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Waterfall Construction Basic Theory
ULI Waterfall Webinar 20 March 2012
Roger Staiger III, FRICS
(202) 640-8912 rstaiger@gwmail.gwu.edu
Waterfall Diagram
Roger Staiger rstaiger@gwmail.gwu.edu 2 of 125
Pari Passu
“Pref” Rate15% good proxy for “Pref”1st Tier
Non Pari Passu split
2nd Tier 2nd Tier rate
N # Tiers
Nth Tier rate
Final Tier
Nth Tier
Example – Final DistributionX % to Promote to Sponsor(1‐X%) distribution Pari Passu
Note: Explained in detail later
Agenda (Session 1) 1) Interest Factors
Basics of Accrual, Compounding, Effective Notional Annual Rate (ENAR)
2) Waterfall Functions (MS Excel) 3) Waterfall (General Concept(s)) 4) Pro Forma Structure 5) Waterfall (Construction) 6) Securitization (Time Permitting) Roger Staiger rstaiger@gwmail.gwu.edu 3 of 125
Agenda (Session 2) Waterfall Construction
MS Excel Construction of Waterfall
Four part construction 1) Project Summary 2) Tranche’ Structures 3) Tranche’ Cash Flows 4) Investor Cash Flows
Deliverable: Final working model & process
Roger Staiger rstaiger@gwmail.gwu.edu 4 of 125
Interest Factors
Understanding of
compounding rates
Roger Staiger rstaiger@gwmail.gwu.edu
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Compound Interest Interest-on-Interest Components (HP-12c)
Initial Deposit (PV) Interest Rate (i) Time (n) Payment rate (PMT) Future Value (FV)
Happy 30th Birthday!
Roger Staiger rstaiger@gwmail.gwu.edu
7 of 125
Future Value - Simple
tt IPVFV
Roger Staiger rstaiger@gwmail.gwu.edu
Future Value – Simple (example) $100,000,000 @ Libor + 250 (one-year) Where: i = Libor + 250 = 275 (2.75%) PV = $100,000,000 it = ($100,000,000)*i = $2,750,000 FVt = PV + it FVt = $100,000,000 + $2,750,000 FVt = $102,750,000
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Roger Staiger rstaiger@gwmail.gwu.edu
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Future Value - Compounded
tiPVFV 1Interest
Compounds Roger Staiger rstaiger@gwmail.gwu.edu
Future Value – Compounded (example)
$100,000,000 @ Libor + 250 (two-year) Where: i = Libor + 250 = 275 PV = $100,000,000 FVt = ($100,000,000)*(1+i)2
FVt = ($100,000,000)*(1+i)*(1+i)
FVt = $102,750,000*(1+i) FVt = $102,750,000*(1+0.0275) FVt = $105,575,625
10 of 125 Roger Staiger rstaiger@gwmail.gwu.edu
11 of 125
Future Value – Periods (Periodic Compounding)
mn
miPVFV
1
Where:
n: periods, e.g. years
m: intervals within 1 year
i: Annual Interest Rate
Roger Staiger rstaiger@gwmail.gwu.edu
12 of 125
Future Value – Periods (Periodic Compounding) cont’d
mn
miPVFV
1
Compounding Periods:
M=2: Semiannual
M=4: Quarterly
M=365: Daily
Roger Staiger rstaiger@gwmail.gwu.edu
Future Value – Periods (Periodic Compounding) example1 PV = $100,000,000 (1 year) I = Libor + 250 = 275bps M(Compounding Periods) = semiannual (2)
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044,779,102
0278.1000,000,1000138.01000,000,100
20275.01000,000,1001
2
21
FVFV
miPVFV
mn
Roger Staiger rstaiger@gwmail.gwu.edu
Future Value – Periods (Periodic Compounding) example2 PV = $100,000,000 (2 years) I = Libor + 250 = 275bps M(Compounding Periods) = monthly (12)
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414,647,105
0565.1000,000,1000023.01000,000,100
120275.01000,000,1001
24
122
FVFV
miPVFV
mn
Roger Staiger rstaiger@gwmail.gwu.edu
Effective Annual Yield (EAY) Annual equivalent yield Assumes annual compounding Converts period compounding to annual
value a.k.a. APR
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1PVFVEAY
Roger Staiger rstaiger@gwmail.gwu.edu
EAY (example1)
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annual)-(semi 2.75% versus%78.2
0278.01000,000,100044,779,1021
044,779,1020278.1000,000,1000138.01000,000,100
20275.01000,000,1001
2
21
EAYPVFVEAY
FVFV
miPVFV
mn
Roger Staiger rstaiger@gwmail.gwu.edu
EAY (example2)
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2.75%) (versus 2.80%or 0280.0
0280.01000,000,100183,795,1021
year) 1(for 183,795,1020280.1000,000,1000023.01000,000,100
120275.01000,000,1001
12
121
EAYPVFVEAY
FVFV
miPVFV
mn
Roger Staiger rstaiger@gwmail.gwu.edu
EAY (multiple Periods)
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rtPVFVNote
:
Roger Staiger rstaiger@gwmail.gwu.edu
Nominal Annual Rate
Compounding Interval Periods/Yr EAY
5% Annual 1 5.0000%
5% Semi‐annual 2 5.0625%
5% Quarterly 4 5.0945%
5% Monthly 12 5.1162%
5% Daily 365 5.1267%
5% Continuous Infinite 5.1271%
Effective Nominal Annual Rate (ENAR)
Equivalent Effective Annual Yield (EAY) when adjusting for compounding
Where: M = compounding period(s)
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111
m
mENAR
PVFVEAY
Roger Staiger rstaiger@gwmail.gwu.edu
ENAR Solved
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mEAYENAR
EAYm
ENARm
ENAREAYm
ENAREAY
mENAR
PVFVEAY
m
m
mm
m
11
11
1111
111
/1
/1
/1
Roger Staiger rstaiger@gwmail.gwu.edu
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Future Value - Periods
Where:
ENAR: Equivalent nominal annual rate
EAY: Effective annual yield
m: Periods
mEAYENAR m 11 /1
Roger Staiger rstaiger@gwmail.gwu.edu
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Future Value – Example1 EAY = 6.00% M = Monthly compounding
5.841%or 05841.012*00.1004868.1
12*106.1
12*106.01083333.0
121
ENARENARENAR
ENAR
Roger Staiger rstaiger@gwmail.gwu.edu
Future Value – Example2
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6.00%or 06.0
112
05841.01
11
12
EAY
EAY
mENAREAY
m
Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall Functions
MS Excel Functions
Roger Staiger rstaiger@gwmail.gwu.edu
MS Excel Functions End of Month: ‘=EOMONTH() Count: ‘=COUNT() Summation: ‘=SUM() Absolute value: ‘=ABS() Minimum: ‘=MIN() Day: ‘=DAY() XIRR: ‘=XIRR(values,dates) XNPV: ‘=NPV(rate,values,dates)
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End of Month Function Returns the serial number of the last day of
the month before or after a specified number of months
“=EOMONTH(start_date,months)” Start Date = 1 January 2011 Last day of March 2011
=EOMONTH(1Jan11,2) Note: 1Jan11 must be value not a name
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Count Function Counts the number of cells in a range that
contains numbers “=COUNT(values)”
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A B C D E
1 4 5 Roger 6
Count 4
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Sum Function Adds all the numbers in a range of cells “=SUM(values)”
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A B C D E
1 4 5 Roger 6
Count 4Sum 16
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Absolute Value Function Returns the absolute value of a number, a
number without its sign “=ABS(value)” |-a| = a; |a| = a
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5 ‐7Absolute 5 7
Roger Staiger rstaiger@gwmail.gwu.edu
Minimum Function Returns the smallest number in a set of
values. Ignores logical values and text. “=MIN(values)”
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5 ‐7Absolute 5 7
Row1 Minimum ‐7Row2 Minimum 5
Roger Staiger rstaiger@gwmail.gwu.edu
Day Function Returns the day of the month, a number
from 1 to 31 “=DAY(serial_number)”
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2‐Feb‐11 6‐Mar‐11 22‐Apr‐11 30‐May‐11 15‐Jun‐11Day 2 6 22 30 15
Roger Staiger rstaiger@gwmail.gwu.edu
XIRR versus IRR IRR discounts on a periodic basis XIRR discounted on a daily basis
Allows analyst to input actual dates of cash flows Recognized capital as a vector, not a static input
Capital has both magnitude (Qty) and direction (date)
Allows for accurate return of cash when received at irregular intervals
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XIRR Requires two inputs: Values and Dates Each Cash Flow is discounted the day it
occurs
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N
idd
ii
rate
PNPV1 365
1
10
where: di = the ith, or last, payment date d1 = the 0th payment date Pi = the ith, or last, payment
Roger Staiger rstaiger@gwmail.gwu.edu
XIRR (cont’d) MS Excel solves the equation using linear
interpolation, i.e. iterative technique Third input can be added to assist MS
Excel when appropriate assumptions can be made
Note: XIRR function requires the analysis toolpak to be installed in MS Excel Excel Add-in
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XIRR Example
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1‐Jan‐11 1‐Jul‐11 1‐Jul‐12 1‐Jul‐13 1‐Jul‐14(35,000) 12,000 5,000 20,000 22,000
IRR 20.85%XIRR 26.46%Delta 5.61%
Roger Staiger rstaiger@gwmail.gwu.edu
MS Excel Add-Ins (Data Analysis & Solver)
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Steps for MS Excel Add-ins
5 minute break for those that have it
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Step 1 – Office Button
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Step 2 – Excel Options (Select)
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Step 3 – Excel Options
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Step 4 – Add-Ins
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Step 5 – Add-Ins
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Step 6 – Select Solver Add-in & Analysis ToolPak
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Step 7 – Hit “OK” Select (Hit) “OK” in the lower right portion
of your screen
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Step 8 – Data (once back in MS Excel)
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Step 9 – Data Analysis & Solver
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Verify (Data Analysis & Solver)
Under data on the ribbon bar verify that ‘Data Analysis’ and ‘Solver’ are there
If not there and you are using a PC, please email me, rstaiger@gwmail.gwu.edu, after the program for assistance
If not there and you are using an Apple, please contact your administrator. Unfortunately I do not know this process (but it should be very similar)
47 of 125 Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall
Let the fun begin…
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Niagara (U.S. Side) (Do not end up on the rocks!)
49 of 125 Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall Method of distributing profits among
partners within a transaction Allows for profits to NOT follow an even
distribution Profits NOT distributed Pari Passu Pari Passu: division entirely by ownership %,
80% capital, 80% of ALL cash flows distributed, 80% of risk
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Simple Waterfall: Bank Model Creditor is paid first Owner is paid second
Payment by value NOT yield Waterfalls typically separate
cash flows to owners (equity)
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DEBT
Equity
Net Operating Income (NOI)
Roger Staiger rstaiger@gwmail.gwu.edu
Syndication versus Securitization Syndication separates cash flows
according to ownership % 20% ownership, 20% of risk
