A Guide to Understanding LP-GP Waterfall Distribution

The following terms are used in the investment industry:

"LP" stands for Limited Partner, who is a passive investor in a project with limited liability to their investment amount. They are also referred to as "equity partners."

"GP" is the General Partner, who is responsible for managing the project from start to finish and has unlimited liability if the project goes bankrupt.

"Sponsor" is another term for the GP, who is in charge of finding the property, financing the deal, and coming up with an exit strategy.

"Sponsor Promote" refers to the GP's share of profit above a certain threshold when they contribute a portion of the equity.

"Members" refers to all investors, including LPs and GP, who own 100% of the equity in the investment.

"Hurdle rate" is the rate of return at which remaining funds will be distributed according to the next tier's rate of return in a waterfall model.

With these basic terms defined, we can move on to the waterfall distribution model. The concept involves a series of distribution stages arranged in a specific sequence. After a distribution tier has been completed according to its predetermined formula, any remaining funds, if any, will be allocated to the next tier according to the next tier's formula. This process continues until all funds have been fully distributed. Sounds straightforward? Hold on, it may not be that simple. But, we are here to make it easy to understand

Explaining the Concept Step By Step

Before breaking this down step by step, let's go over the general concept. The first distribution tier prioritizes the recovery of the initial investment by the investors (LPs). Then, the investors (LPs) receive their share of profit, for example 8%. At this point, the investors have received their principal plus interest (commonly referred to as "pref rate" in the industry), while the general partner (GP) has yet to receive any profits. To incentivize the GP to fulfill their responsibilities for the project, a profit-sharing scheme (the third tier in this model) is established. Remember, the GP is responsible for all aspects of the project, including:

• finding a suitable investment,
• designing a valuable business model,
• forming a team,
• conducting due diligence,
• securing financing,
• collecting equity,
• executing the business plan,
• stabilizing the asset,
• creating an optimal exit plan, and
• distributing the funds upon completion

So, it is important to keep the GP motivated. For a more detailed description of the development process, please see our blog post on development process. So, here is the step by step process:

Step 1: LP Receives Investment from Proceeds

Priority number one: securing a return on investment for our valued investors!

Step 2: LP Receives Preferred Return based on a Set Percentage

Having ensured the recoupment of their investment, the Limited Partners are now able to reap their rewards through a pre-agreed profit distribution.

Step 3: GP Receives Catch-Up Amount Based on a Predetermined Rate

It is now GP's turn. After all, the GP is in charge of running the project and a more motivated manager can make everyone more money.

Step 4: Remaining Proceeds Distributed Based on a Split Rate

Finally, whatever is left is split between the LP and GP based on a pre-determined rate, similar to splitting the last slice of pie between friends.

Live Example:

They say a picture is worth a thousand words. By the same token, a live example is worth a thousand example simply because you can plug in your numbers and see for yourself how the waterfall distribution model works in practice with your own data, and for free (you're welcome!):

Investment Assumptions

In Conclusion

And there you have it! LP-GP waterfall distribution explained in simple terms. Now you're all set to wow your investors with a pitch that's both confident and crystal clear or impress your friends with your newfound knowledge of this financial concept. Who said finance has to be dull?