Pari Passu. Pref Rate 15% good proxy for Pref Non Pari Passu split. 1 st Tier. 2 nd Tier 2 nd Tier rate N # Tiers. N th Tier rate.

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1 STAGE CAPITAL, LLC TO: FROM: SUBJECT: INVESTORS OF ALL TYPES, SHAPES AND SIZES! ROGER STAIGER, MANAGING DIRECTOR WATERFALL DISTRUBTIONS DATE: 27 JUNE 2010 CC: TERRA WEIRICH The Waterfall is the method of distributing profits among partners within a transaction. In more complex transactions profits do not follow an even distribution, i.e. profits are not distributed Pari Passu. (Pari Passu is the proportional distribution of profits in accordance with percentage of capital provided for an investment. That is, an investor that provides 80% of capital receives 80% of profit if distribution follows Pari Passu.) A graphic depiction of a general waterfall structure is below. Please note that rates discussed are internal rates of return, i.e. accrual rates on capital, and not simple interest rates. The distribution of profits by investor can be different at each tier and is prenegotiated from project onset. Pari Passu 1 st Tier Pref Rate 15% good proxy for Pref Non Pari Passu split 2 nd Tier 2 nd Tier rate N # Tiers N th Tier N th Tier rate Final Tier Example Final Distribution X % to Promote to Sponsor (1 X%) distribution Pari Passu Roger Staiger III (202) rstaiger@gwmail.gwu.edu Memo_Waterfall_27Jun10

2 This memorandum will theoretically lay out the process of a waterfall and provide a numerical example as the coda. In addition, there is a numerical spreadsheet which students should all recreate to ensure an understanding of waterfall structure.. Waterfall Construction Steps: Step 1 Quantify Equity Contributions These are quantified within the project pro forma. Generally in a Staiger pro forma, these values are quantified and separated by investor on the Inflow_Outflow page. The separation will be as follows: Sponsor Investor(s) Step 2 Quantify Project Cash Flows These are the quantified cash flows from the project pro forma. This is not the project income which is an accounting number. On a Staiger pro forma, these values will be quantified by major classification on the Inflow_Outflow page. Step 3 Quantify Project Characteristics This quantification for the project characteristics determines if the project is viable prior to investor distributions. The short-list of project metrics which determine viability include, but are not limited to, the following: Total Profit (nominal) Internal Rate of Return (IRR) Multiple (Profit/Invested Capital) Step 4 Calculate the 1 st Waterfall ( Pref Rate), i.e. Tier 1 The recommended structure uses the following line items: Beginning of Period Balance (BoP) Total equity contribution/period Accrual (calculate daily rate to use XIRR) Paydown (distributed capital at stated rate) End of Period Balance (EoP) Remaining cash IRR Check An example of the structure from the MS Excel follows: Tier BoP Balance Equity Contributions (200.0) Accrual 15.00% (19.2) Paydown EoP Balance Cash left for distribution 30.8 IRR Check 15.00% 19.2 Period Cash Flows BoP Balance Cash balance from the previous period. It is also the End-of-Period balance from the previous period. 2

3 Equity Contributions This is the total funding requirement for the period. This value comes directly from the summary atop the waterfall. See also Step 1 Quantify Equity Contributions. Accrual This calculates the amount to achieve a total distribution equal to the specific rate for the quantified tier. For the first tier this is the Pref rate. The rate is as specified in the agreement between the sponsor and investor(s). Generally the documents will state this rate as an annual rate. To complete the accrual correctly the annual rate must first be converted to a daily rate. (this allows the use of the XIRR function which quantifies the rate on a daily basis (see Staiger Memorandum on XIRR function for additional information)). To convert an annual rate to a daily rate the following relationship must be remembered: 1/ ENAR 1 EAY m m Where: ENAR: Equivalent Nominal Annual Rate EAY: Equivalent Annual Yield m: Periods For example, a 15% rate with annual compounding is equivalent to a % rate compounded daily. See below. ENAR Note the daily accrual rate is This conversion is critical as the XIRR function in MS Excel discounts on a daily basis. This also provides a more accurate distribution of cash flow. Once the daily rate, as calculated, is then used to calculate the accrual amount. The accrual is calculated as follows: Accrual 1 1 daily _ rate days period BoP Pay Down The paydown is the amount distributed to achieve the rate for an individual waterfall tier. It is calculated as the lesser of the cash available/period and the absolute summation of BoP, Equity Contribution, and Accural. It is the lesser of the two quantities as the goal is to quantify the exact $$$ amount to achieve the tier rate only. The tier rate is the IRR as stated for the particular waterfall. EoP Balance This is calculated as the BoP + Equity contribution + Accrual Paydown. Be careful regarding sign convention when building the model. 3