Securitization separates cash flows according to risk tranches Transformation of a portfolio of financial obligations
into liquid form attractive to a myriad of investors
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Syndication versus Securitization (graphic)
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Syndication Securitization
Capital Stack
Ownership Division
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Structure Example (Generic)
Bond1 Bond2 Bond3
Bondn (y = 8.5%)
TRUST
Tranche 4 (Residual) 4th 5% Loss; y=35%
Tranche 3 3rd 10% Loss; y=15%
Tranche 2 2nd 10% Loss; y=7.5%
Tranche 1 1st Senior; y=6%
Wat
erfa
ll
Roger Staiger rstaiger@gwmail.gwu.edu
Syndication/Structured Issue: Too large for single
lender Result: Bifurcate into two
tranches Senior “A” Piece Junior “B” Piece
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Single Bond $100.0m 10 years
Interest only 6% Coupon WAM = 10
WAC = 6.00%
Syndication/Structured
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Single Bond $100.0m 10 years
Interest only 6% Coupon WAM = 10
WAC = 6.00%
Tranche “A” $50.0m 10 years
Interest only 4% Coupon WAM = 10
WAC = 4.00%
Tranche “B” $50.0m 10 years
Interest only 8% Coupon WAM = 10
WAC = 8.00%
Syndication/Structured (cont’d) Tranche “A” Senior Piece Reduced Coupon Tranche “B” Junior Piece Higher Coupon
Compensates for higher risk Prepayment Recovery Rate
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Tranche “A” $50.0m 10 years
Interest only 4% Coupon WAM = 10
WAC = 4.00%
Tranche “B” $50.0m 10 years
Interest only 8% Coupon WAM = 10
WAC = 8.00%
Syndication/Structured (cont’d)
Roger Staiger rstaiger@gwmail.gwu.edu 58 of 125
Tranche “A” $50.0m 10 years
Interest only 4% Coupon WAM = 10
WAC = 4.00%
Tranche “B” $50.0m 10 years
Interest only 8% Coupon WAM = 10
WAC = 8.00%
Prepayment 1. Refinance 2. Foreclosure 3. Sale Recovery
Loss %
Risk (σ)
Order of Payments: 1. Interest Tranche A 2. Interest Tranche B
3. Principal Tranche A 4. Principal Tranche B
- Residual
Single Bond ($100.0m) (No Prepay/Default/100% Recovery)
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Principal 100,000,000 WAM 10Interest 6% WAC 6%Term 10Prepay Date 10Recovery 100%
Period 0 1 2 3 → 9 10BoP 100,000,000 100,000,000 100,000,000 → 100,000,000 100,000,000Interest 6,000,000 6,000,000 6,000,000 → 6,000,000 6,000,000 Principal ‐ ‐ ‐ → ‐ 100,000,000EoP 100,000,000 100,000,000 100,000,000 100,000,000 → 100,000,000 ‐
Cash Flow (100,000,000) 6,000,000 6,000,000 6,000,000 → 6,000,000 106,000,000IRR 6.00%
Tranche A & B (No Prepay/Default/100% Recovery)
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Transformation 1 2 3 → 9 10Investor A ‐ Senior 4.00%BoP 50,000,000 50,000,000 50,000,000 → 50,000,000 50,000,000Interest 2,000,000 2,000,000 2,000,000 → 2,000,000 2,000,000 Principal ‐ ‐ ‐ → ‐ 50,000,000EoP 50,000,000 50,000,000 50,000,000 50,000,000 → 50,000,000 ‐
Invstor A ‐ Cash Flow(50,000,000) 2,000,000 2,000,000 2,000,000 → 2,000,000 52,000,000
IRR 4.00%
Investor B ‐ Junior 8.00%BoP 50,000,000 50,000,000 50,000,000 → 50,000,000 50,000,000Interest 4,000,000 4,000,000 4,000,000 → 4,000,000 4,000,000 Principal ‐ ‐ ‐ → ‐ 50,000,000EoP 50,000,000 50,000,000 50,000,000 50,000,000 → 50,000,000 ‐
Invstor A ‐ Cash Flow(50,000,000) 4,000,000 4,000,000 4,000,000 → 4,000,000 54,000,000
IRR 8.00%
Single Bond ($100.0m) (2-year prepay/90% Recovery)
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Principal 100,000,000 WAM 10Interest 6% WAC 6%Term 10Prepay Dat 8Recovery 90%
Period 0 1 2 3 → 7 8BoP 100,000,000 100,000,000 100,000,000 → 100,000,000 100,000,000Interest 6,000,000 6,000,000 6,000,000 → 6,000,000 6,000,000 Principal ‐ ‐ ‐ → ‐ 90,000,000 EoP 100,000,000 100,000,000 100,000,000 100,000,000 → 100,000,000 10,000,000
Cash Flow (100,000,000) 6,000,000 6,000,000 6,000,000 → 6,000,000 96,000,000 IRR 4.95%
105bp loss
Tranche A & B (2-year prepay/90% Recovery)
Roger Staiger rstaiger@gwmail.gwu.edu 62 of 125
Transformation 1 2 3 → 7 8Investor A ‐ Senior 4.00%BoP 50,000,000 50,000,000 50,000,000 → 50,000,000 50,000,000Interest 2,000,000 2,000,000 2,000,000 → 2,000,000 2,000,000 Principal ‐ ‐ ‐ → ‐ 50,000,000EoP 50,000,000 50,000,000 50,000,000 50,000,000 → 50,000,000 ‐
Invstor A ‐ Cash Flow(50,000,000) 2,000,000 2,000,000 2,000,000 → 2,000,000 52,000,000
IRR 4.00%
Investor B ‐ Junior 8.00%BoP 50,000,000 50,000,000 50,000,000 → 50,000,000 50,000,000Interest 4,000,000 4,000,000 4,000,000 → 4,000,000 4,000,000 Principal ‐ ‐ ‐ → ‐ 40,000,000EoP 50,000,000 50,000,000 50,000,000 50,000,000 → 50,000,000 10,000,000
Invstor A ‐ Cash Flow(50,000,000) 4,000,000 4,000,000 4,000,000 → 4,000,000 44,000,000
IRR 5.98%
No Loss
202bp Loss
Tranche B Sensitivity
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Tranche B 1 2 3 4 5100.0% 8.00% 8.00% 8.00% 8.00% 8.00%90.0% 6.28% 5.98% 5.59% 5.06% 4.33%80.0% 4.26% 3.60% 2.74% 1.59% 0.00%70.0% 1.80% 0.68% ‐0.77% ‐2.70% ‐5.36%60.0% ‐1.40% ‐3.16% ‐5.43% ‐8.43% ‐12.55%50.0% ‐6.11% ‐8.98% ‐12.70% ‐17.65% ‐24.40%
Prepayment years
Recovery %
Tranche A suffers no losses (exposed to reinvestment rate risk)
Waterfall Considerations Separation of cash flows according to
owners’ agreement Separation of cash flows by yield, NOT by
order Order: Bank vanilla example
“Pref” Rate: Preference Rate Generally provided to Investor Acts as a coupon rate, e.g. Preferred Equity
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Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall Diagram
