When an investor starts looking at private equity investments they will quickly notice there is some unique terminology used describing the performance of the investment. To keep this from being a mental roadblock we want to help the potential investor understand a few of the commonly used terms.
One metric you will see in private equity investing is the preferred return. This is simply the amount (a percentage) that is dedicated to the limited partners (you and other investors) before the general partner receives any funds.
For example, if you invested $200,000 and there was a 7% preferred return you would receive $14,000 per year during the life of the investment. The preferred return is the first tier that is paid out with priority given to the investors.
The next term you may see used is the split. This is how profits are divided up between the general partner (sponsor) and the limited partners (investors). After investors receive all their original investment capital back, then distributions exceeding the 7% preferred return follow a split as enumerated by the operating agreement between the general partner and the limited partners. An example would be a distribution of remaining profits up to 15% internal rate of return (IRR) being split 70/30 between the limited partners and the general partner.
If and when the investment’s performance exceeds 15% IRR there is what is called an waterfall. Waterfall distributions are split between the partners according to the operating agreement. An example of this might be a 50/50 split between the limited partners and general partner of all the profits exceeding a 15% IRR benchmark.
The internal rate of return is not unique to private equity, but since it is integral to the distribution waterfall we will touch on its meaning. The IRR is the intrinsic rate of return that is expected from an investment factoring the amount and timing of cash flows. The IRR is the discount rate that makes the net present value equal to zero in a discounted cash flow analysis. What this tells us is the percentage rate earned on each dollar invested for the period of the investment.
The last term we are going to cover is distributable cash flow – since this is central to all the above. Distributable cash flow is the income received from the investment (not counting capital contributions), less the portion used to pay expenses, make capital expenditures, and fund reserves. This is the primary source of revenue for a multi-family property investment until it is sold and capital gains are realized.
For more resources, you can watch our webinar series to learn more about multi-family real estate syndication.