Investment approach
Waterfall: preferred return, catch-up and promote in a JV
A waterfall splits project cash in order: capital, preferred return, an operator catch-up, then the percentage splits. The tiers, the LSC rules and how it differs from a plain 50/50.
A waterfall (distribution waterfall) is the order in which a joint project's cash is divided between the investors and the operator in tiers: first the return of what was contributed, then the preferred return, then a payment to the operator (catch-up), after which the percentages are split in the agreed proportion. The operator's share in the last tier is called the promote. It is a classic private equity instrument in real estate, not the DNPI structure: DNPI's published model is different, and the difference is described below. The limits of IRR as a measure of return were written about by Ludovic Phalippou on the CFA Institute blog (8 November 2024).
What tiers make up a classic waterfall?
- Return of capital. All distributions go to the investors until they have received back what they put in.
- Preferred return (hurdle). The investors receive an agreed minimum, for example 8% a year accruing on the amount contributed.
- Catch-up. The operator receives most of the next money until their share of the profit already paid reaches an agreed percentage. This tier may not exist.
- Split of the remainder. From there the profit is divided at a set rate, for example 80% to the investors and 20% to the operator. The operator's share here is the promote.
The order and the parameters of each tier depend on the contract. The words "preferred return of 8%" are not enough: the starting point, compounding and the method of calculation are needed, because the result depends on them. Phalippou writes that IRR does not equal return in the ordinary sense and depends on assumptions about the timing of cash flows (CFA Institute). If the hurdle is expressed as an IRR, the timing of payments affects it. The articles on IRR in plain words and on equity multiple explain how these measures differ.
What does it look like in numbers?
Worked example, not a forecast and not DNPI terms. The investor put in 1 M€, the project lasted two years and returned 1.6 M€. Terms: preferred return of 8% a year with compound interest, no catch-up, the remainder split 80/20.
| Tier | Investor | Operator |
|---|---|---|
| Return of capital | 1 M€ | 0 € |
| Preferred return (1 M€ × (1,08² − 1)) | 166 400 € | 0 € |
| The remaining 433 600 € split 80/20 | 346 880 € | 86 720 € |
| Total | 1.51328 M€ | 86 720 € |
For comparison: with a plain split of the 600 000 € profit in equal parts, each side would have received 300 000 €. There is no conclusion here on which scheme is better: operators put in different amounts of their own capital, charge different fees and bear different risks, and a comparison without the contract terms is not possible.
What does Spanish law say about such arrangements?
In an SL an unequal distribution has to be set out in the articles. By default a dividend is divided in proportion to capital unless the articles say otherwise (art. 275 LSC). Partners can hold different rights; a privilege is created under the rules for amending the articles (art. 94). If the privilege is a preferential dividend, the other shares receive no dividends until it has been paid for the year, and the articles must say whether unpaid amounts accumulate (art. 95). But the law makes void the creation of shares carrying a right to an "interest" in any form (art. 96.1), so the wording of a preferred return needs review by an abogado.
In arrangements without a separate SL, for example cuentas en participación, the participants divide the result in the proportion they determine themselves (art. 239 Código de Comercio), that is, the formula is left to the contract. The general limits for profit-sharing contracts are set by the Código Civil: a pact that excludes a partner from all the profit or from all the losses is void (art. 1691). Whether it applies to your arrangement is for a lawyer to determine.
How does the DNPI model differ from a classic waterfall?
Published parameters: DNPI's fee is 50% of the project's profit; the other half stays with the investor. If the investor's return over the whole project, after distribution, falls below the contractual 10%, DNPI pays compensation out of its own fee. The terms, the calculation base and the limits are set by the project contract. This is a return per project, not annual, and not a guarantee of capital preservation.
| Feature | Classic waterfall | DNPI model under the public terms |
|---|---|---|
| Split of the remainder | Changes by tier | 50/50 |
| Hurdle | Preferred rate, usually annual | 10% investor return over the whole project, not an annual rate |
| How the hurdle works | Through the order of payments | Through contractual compensation out of DNPI's fee |
| Where the details are | Contract and articles | The contract for the specific project |
How the order of capital return and calculation is worded in your contract has to be read in the project contract. A detailed look at the fee is in the article on DNPI's 50% fee, and on the top-up in the article on the 10% contractual top-up.
What questions should you ask about the contract?
| Area | What to check |
|---|---|
| Definition of profit | Which costs are deducted before the split, whether the operator is paid a fee (costs before the split) |
| Hurdle | Rate, accrual, start date, method of calculation |
| Order | What comes first: capital, hurdle, the operator's share |
| Clawback of earlier payments | What happens if the operator received their share and the project later ran into a loss |
| Timing | When the result is calculated and when it is paid |
| Information rights | Who checks the calculation and how |
| Disputes | Governing law, court or arbitration |
Who is a waterfall not suited to?
It does not suit you if you need simple, verifiable arithmetic: more tiers mean more places for a dispute. It also does not suit anyone who compares projects by a single hurdle figure, without the timing and without the definition of profit. Nor anyone who judges a scheme from public materials: they usually give a target return, but the waterfall parameters are disclosed only in the contract.
You can check your project's parameters in the investor calculator, and a general list of questions for the contract is in the article on questions for the lawyer.
Questions and answers
What is the promote in a joint project?
It is the operator's share of profit above the hurdle. It is paid after the investors have received back their capital and the preferred return.
How does a preferred return differ from interest on a loan?
It is usually paid out of the project's cash and not as a fixed debt, but the order and terms are set by the contract. The legal characterisation, especially in an SL, is determined by the abogado (art. 96.1 LSC).
Is DNPI's 10% compensation the same as a preferred return?
No. It is a contractual payment out of the fee if the investor's return over the whole project, after distribution, falls below 10%, and it is neither a waterfall tier nor an annual rate. The terms are set by the contract for the specific project.
How do I check the waterfall in an operator's proposal?
Ask for the calculation under two or three scenarios with figures and check it against the text of the contract: hurdle, order, timing, costs before the split.