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Pari Passu
“Pref” Rate15% good proxy for “Pref”1st Tier
Non Pari Passu split
2nd Tier 2nd Tier rate
N # Tiers
Nth Tier rate
Final Tier
Nth Tier
Example – Final DistributionX % to Promote to Sponsor(1‐X%) distribution Pari Passu
Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall Split Pref Rate: Up to 15% IRR
10% Sponsor 90% Investor
15% - 20% IRR Split 20% Sponsor 90% Investor
Over 20% 40% Promote (Sponsor) 60% Split (10% Sponsor; 90% Investor)
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Waterfall Split Graphic
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15% IRR
20% IRR
20% + IRR
Sponsor10%
Sponsor20%
PromoteSponsor
40%
Investor90%
Investor80%
Investor90%
Sponsor10%
Roger Staiger rstaiger@gwmail.gwu.edu
Pro Forma Structure
Incorporating the Waterfall
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Pro Forma Structure/Logic Flow
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Summary Page Pro Forma Page
(s2)
Amortization Page (s3) Inputs Section
(s1)
Analysis (s4)
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Pro Forma Structure/Logic Flow (Waterfall Addition)
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Summary Page
Pro Forma Page (s2)
Amortization Page (s3)
Inputs Section (s1)
Analysis (Project)
(s4)
Waterfall Page (Investor)
(s5)
Waterfall (Step 1) Quantify Equity Contributions Modeled in Sources/Uses
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Sources 549,000 Operations Units I/P Finance I/P
Equity 99,000 Unit 1 ‐ One Bedroom per mont 1,500 Tranche 1
Investor 1 80,000 Unit 2 ‐ Two Bedroom per mont 2,000 Principal 400,000
Investor 2 19,000 Unit 3 ‐ Two Bedroom per mont 2,000 Term (years) 20
Debt 450,000 Unit 4 ‐ Two Bedroom per mont 2,000 Interest Rate 8%
Tranche 1 400,000 Interest Only
Tranche 2 50,000 Vacancy 1 5.00% Origination Fee 1%
Vacancy 2 5.00%
Uses 549,000 Vacancy 3 5.00% Tranche 2
Purchase Price 350,000 Vacancy 4 5.00% Principal 50,000
Renovation 165,000 Term (years) 20
Legal 3,500 Rental Escl 2% Interest Rate 15%
Bank 2,000 Interest Only
Personal 1,500 Management per Net Rev 5% Origination Fee 1%
IDC 24,700 Repairs per Net Rev 5%
Tax Escrow 1,300 Janitor per year 2600 Valuation I/P
Finance Cost 4,500 Heat per year 2130 Cap Rate 10.9%
Electricity per year 1000 Sales Expense 6%
Surplus/(Deficit) ‐ Water per year 1200 Discount Rate 10%
Property Tax per year 7800
Insurance per year 2600 Sales Period Year 10
Expense Escl 2%
Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall (Step 2) Quantify the project cash flows for
distribution, i.e. cash distributions Modeled on pro forma page Cash flows must not be accounting values,
i.e. no earnings, free cash flows distributed to investors AFTER debt service
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Waterfall (Step 2) (cont’d) (Note: not yet…)
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Periods 1 2 3 4 5 6 7 8 9 10 11 12
Revenue Year 1 1 1 1 1 1 1 1 1 1 1 1
Unit1 Rent 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500 1,500
Unit2 Rent 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000
Unit3 Rent 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000
Unit4 Rent 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000
Total Rent 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500 7,500
Vacancy 1 75 75 75 75 75 75 75 75 75 75 75 75
Vacancy 2 100 100 100 100 100 100 100 100 100 100 100 100
Vacancy 3 100 100 100 100 100 100 100 100 100 100 100 100
Vanancy 4 100 100 100 100 100 100 100 100 100 100 100 100
Total Vacancy 375 375 375 375 375 375 375 375 375 375 375 375
Total Revenue 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125 7,125
Expenses
Management 356 356 356 356 356 356 356 356 356 356 356 356
Repairs 356 356 356 356 356 356 356 356 356 356 356 356
Janitor 217 217 217 218 218 218 219 219 220 220 220 221
Heat 178 178 178 178 179 179 179 180 180 180 180 181
Electricity 83 83 84 84 84 84 84 84 84 85 85 85
Water 100 100 100 101 101 101 101 101 101 102 102 102
Property Tax 650 651 652 653 654 655 657 658 659 660 661 662
Insurance 217 217 217 218 218 218 219 219 220 220 220 221
Total Expenses 2,157 2,159 2,161 2,164 2,166 2,169 2,171 2,174 2,176 2,178 2,181 2,183
Net Operating Income 4,968 4,966 4,964 4,961 4,959 4,956 4,954 4,951 4,949 4,947 4,944 4,942
Roger Staiger rstaiger@gwmail.gwu.edu
Waterfall (Step 2) (cont’d) (…yet)
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Debt
Tranch 1 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346 3,346
Tranch 2 658 658 658 658 658 658 658 658 658 658 658 658
Tranche 1 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004 4,004
Sales Proceeds
Sales Price ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
Sales Expense ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
Principal Repay ‐Tranche 1 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
Principal Repay ‐Tranche 2 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
Net Sales Proceeds ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
Reversion FCF ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐
Operating FCF 964 962 959 957 955 952 950 947 945 942 940 937
Total FCF (99,000) 964 962 959 957 955 952 950 947 945 942 940 937
Roger Staiger rstaiger@gwmail.gwu.edu
Note: No bifurcation (Operations/Reversion)
Waterfall (Step 3) Quantify project characteristics Is project viable as a whole?
