing, and then they're like, "Okay. So that we can close this fund because it is so expensive to be running it, we're gonna sell this apartment to this other fund that we started over here."
But how do you know? They tell you, "Oh yeah, we got an appraisal and this is what we bought it for." But how do you know that you even got the best price for that? Because the way you're gonna get the best price for that is putting it on the market and having people bid for it, right? You gotta, just like the MLS and with housing and all that is where you h- get the best price is when people are competing for it, not when the same company takes it and just moves it from one entity to the other and then they make a transfer of money.
So these are the kinds of things that you wanna watch out for is do they actually sell these apartments or are they just moving them to another fund that they have, and was it a fair market value, and did they put a lot of fees with that when they moved it from one, one fund to the next?
Because a lot of times they'll do all these disposition fees and things even if they just moved it from one fund to the next. So these are the kinds of things that you want to write this down, put it into your AI agent that you're using and, it's just one of the things that... And go listen to my episode about litmus test and plug all of that stuff in and it will help you to determine whether some of these deals are written right.
You wanna make sure that you're getting a market rate of return and that their fees are within the market rate, I should say. I still think some of those fees are pretty high, but that's my opinion and I'm cheap on things like that. But I think as you listen to some of these episodes you can piece together what you're gonna, you could put in there to review some of these deals and then you can, upload their PPM and look at their history and, upload all kinds of documentation if they can give it to you.
Wrap Up and Next Steps
And I think that's all I have to say about this. I hope it helps you understand how you earn money in some of these funds. It's not just a straight "Hey, we made this much and we're just all gonna split it equally." It doesn't really work like that. The, the sponsor is going to Get their money, f- through some fees, but they also need to, to make it...
they're asking strangers for money, and so they need to make it attractive. And so th- that's what they're doing by saying, "We don't get paid until you have your investment back plus your preferred return." So if you guys have any questions about this, feel free to go to my website. It's mefinancial.net, and you can book a 15-minute call or an hour if you just wanna talk about some things.
The hour is just, where we're just talking about your situation. It doesn't include any due diligence or research on stuff. But anyway, if you have any questions or anything, please reach out. Thank you so much for listening. And if you do think about it, please leave a review for the show, as it really helps me to reach other people, and I am having a lot of fun doing this.
So I hope you have a wonderful day. Thank you. Thank you for listening to the Unconventional Investor Podcast. I hope you feel more confident in how you can grow your wealth using the strategies I shared in this episode. If you're ready to take the next step in diversifying your portfolio outside the stock market with alternative investments, head to mefinancial.net/contactus to book a 15-minute consult call with me.
Let's discuss how we can work together to achieve your financial goals. Until then, I'll see you on the next episode.
Disclaimer: The information provided in this podcast is for general informational purposes only and should not be construed as professional financial advice. Always consult with a qualified financial advisor or professional before making any financial decisions. The hosts and guests of this podcast are not responsible for any actions taken based on the information presented.