4 Cash Left for Distribution The difference between cash available to distribute and paydown, i.e. cash available to distribute Paydown amount. This is the amount to distribute above what is needed to achieve the specific tier amount. IRR Check The cash flows are a combination of equity contribution and paydown. These cash flows are the actual investor cash flows for the tier, i.e. investor inflow and outflow attributable. Note: Repeat this step, Step 4, for the number of tier s, waterfalls, within the agreement. Additional Note: The tiers are all cumulative. That is, the second tier, Tier 2, includes the cash flow from Tier 1. Therefore distributions for the second tier must be Tier 2 Tier 1 cash flows, i.e. the delta. Step 5 Separate cash flows by tier by investor This quantification proportions the cash flows by tier by investor, i.e. separates cash flows according to division. The percentage allocation is specified in the agreement between the Equity/Sponsor and Investors. Note that Tier 2 and above require the delta to be calculated as each Tier is cumulative of the cash flows above it. Step 6 Analyze Investor Cash Flows Aggregate the cash flow by investor to analyze individual returns. Example: The MS Excel example depicts a $200.0m project funded with 10% developer/sponsor equity and 90% by an equity partner. The project provides $50.0m profit over the $200.0m invested capital. This represents a project IRR of 38.96% and a 1.25x multiple, i.e. 250/200. The partner agreement for the waterfall is as follows: Pari Passu to a 15% Pref Rate (IRR) o Up to 15%, profits are distributed proportional to invested capital Developer/Sponsor receives 10% Equity Partner receives 90% Second tier 20% IRR o Profits are split unequally Developer/Sponsor receives 20% Equity Partner receives 80% Third/Final tier o 40% Promote Developer/Sponsor receives 40% of remaining cash flow o 60% remaining distributed Pari Passu Developer/Sponsor receives 10% Equity Partner receives 90% Summary: The above structure for the stated example provides the following returns delineated by capital provider: Developer/Sponsor o IRR = % Equity Partner o IRR = 30.83% 4

5 Note the difference in return for each capital investor. The waterfall structure benefits each investor differently. This is similar to a structured finance investment. MS Excel Waterfall Example Waterfall Sample Period ($MMs) Total 1/31/2010 2/28/2010 3/31/2010 4/30/2010 5/31/2010 6/30/2010 7/31/2010 8/31/2010 9/30/ /31/ /30/ /31/2010 Step 1 PROJECT FUNDING Equity Contributions (125.0) (25.0) (20.0) (15.0) (15.0) Sponsor 10% (20.0) (12.5) (2.5) (2.0) (1.5) (1.5) Equity Partner 90% (180.0) (112.5) (22.5) (18.0) (13.5) (13.5) Total 100% (200.0) (125.0) (25.0) (20.0) (15.0) (15.0) Step 2 Cash Proceeds for Distribution Project Cash Flow 50.0 (125.0) (25.0) (20.0) (15.0) (15.0) Profit $50.0 IRR 38.96% Multiple 1.25x Step 3 STRUCTURE Tier 1 Step BoP Balance 0.0 (125.0) (151.3) (173.2) (190.2) (207.4) (209.8) (212.3) (164.9) (116.8) (68.2) (18.9) Equity Contributions (200.0) (125.0) (25.0) (20.0) (15.0) (15.0) Accrual 15.00% (19.2) 0.0 (1.3) (1.8) (2.0) (2.3) (2.4) (2.5) (2.5) (1.9) (1.4) (0.8) (0.2) Paydown EoP Balance (125.0) (151.3) (173.2) (190.2) (207.4) (209.8) (212.3) (164.9) (116.8) (68.2) (18.9) 0.0 Cash left for distribution IRR Check 15.00% 19.2 (125.0) (25.0) (20.0) (15.0) (15.0) Tier Starting Balance 0.0 (125.0) (151.8) (174.1) (191.8) (209.8) (212.9) (216.2) (169.6) (122.2) (74.1) (25.2) Equity Contributions (200.0) (125.0) (25.0) (20.0) (15.0) (15.0) Accrual 20.00% 0.0 (1.8) (2.4) (2.6) (3.0) (3.2) (3.3) (3.4) (2.6) (1.9) (1.1) (0.4) Paydown Balance (125.0) (151.8) (174.1) (191.8) (209.8) (212.9) (216.2) (169.6) (122.2) (74.1) (25.2) 0.0 Cash left for distribution IRR Check 20.0% 25.6 (125.0) (25.0) (20.0) (15.0) (15.0) Step 5 Cash Flows to each tranche: I. Pari Passu to an IRR of 15.00% Sponsor 10.00% Equity Partner 90.00% II. Splits up to an IRR of 20.00% Sponsor 20.00% Equity Partner 80.00% Cash left for Distribution III. Sponsor Promote 40.00% Cash to Equity 60.00% Sponsor 10.00% Equity Partner 90.00% INVESTOR CASH FLOWS SPONSOR Equity Investment Step 6 (20.0) (12.5) (2.5) (2.0) (1.5) (1.5) Proceeds CF 14.4 (12.5) (2.5) (2.0) (1.5) (1.5) Profit $14.4 % of Total Profit 28.9% IRR % Multiple 1.72x EQUITY PARTNER Equity Investment (180.0) (112.5) (22.5) (18.0) (13.5) (13.5) Proceeds CF 35.6 (112.5) (22.5) (18.0) (13.5) (13.5) Profit $35.6 % of Total Profit 71.1% IRR 30.83% Multiple 1.20x Check TRUE MS Excel Functions utilized in the above example: =EOMONTH() =COUNT() =SUM() =XIRR() =ABS() =MIN() =DAY() 5