Modigliani and Miller
Total Profit Internal Rate of Return (IRR) Multiple (Profit/Invested Capital)
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Waterfall (Step 3) (Project Valuation)
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Valuation:Year 1 2 3 4 5 6 7 8 9 10
RevenueRental 90,000 91,800 93,636 95,509 97,419 99,367 101,355 103,382 105,449 107,558 Vacancy 4,500 4,590 4,682 4,775 4,871 4,968 5,068 5,169 5,272 5,378
Total Revenue 85,500 87,210 88,954 90,733 92,548 94,399 96,287 98,213 100,177 102,180
ExpenseManagement 4,275 4,361 4,448 4,537 4,627 4,720 4,814 4,911 5,009 5,109 Repairs 4,275 4,361 4,448 4,537 4,627 4,720 4,814 4,911 5,009 5,109 Janitor 2,624 2,677 2,731 2,786 2,842 2,900 2,958 3,018 3,079 3,141 Heat 2,150 2,193 2,237 2,282 2,329 2,376 2,423 2,472 2,522 2,573 Electricity 1,009 1,030 1,050 1,072 1,093 1,115 1,138 1,161 1,184 1,208 Water 1,211 1,236 1,260 1,286 1,312 1,338 1,365 1,393 1,421 1,450 Property Tax 7,872 8,031 8,193 8,358 8,527 8,699 8,875 9,054 9,237 9,423 Insurance 2,624 2,677 2,731 2,786 2,842 2,900 2,958 3,018 3,079 3,141
Total Expenses 26,040 26,564 27,098 27,644 28,200 28,767 29,346 29,937 30,539 31,154
Net Operating Income 59,460 60,646 61,856 63,090 64,348 65,631 66,941 68,276 69,638 71,026
DebtTranche 1 40,149 40,149 40,149 40,149 40,149 40,149 40,149 40,149 40,149 40,149 Tranche 2 7,901 7,901 7,901 7,901 7,901 7,901 7,901 7,901 7,901 7,901
Total Debt 48,050 48,050 48,050 48,050 48,050 48,050 48,050 48,050 48,050 48,050
Net Sales Proceeds ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 308,167
Reversion FCF ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 308,167 Operating FCF 11,410 12,596 13,806 15,040 16,298 17,582 18,891 20,226 21,588 22,977
Total FCF (99,000) 11,410 12,596 13,806 15,040 16,298 17,582 18,891 20,226 21,588 331,144
DSCR 1.24 1.26 1.29 1.31 1.34 1.37 1.39 1.42 1.45 1.48Minimum 1.24
Cash‐on‐Cash 11.53% 12.72% 13.95% 15.19% 16.46% 17.76% 19.08% 20.43% 21.81% 23.21%Minimum 11.53%
PV Reversion 118,812 54.64%PV Operating 98,616 45.36%
Total 217,428 CF0 99,000 NPV 118,428 IRR 22.42%
Waterfall (Step 4) (Structure)
Construct Waterfall addition for pro forma Four Sections:
Project Summary Tranche Structures (Accruals) Tranche Cash Flows Investor Cash Flows
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Waterfall (Step 4) (Structure)
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Waterfall Period 1 2 3 4 5 6 7 8 9 10 11 12(Units) Total 1/31/2010 1/31/2011 1/31/2012 1/31/2013 1/31/2014 1/31/2015 1/31/2016 1/31/2017 1/31/2018 1/31/2019 1/31/2020 1/31/2021
Project Cash FlowContributions (200.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Sponsor 10% (20.0) (20.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Equity Partner 90% (180.0) (180.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Total 100% (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Project
SummaryCash Proceeds for Distribution 550.0 0.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 100.0 0.0
Project Cash Flow 350.0 (200.0) 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 100.0 0.0Profit $350.0IRR 22.43%Multiple 2.75x
STRUCTURETier 1 0.0383% Daily RateBoP Balance 0.0 (200.0) (180.0) (157.0) (130.6) (100.2) (65.2) (25.0) 0.0 0.0 0.0 0.0Equity Contributions (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Accrual 15.00% (128.8) 0.0 (30.0) (27.0) (23.6) (19.6) (15.0) (9.8) (3.8) 0.0 0.0 0.0 0.0Paydown 328.8 0.0 50.0 50.0 50.0 50.0 50.0 50.0 28.8 0.0 0.0 0.0 0.0EoP Balance (200.0) (180.0) (157.0) (130.6) (100.2) (65.2) (25.0) 0.0 0.0 0.0 0.0 0.0Cash left for distribution 221.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 21.2 50.0 50.0 100.0 0.0IRR Check 15.00% 128.8 (200.0) 50.0 50.0 50.0 50.0 50.0 50.0 28.8 0.0 0.0 0.0 0.0 Tranche
StructuresTier 2 0.0500% Daily Rate (Accruals)Starting Balance 0.0 (200.0) (190.0) (178.0) (163.7) (146.4) (125.7) (100.9) (71.1) (35.3) 0.0 0.0Equity Contributions (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Accrual 20.00% 0.0 (40.0) (38.0) (35.7) (32.7) (29.3) (25.1) (20.2) (14.2) (7.1) 0.0 0.0Paydown 442.4 0.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 42.4 0.0 0.0Balance (200.0) (190.0) (178.0) (163.7) (146.4) (125.7) (100.9) (71.1) (35.3) 0.0 0.0 0.0Cash left for distribution 107.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 7.6 100.0 0.0IRR Check 20.00% 242.4 (200.0) 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 42.4 0.0 0.0
Cash Flows to each tranche:I. Pari Passu to an IRR of 15.00% 328.8 0.0 50.0 50.0 50.0 50.0 50.0 50.0 28.8 0.0 0.0 0.0 0.0
Sponsor 10.00% 32.9 0.0 5.0 5.0 5.0 5.0 5.0 5.0 2.9 0.0 0.0 0.0 0.0Equity Partner 90.00% 295.9 0.0 45.0 45.0 45.0 45.0 45.0 45.0 25.9 0.0 0.0 0.0 0.0
II. Splits up to an IRR of 20.00% 113.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 21.2 50.0 42.4 0.0 0.0Sponsor 20.00% 22.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0 4.2 10.0 8.5 0.0 0.0Equity Partner 80.00% 90.9 0.0 0.0 0.0 0.0 0.0 0.0 0.0 17.0 40.0 33.9 0.0 0.0 Tranche
CashCash left for Distribution 107.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 7.6 100.0 0.0 Flows
III. Sponsor Promote 40.00% 43.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 3.0 40.0 0.0
Cash to Equity 60.00% 64.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 4.5 60.0 0.0Sponsor 10.00% 6.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.5 6.0 0.0Equity Partner 90.00% 58.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 4.1 54.0 0.0
INVESTOR CASH FLOWSSPONSOR
Equity Investment (20.0) (20.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Proceeds 105.1 0.0 5.0 5.0 5.0 5.0 5.0 5.0 7.1 10.0 12.0 46.0 0.0CF 85.1 (20.0) 5.0 5.0 5.0 5.0 5.0 5.0 7.1 10.0 12.0 46.0 0.0Profit $85.1% of Total Profit 24.3%IRR 30.03%Multiple 5.25x
