Waterfall Section

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Transcript

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Welcome to this video. In this video, I will cover the waterfall section in the ARGUS Portfolio Model. Waterfall is a terminology of a profit-splitting structure between general partners and limited partners.

Waterfall Assumptions

Let’s get started. I am going to say the profit is distributed to equity investors on a monthly basis. The maximum number of tiers is 5 in the ARGUS Portfolio Model. If I input 5 tiers, I can see 5 tiers are activated at the bottom. If I change it to 3, only 3 tiers are activated. The preferred return is 8%. Preferred return is similar to the interest on the capital deployed. AAA capital contributes 10% of the equity stack and BBT capital contributes the remaining 90%. Both of them will earn an 8% preferred return on their capital invested before the return of their capital and the excess profit distributed through different tiers. The preferred return is compounding rather than accumulating. If the preferred return is missed due to a temporary lack of cash flow. The compounding interests on the missed amount will need to be paid. For accumulative preferred return, the missed amount will simply be carried forward. If the preferred return is met, then the first-tier kicks in. Before the BBT Capital, which is the limited partner, reaches 10% IRR, the cash flow is split 12/88 between the general partner and the limited partner. I can see that AAA Capital is being disproportionally rewarded as it contributes 10% of the capital stack but receives 12% of the excess profit over the preferred return. This disproportional reward is also called promote or carried interest. The waterfall is designed this way to incentivize the general partner to achieve a higher return for the deal. After the BBT Capital reaches 10% IRR, the profit will be split 15/85. If BBT Capital reaches 15% IRR, then the profit will be split 20/80 between the GP and LP.

Waterfall Cash Flow

Let’s go to the Annual Waterfall tab. I can see how the profit is distributed in detail. I can see the preferred return keeps compounding until it is fully met in year 5 with a large cash flow available for distribution from the refinance. Then the excess profit is used to pay down a small portion of the equity balance. I can also see nothing hit tier 1 until the exit. The general partner gets the promote in tier 1 and tier 2, and nothing gets distributed in tier 3, which means the limited partner’s IRR does not hit 15% in this deal. At last, there are AAA Capital Summary, BBT Capital Summary, and Promotes Summary.

I have completed the waterfall section in the ARGUS Portfolio Model. Thanks for watching this video. I will see you at the next one.