A guide to waterfall fee structures across fund types. Real estate and private equity typically use a preferred return of 6-8%, while venture capital and hedge funds favor hurdle rates. Hedge funds also use high-water-mark clauses to prevent performance fees unless the fund's NAV exceeds its previous peak.
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What's up guys? In this episode, we're gonna talk about waterfall structures, private equity, real estate, venture capital, and hedge funds. I know we talk a little bit about this in other videos, but I just really wanna go in depth on this one about how it's different for different types of funds that you're starting. All right, so I'm gonna start with like kind of reviewing, um, the other structures that we talk about traditionally. And so this might be review for a second, then we'll kind of get into some new stuff. But we often talk about this Pref, right? This preferred rate of return. And why do we do that? It's honestly just to align incentives of investors and managers. So we often talk about a preferred rate of return of anywhere between 6 to 8%, right? And then we talk about, you know, maybe a catch-up of like 2%, and then, you know, maybe an 80/20 split. So that's like kind of a traditional waterfall. But this isn't for all funds. So this preferred rate of return can be pretty dangerous. It can, you know, back you up and like in a hedge fund, for example, you do not want to do a preferred rate of return. It's not very common. Now the equivalent of a pref versus a hurdle. So they're kind of 2 different things. So a preferred rate of return is saying, okay, the first 8%, Or the first 6% is going to go to you regardless. And it's usually an IRR and that's on an annualized basis. Okay. So at the end of the project, you don't have to pay it out every year. It can just be paid out on an annualized basis, like retroactively when you pay out your distributions at the end. So the only time that you're going to be really paying out a regular distribution is if you're cash flowing. Like that's obviously common in real estate because of like rental income. You know, where you'd pay out a monthly distribution. But for the most part in private equity, you're going to be reinvesting those cash flows back into the company, right? You're not concerned about cash flow. You, in private equity, usually buy a cash flowing company and then you're focused on the equity multiple, right? You're not concerned about cash flowing a company. It's about improving the enterprise value. You know, as long as you don't, you can still do a pref in private equity, but you probably don't want to pay that out annualised. If you're cash flowing on real estate and acquisition, then you can pay out like your preferred rate of return annualized if it reaches that. Now, most of these funds have a clause where that says, hey, look, this waterfall doesn't even start until 100% of your initial investment, also known as the principal investment, is returned. So I kind of digressed there a little bit, but the difference between pref and hurdle rate, right? So the pref is like, hey, I'm going to give you this money and then kind of like our fee structure starts. The hurdle is an unlocking mechanism. Okay, so hedge funds, for example, they often have like an 80/20 split, but there's no pref. And with a hurdle rate of 8% basically means that the, the general partnership doesn't get this 20% until they achieve an 8% gross return. So if you reach 7%, then the general partnership gets no performance fee or incentive fee. But if you get 9%, then they get You know, retroactively 20% of that 9%. So if they get 10%, then they'll get, you know, a 2% performance fee. Now, where pref is more like, hey, we're gonna pay this out no matter what, like the first 6-8% of the deal is paid to you. Like, that's all there is to it. So before we make any money, you make that, that percentage. So let's talk about the dynamics here a little further on pref versus hurdle. So Real estate, again, real estate, private equity, they're gonna have— it's common to have, you know, a preferred rate of return. Venture capital and hedge funds, however, they usually do not. So, I mean, think about it, right? With— let's take venture for example. You invest, you know, somebody invests $1 million and then you're gonna take that money and you're gonna invest in all these moonshots and hope that, you know, you get like 100x multiple or whatever, 50x multiple on, on, on these deals. Um, and then so the fund starts in year 0, and, you know, usually has 10 years, you know, 10-year fund, common and venture. And then you're going to be receiving these distributions as you exit throughout. So you don't want to pay any sort of preferred, but where you're shooting for the moon on this, like usually it's, okay, look, the general partnership doesn't make any money until 100%, you know, principal is returned back. Or, you know, some aggressive funds will, it's almost like a performance fee. It's a 1.1 equity Multiple. But it's different from a time value of money, right? Because IRR, so this is measured in terms of IRR usually, you know, this pref annualised, but a venture will often do it in terms of equity multiple. So, or until you make as high as, you know, 1.5 times your money, then that's where the waterfall starts. So you can play with equity multiples. And then you go into an 80/20 split of profits. And same hedge, same with hedge funds. Hedge funds have a unique clause. They often do a hurdle. They'll do a you know a performance split, but they'll often have you know something called a high watermark, which is something we don't talk about very much. And basically what that is is that's saying let's say you have a fund for a million dollars. You then grow the account up to 1.1 million. And let's say end of year, and you want to take your 20% performance fee. So you collect that, right? You pay that out to the GP. Next year, you know, you drop down to $900K, and then the next year you go back up to $1 million. So, you know, pretty volatile here. What a high watermark says is, look, you don't get to collect this 20%. It's only if it's above your previous highest, you know, account balance. That way it's ensuring that, you know, the general partnership isn't winning if, you know, just from a volatile account. So definitely a high watermark if you're in hedge funds, you want to have that in your waterfall and fee structure. But yeah, I mean, look guys, you can get very creative on the fee structure of funds. Now, go watch the video about, you know, current versus new investors. Because that really plays a large role in determining your fee structure. A lot of people come to the program and they're like, Lincoln, I want to do a 50/50 split. I'm not going to make any money off an 80/20. I would make more money just by syndicating these deals. This is often real estate guys. And I'm like, yeah, okay, you would on that one deal, you know, by syndicating it. But that's not the point of a fund, right? You're trying to do 20 or 50 or 100 of those deals. And obviously by leveraging other people's money, you're going to make way more with an 80/20 split than you would with a 50/50. Now, still there are some funds out there that will have a 50/50 split. Um, it's usually because they raise from their current investor base. They've already made their investors money and, you know, they can constitute, you know, having this aggressive fee structure. Um, Honestly, and if they're not, the only time I'd recommend a 50/50 split is probably after, you know, a 20% return. So how, so how that would look like is, you know, the first, you know, maybe a pref, 2% catch-up, 80/20 up to 20%. And then afterwards you can go to a 50/50 split, but nothing really before that. So I hope this video cleared up some confusion for you guys about waterfalls and splits and, And whatnot. Just know that they're different based on the fund that you that you launch, and to always seek legal counsel. Definitely, you always want to do that. Hope you guys enjoyed this video. Have a good one.