InvestorEQUITY PARTNER Cash
Equity Investment (180.0) (180.0) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 FlowsProceeds 444.9 0.0 45.0 45.0 45.0 45.0 45.0 45.0 42.9 40.0 38.0 54.0 0.0CF 264.9 (180.0) 45.0 45.0 45.0 45.0 45.0 45.0 42.9 40.0 38.0 54.0 0.0Profit $264.9% of Total Profit 75.7%IRR 21.13%Multiple 2.47x
Check TRUE
A. Project Summary
B. Tranche Structures
C. Tranche Cash Flows
D. Investor Cash Flows
Waterfall (Step 4) (Project Summary)
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Waterfall Period 1 2 8 9 10 11 12(Units) Total 1/31/2010 1/31/2011 1/31/2017 1/31/2018 1/31/2019 1/31/2020 1/31/2021
Project Cash FlowContributions (200.0) 0.0 0.0 0.0 0.0 0.0 0.0Sponsor 10% (20.0) (20.0) 0.0 0.0 0.0 0.0 0.0 0.0Equity Partner 90% (180.0) (180.0) 0.0 0.0 0.0 0.0 0.0 0.0Total 100% (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0 Project
SummaryCash Proceeds for Distribution 550.0 0.0 50.0 50.0 50.0 50.0 100.0 0.0
Project Cash Flow 350.0 (200.0) 50.0 50.0 50.0 50.0 100.0 0.0Profit $350.0IRR 22.43%Multiple 2.75x
Note: Years 3 – 8 hidden
Waterfall (Step 4) (Tranche Structures (Accruals))
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STRUCTURETier 1 0.0383% Daily RateBoP Balance 0.0 (200.0) (25.0) 0.0 0.0 0.0 0.0Equity Contributions (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0Accrual 15.00% (128.8) 0.0 (30.0) (3.8) 0.0 0.0 0.0 0.0Paydown 328.8 0.0 50.0 28.8 0.0 0.0 0.0 0.0EoP Balance (200.0) (180.0) 0.0 0.0 0.0 0.0 0.0Cash left for distribution 221.2 0.0 0.0 21.2 50.0 50.0 100.0 0.0IRR Check 15.00% 128.8 (200.0) 50.0 28.8 0.0 0.0 0.0 0.0 Tranche
StructuresTier 2 0.0500% Daily Rate (Accruals)Starting Balance 0.0 (200.0) (100.9) (71.1) (35.3) 0.0 0.0Equity Contributions (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0Accrual 20.00% 0.0 (40.0) (20.2) (14.2) (7.1) 0.0 0.0Paydown 442.4 0.0 50.0 50.0 50.0 42.4 0.0 0.0Balance (200.0) (190.0) (71.1) (35.3) 0.0 0.0 0.0Cash left for distribution 107.6 0.0 0.0 0.0 0.0 7.6 100.0 0.0IRR Check 20.00% 242.4 (200.0) 50.0 50.0 50.0 42.4 0.0 0.0
Note: Years 3 – 8 hidden
Waterfall (Step 4) (Tranche Cash Flows)
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Cash Flows to each tranche:I. Pari Passu to an IRR of 15.00% 328.8 0.0 50.0 28.8 0.0 0.0 0.0 0.0
Sponsor 10.00% 32.9 0.0 5.0 2.9 0.0 0.0 0.0 0.0Equity Partner 90.00% 295.9 0.0 45.0 25.9 0.0 0.0 0.0 0.0
II. Splits up to an IRR of 20.00% 113.6 0.0 0.0 21.2 50.0 42.4 0.0 0.0Sponsor 20.00% 22.7 0.0 0.0 4.2 10.0 8.5 0.0 0.0Equity Partner 80.00% 90.9 0.0 0.0 17.0 40.0 33.9 0.0 0.0 Tranche
CashCash left for Distribution 107.6 0.0 0.0 0.0 0.0 7.6 100.0 0.0 Flows
III. Sponsor Promote 40.00% 43.0 0.0 0.0 0.0 0.0 3.0 40.0 0.0
Cash to Equity 60.00% 64.5 0.0 0.0 0.0 0.0 4.5 60.0 0.0Sponsor 10.00% 6.5 0.0 0.0 0.0 0.0 0.5 6.0 0.0Equity Partner 90.00% 58.1 0.0 0.0 0.0 0.0 4.1 54.0 0.0
Note: Years 3 – 8 hidden
Waterfall (Step 4) (Investor Cash Flows)
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INVESTOR CASH FLOWSSPONSOR
Equity Investment (20.0) (20.0) 0.0 0.0 0.0 0.0 0.0 0.0Proceeds 105.1 0.0 5.0 7.1 10.0 12.0 46.0 0.0CF 85.1 (20.0) 5.0 7.1 10.0 12.0 46.0 0.0Profit $85.1% of Total Profit 24.3%IRR 30.03%Multiple 5.25x
InvestorEQUITY PARTNER Cash
Equity Investment (180.0) (180.0) 0.0 0.0 0.0 0.0 0.0 0.0 FlowsProceeds 444.9 0.0 45.0 42.9 40.0 38.0 54.0 0.0CF 264.9 (180.0) 45.0 42.9 40.0 38.0 54.0 0.0Profit $264.9% of Total Profit 75.7%IRR 21.13%Multiple 2.47x
Check TRUE
Note: Years 3 – 8 hidden
Waterfall
Construction
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Project Summary (Part a)
Models Contributions from Investor(s) and Sponsor separately (Can be spread or Point-in-Time)
Assigns dates with specific cash flows Models Cash Distribution (after debt service) Quantify Project performance (check with pro forma) Roger Staiger rstaiger@gwmail.gwu.edu 84 of 125
Waterfall Period 1 2 8 9 10 11 12(Units) Total 1/31/2010 1/31/2011 1/31/2017 1/31/2018 1/31/2019 1/31/2020 1/31/2021
Project Cash FlowContributions (200.0) 0.0 0.0 0.0 0.0 0.0 0.0Sponsor 10% (20.0) (20.0) 0.0 0.0 0.0 0.0 0.0 0.0Equity Partner 90% (180.0) (180.0) 0.0 0.0 0.0 0.0 0.0 0.0Total 100% (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0 Project
SummaryCash Proceeds for Distribution 550.0 0.0 50.0 50.0 50.0 50.0 100.0 0.0
Project Cash Flow 350.0 (200.0) 50.0 50.0 50.0 50.0 100.0 0.0Profit $350.0IRR 22.43%Multiple 2.75x
Tranche Structures (Accruals) (Part b)
Calculate Daily rate (note: daily, i.e. 365/year) from target
Calculate Accrual amount for Tranche Calculate distribution from accrual Check the IRR (verify)
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STRUCTURETier 1 0.0383% Daily RateBoP Balance 0.0 (200.0) (25.0) 0.0 0.0 0.0 0.0Equity Contributions (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0Accrual 15.00% (128.8) 0.0 (30.0) (3.8) 0.0 0.0 0.0 0.0Paydown 328.8 0.0 50.0 28.8 0.0 0.0 0.0 0.0EoP Balance (200.0) (180.0) 0.0 0.0 0.0 0.0 0.0Cash left for distribution 221.2 0.0 0.0 21.2 50.0 50.0 100.0 0.0IRR Check 15.00% 128.8 (200.0) 50.0 28.8 0.0 0.0 0.0 0.0 Tranche
StructuresTier 2 0.0500% Daily Rate (Accruals)Starting Balance 0.0 (200.0) (100.9) (71.1) (35.3) 0.0 0.0Equity Contributions (200.0) (200.0) 0.0 0.0 0.0 0.0 0.0 0.0Accrual 20.00% 0.0 (40.0) (20.2) (14.2) (7.1) 0.0 0.0Paydown 442.4 0.0 50.0 50.0 50.0 42.4 0.0 0.0Balance (200.0) (190.0) (71.1) (35.3) 0.0 0.0 0.0Cash left for distribution 107.6 0.0 0.0 0.0 0.0 7.6 100.0 0.0IRR Check 20.00% 242.4 (200.0) 50.0 50.0 50.0 42.4 0.0 0.0
Tranche Structures (Accruals) (Part b) (Hints)
Daily Rate Accrual
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00038298.010.151
1Pref_Rate1RateDaily 365
1
3651
DR
30Accrual20010.000382981Accrual
1DR1Accrual365
BoPDays
Tranche Cash Flows (Part c)
