Lookback Provision Explained
Equity waterfall deals have become a popular way to invest in real estate through a syndication. Because they involve trusting other parties (sponsors or general partners), investors want to feel confident in their investment and have a level of security written into the deal.
A lookback provision is included in some waterfall-structured investment deals. They stipulate that if the investor does not receive the pre-agreed upon the rate of return, the sponsor will be required to give up a portion of their already distributed profits to fill that gap.
Lookback Provision Example
If in years 1, 2, and 3 of a deal, the property pays its preferred return, plus a return for the sponsor. But then in year 4, the asset is disposed of, resulting in profits that do not meet the LP’s pref. In this scenario, the GPs or sponsors must dip back into their already distributed profits to ensure the LPs receive the entirety of their pref.
Effectively, including a lookback provision means the sponsor is required to meet the disclosed preferred return before receiving their own profits. Investors like this provision because it provides a safety net, ensuring that they are not left out of pocket if the deal falls short. Furthermore, the lookback provision incentivizes the sponsor to act in the best interests of investors, as they are required to give up a portion of their profits if the agreed-upon returns are not met.
Potential Drawbacks of a Lookback Provision
While a lookback provision can provide protections for investors, we also need to consider the potential downsides of this provision. Some of the downsides of a lookback provision include:
- Reduced Flexibility: The lookback provision can limit the sponsor’s flexibility in making decisions regarding the project. For instance, the sponsor may be reluctant to make certain investments or take certain actions that could impact their ability to meet the anticipated rate of return. This can limit the long term viability of the project.
- Increased Sponsor Risk: The lookback provision increases the sponsor’s risk and liability in the event that the project fails to meet the anticipated rate of return. This can lead to increased pressure on the sponsor to perform, which could impact their ability to make strategic decisions in the project’s best interest.
- Reduced Returns: The lookback provision reduces investor risk but tends to come hand-in-hand with lower returns.
- Complexity: The lookback provision can make the deal structure more complex, making it more difficult for investors to understand the terms of the deal and make informed decisions.
- Increased Costs: The lookback provision can increase the costs associated with the project, particularly if the sponsor needs to engage legal and accounting professionals to help calculate and distribute profits.
Remember to weigh the benefits and drawbacks of a lookback provision when deciding on an investment strategy or whether or not a specific real estate syndication is the right choice for you.