Equity Waterfall

A syndicator that raises private equity may consider an equity  waterfall that is similar to a combination of debt and equity. Treat the senior equity like a 1st lien and the preferred equity like a 2nd lien, with a debt-like structure with a fixed annual rate, amortization term, and rolled-in points. An amortization schedule shows how much each tranche receives for cash flow and how much of the exit strategy is distributed to the senior tranches before the common equity tranche receives its distribution.

The senior tranches receive cash flow and exit strategy in their prioritized order, as specified in the LLC Operating Agreement, with no management vote. If the cash flow defaults, then the senior tranches can take over the membership interests (personalty) of the junior equity members, as provided in the LLC Operating Agreement.

The junior equity members are what I like to call “common equity” and “subordinated equity”. Subordinated equity is simply the syndicator who arranged all of the equity financing and received a percentage ownership (from 30% to 70%) that gets paid dead last after everyone else gets paid for cash flow and exit strategy, in exchange for having no liability on expenses or debt service. The syndicator also receives an asset management fee, accounted as an operating expense, that is typically 2% to 4% of the asset value.

The common equity membership receives a percentage of the cash flow subject to the senior tranches first receiving their specified cash flow as if it were a periodic debt payment (i.e., “Time Value of Money” calculation).

The remaining cash flow is split according to the common equity membership portion and then compared to a minimum agreed yield calculated as non-amortizing (“interest only”) on their equity. If the amount is insufficient, then the syndicator sacrifices as much of his portion as necessary to produce the required minimum yield to the common equity membership.

Thus, the effective yield of each tranche increases as the priority decreases. The highest priority senior equity gets paid first and has the lowest yield. The preferred equity (second tranche) gets paid next and has a higher yield than the senior equity. The common equity (third tranche) gets paid only after the first and second tranches, and gets the highest yield on its investment. The risk of loss is inverted with the common equity the first to cover any losses before the second tranche. The second tranche (preferred equity) covers losses before the first tranche (senior equity).

Seems complicated, but for the senior tranches the math is very simple, just like calculating a periodic debt constant and a balloon payment. An amortization schedule for the first and second tranches is easily calculated and included as an exhibit in the LLC Operating Agreement.

For the common equity tranche, just split the remaining cash flow according to the common equity versus subordinated equity ratio, then compare to the minimum agreed yield that is specified in the LLC Operating Agreement. Similar calculations apply to the exit strategy for the amount remaining after paying off the senior tranche “balloon payments”.

Remember that equity is not debt, so the common equity investors only receive back their initial investment when the LLC Operating Agreement specifically states that requirement. In general, the “Equity Multiple” is a better measure of the return of equity, because it calculates the total sum of the periodic cash flow plus the portion of the exit strategy without regard to the Time Value of Money (TVM) yield calculations. If the “Equity Multiple” is 2.0, then that means the common equity members received sufficient periodic cash flow plus exit strategy to equal 2.0 times their initial equity investment.

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