Separate tranches by split percentages (X2) Calculate remaining split for promote Calculate Cash to Equity after promote
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Cash Flows to each tranche:I. Pari Passu to an IRR of 15.00% 328.8 0.0 50.0 28.8 0.0 0.0 0.0 0.0
Sponsor 10.00% 32.9 0.0 5.0 2.9 0.0 0.0 0.0 0.0Equity Partner 90.00% 295.9 0.0 45.0 25.9 0.0 0.0 0.0 0.0
II. Splits up to an IRR of 20.00% 113.6 0.0 0.0 21.2 50.0 42.4 0.0 0.0Sponsor 20.00% 22.7 0.0 0.0 4.2 10.0 8.5 0.0 0.0Equity Partner 80.00% 90.9 0.0 0.0 17.0 40.0 33.9 0.0 0.0 Tranche
CashCash left for Distribution 107.6 0.0 0.0 0.0 0.0 7.6 100.0 0.0 Flows
III. Sponsor Promote 40.00% 43.0 0.0 0.0 0.0 0.0 3.0 40.0 0.0
Cash to Equity 60.00% 64.5 0.0 0.0 0.0 0.0 4.5 60.0 0.0Sponsor 10.00% 6.5 0.0 0.0 0.0 0.0 0.5 6.0 0.0Equity Partner 90.00% 58.1 0.0 0.0 0.0 0.0 4.1 54.0 0.0
Investor Cash Flows (Part d)
Create Final Cash Flows for Sponsor and Investor Review cash flow distribution, i.e. IRRs Built in Self-Test
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INVESTOR CASH FLOWSSPONSOR
Equity Investment (20.0) (20.0) 0.0 0.0 0.0 0.0 0.0 0.0Proceeds 105.1 0.0 5.0 7.1 10.0 12.0 46.0 0.0CF 85.1 (20.0) 5.0 7.1 10.0 12.0 46.0 0.0Profit $85.1% of Total Profit 24.3%IRR 30.03%Multiple 5.25x
InvestorEQUITY PARTNER Cash
Equity Investment (180.0) (180.0) 0.0 0.0 0.0 0.0 0.0 0.0 FlowsProceeds 444.9 0.0 45.0 42.9 40.0 38.0 54.0 0.0CF 264.9 (180.0) 45.0 42.9 40.0 38.0 54.0 0.0Profit $264.9% of Total Profit 75.7%IRR 21.13%Multiple 2.47x
Check TRUE
Securitization (Detail)
Time Permitting
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Securitization Transformation of a portfolio of financial
obligations into liquid form attractive to a myriad of investors
‘Value’ of obligations depends on ability/willingness of obligator to pay, i.e. Risk
Financial Obligation Portfolios (Examples): Mortgages (Commercial & Residential) Automotive Loans Credit Card Loans
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Structuring Transforming financial obligations into palatable
financial assets by means of cash flow segmentation & risk
Types of Instruments 1) Direct obligations of corporates and sovereigns 2) Derivatives, e.g. Swaps & Futures 3) *Securitized & Structured Financial Assets
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Direct Obligations Obligation created by issues for investors Equities Treasuries Corporate Debt Convertibles
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Derivatives An asset whose value depends upon an
underlying asset Swaps & Futures (see other lectures)
Represent zero sum game (In Theory Only)
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Securitization Transforms raw assets into tradeable units Allows bifurcation of Origination & Investment
Functions Structuring rearranges cash flows and risk
Structuring financial instruments similar to transforming physical Real Estate assets
“Working the Asset”
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Major Asset Classes 1) MBS
Residential Commercial
2) Credit Cards 3) Automobile Loans 4) Home Equity Line of
Credit (HELOCs)
5) Manufactured Housing
6) Student Loans 7) Equipment Leases
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Critical Concepts to Consider 1) Collateral 2) Credit Enhancement 3) Standardization 4) Liquidity
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Collateral Raw commitments that support
transaction (Mortgage, i.e. home) Cash Flow & Credit Characteristics
determine performance + drive structuring
Must understand collateral of specific asset + portfolio consideration (Critical)
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Credit Enhancement Process of protecting payment stream to
investors Result from: External guarantee Interesting structuring
Subordination Waterfall Structure Order of payments
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Standardization Process of taking dissimilar loan types
and terms & transforming within a portfolio
Portfolio versus Asset Analysis
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Asset 1 Asset 2 Asset 3 Asset 4 Asset 5 Asset 6 Asset 7 Asset 8
Asset 9…
Each Asset has individual
characteristics, i.e. exposed to unsystematic
risk
Portfolio of Assets 1 – 9
Standard: Coupon Terms
Diversified, standardized Portfolio, i.e. exposed to
systematic risk only (allegedly)
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Liquidity Ability to transfer assets among investors Increasing liquidity goal to securitization Measures:
Bid-Ask Spread Amount of time to sell a position
@ Fair Value, i.e. not deeply discounted
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Tax, Accounting, Legal Issues 1) Tax
Will there be tax @ Trust Level 2) Accounting
Securitization treated as ‘Sale’ or ‘Financing’? 3) Legal
Does Trust or legal entity have sufficient title to assets? Issuing firm protected from bankruptcy &/or disruptions
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Mortgage-Backed Security Process
John & Jane America want a home J&J meet mortgage broker Mortgage Broker and Mortgage
Banker meet to originate loan M. Banker sells loan to Dealer Dealer structures loan and sells Norway purchases loan structure
Education High School High School
College
Graduate School Unknown Unknown
No Recourse (Paid Immediately)
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Realtor (Paid Immediately) = High School
Default Losers = John&Jane & Norway
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Dealer/Risk Sharing Paid up-front (immediate) Structures product with assistance
Lawyers, Accountants, Rating Agencies
Sells product into Capital Markets Risk born by John/Jane & Capital Markets
(Norway) NO risk by Mortgage Broker, Mortgage Banker,
and Dealer (or Realtor!)
