Of the most popular distribution structure, the three most common flavors are as follows:
• Pro rata: We call this a standard split. Pro rata is basically a fancy Latin term that means proportional. So, under a pro rata distribution model, the distributable cash is given to investors proportionally according to their membership interests when it comes to splits. A typical multi-family split between investors and sponsors is 70/30, meaning that seventy percent goes to investors pro rata and thirty percent to the sponsor. There’s usually a ten percent standard deviation, which means there is a range from 60/40 to 80/20 splits.
• Preferred return, followed by a split: The preferred return gives investors a distribution preference — usually 8%-9% in multi-family deals. After the preferred return, the rest is basically split pro rata according to the split ratio.
• Preferred return inclusive of split: In this scenario, after investor members receive their preferred return, the investor members then get a percentage of the distributable cash pro rata according to the split, and the sponsor receives a percentage of the rest the remaining percentage of the distributive cash. The difference between this distribution structure and the previous one is that the preferred return is included in the calculation of the split.
Frequency of Distribution
When structuring distributable cash, one thing to take into account is frequency of distribution to investors. As sponsor, you need to ask how often are you going to be doing distributions–annually? Quarterly? Monthly? Most sponsors opt to process distributions quarterly– it’s not so frequent that it kind of becomes a pain every month, but is still frequent enough to establish regular communications with investors. Most investors won’t only want to hear from you once a year. Whats more, when one makes a distribution to an investor and opens the line of communication, investors are in a happier mood and may be more receptive to talk of another upcoming offering.
With distribution structures, there are also reinvestment options. While reinvestment options are seldom used, they’re not entirely rare. Sponsors who use reinvestment options only want to use them in certain types of deals. For example, where a sponsor expects to hold a multi-family property for 5 to 7 years, but suspects there is a possibility that they could achieve a large IRR relatively quickly within the first three years. In that case, sponsors may write into their offering a reinvestment option that states that if the sponsor exits from the property within the first three years, the sponsor may reinvest the proceeds into another property. Reinvestment options are a feature that sponsors will want to ensure that their investors know upfront.
Occasionally, clients will request multiple waterfalls. For example, they may write in a distribution structure that once an investor receives a 8% preferred return, remaining distributable cash will be split 80/20 between investors and the sponsor, until investors receive a
13% preferred return. Thereafter, remaining cash would be split 60/40 split until investors receive a 25% preferred return, after which remaining distributable cash would be split 50/50.
Some sponsors (and investors) prefer multiple waterfall structures because it incentivizes the sponsor to make investors as much money as possible. However, it can be more difficult to calculate, and for less sophisticated investors, it structure may be confusing.
Which brings me to my final point–KISS, or ‘keep it simple, smartie.” Simplicity is often more understandable, comprehensible, and approachable for certain types of investors. If you cannot explain the deal in a couple breaths, your investor is likely going to get confused. While accredited investors are deemed to be “sophisticated”, having verified the accreditation status of hundreds of investors for Rule 506(c) purposes, you would be surprised at how unsophisticated many accredited investors still are. Some inherited their funds or just got lucky, or simple don’t understand real estate. Complexity is often a deal-killer.