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Loan Servicer Receives payments and distributes to
investors according to agreement Handles paperwork for loan Responsible for collections in event of
default Low-risk business
Paper administrators
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Default Case Guarantor called to cover any losses Servicer “Special Servicer” passes payments
on to appropriate investors Servicer “Special Servicer”, guarantor and
trustee compensated immediately for services No risk
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Allocation of $$$ (T = 0) Mortgage Broker Mortgage Banker
Dealer
Borrower Receives Investor Pays
97 98 99
100
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Realtor paid at T = 0
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Allocation of Interest Payments
Investor Receives
Guarantor Servicer
Spread to Investor Option Cost to Investor
Duration Cost to Investor
Funding Cost to Investor Borrower
Pays
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Securities – Investment Characteristics
1) Principal repayment timing 2) Amount & form of interest payment 3) Credit quality of instrument (Risk)
t
Risk of Receiving
Interest Pay (Form and Quantity)
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Price of Asset
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Risk Measures 1) Spread
Difference between the yield on the investment and yield on base instrument (Compensates for Risk)
2) Rating (Provide “independent” risk assessment) S&P, Moodys, Fitch
3) Duration/Convexity (See Whitepaper) Duration: Measure of sensitivity of price to interest
rates (Rate of change (1st Derivative)) Convexity: Change in Duration as interest rates
change (Rate of change of change (2nd Derivative)) Roger Staiger rstaiger@gwmail.gwu.edu
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Securitization - Classification Sale versus Financing Issues:
Financial Regulatory Tax Accounting Strategic
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Financial Advantages Asset Sale (Off-Balance Sheet)
Risks 100% transferred to buyer (Seller has Reps/Warrants)
Cost lower than securitization
Financing (Securitization) Several classes created & sold (Off-Balance Sheet)
Issuer retains residual class Residual considered “equity”
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Financial Transaction (versus sale) Financing expenses Sale Expenses 1. Coupons Paid Corporate: 2. U/W fees 1. Debt 3. Administration Costs 2. Equity
Which is cheaper/beneficial? How each changes risk of institution?
- How changes makeup of corporate BS Securitization
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Securitization & Capital Structure Firms generally limited to amount of debt
on Balance Sheet (Capital Structure) Structure Off-Balance Sheet activities in Special
Purposes Entities (SPEs) Remember Repo 105 (classic example)
Securitization may permit greater debt issuance Free equity for more transactions
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Residual Interest “Equity” like Held by issuer Illiquid & Complex instrument Bear prepayment & credit risk Generally no risk beyond tranche (residual)
Risk is loss of interest only
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Regulatory - Securitization Rated security have lower capital
requirements Rated securities may allow firms to lower
capital requirements Lower capital requirements increase leverage Double edged sword
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Tax Securitization Issues general prefer financing ‘tax’
treatment Asset sale requires immediate recognition
of gain/loss on transaction Asset types:
1) Trading 2) Available-for-Sale
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Asset Types 1) Trading
Must hold @ market value and/or fair value 2) Available-for-Sale
Held on book @ lower of: Cost Market value (hence Bear Stearns bailout)
3) Loans in Portfolio Considered “Held-to-Maturity’
Held at original cost
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Accounting - Securitization Firms prefer to record securitization as
“sale” (Reduces capital requirements) Strengthens Balance Sheet - generally
Can lead to income instability How flow through accounting
statements?: Depends on how residual classified
Sale versus Trading
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Strategic - Securitization Increase origination of loan product Adjust portfolio of assets
Securitize to maintain control of assets Lost leader but strategic play Increase assets under control while
reducing capital requirements
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Balance Sheet – Pre-Securitization
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Assets ($m) Ratios Calc ValueCash 25,000 D/E 340/50 6.80 Loans 300,000 Current 25/45 0.56 Investments 60,000 PP&E 50,000 Assets Delta
Total Assets 435,000 300,000 → 30,000 270,000
Liabilities ($m) Liability Reduction 280,000 Short‐Term 45,000 45,000 → 30,000 15,000 Long‐Term 340,000 340,000 → 75,000 265,000
Total Liabilities 385,000 Equity (Gain on Sale)
Equity ($m) 50,000 50,000 → 60,000 10,000
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Balance Sheet – Post-Securitization
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Assets ($m) Ratios Calc ValueCash 25,000 D/E 75/60 1.25Residuals 30,000 Current 25/30 0.83Investments 60,000 PP&E 50,000 Previous Values:
Total Assets 165,000 Ratios Calc ValueD/E 340/50 6.80
Liabilities ($m) Current 25/45 0.56Short‐Term 30,000 Long‐Term 75,000
Total Liabilities 105,000
Equity ($m) 60,000
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Balance Sheet – Cost of Capital Securitization can decrease cost of
capital (reduced corporate “risk”) If securitization coupon < Corporate
WACC Cost of Capital reduced
* Firms value maximized @ point of WACC minimization
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Securitization Factors - Balancing
Financial
Regulatory Tax
Accounting
Strategic All five must
balance
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Structuring Entity Generally structured as Trust
Trust not subject to taxation Trust issues securities Established legal separation between issuer &
pool of assets Bankruptcy – Remote of Trust
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Structure Example (Generic)
Bond1 Bond2 Bond3
Bondn (y = 8.5%)
TRUST
Tranche 4 (Residual) 4th 5% Loss; y=35%
Tranche 3 3rd 10% Loss; y=15%
Tranche 2 2nd 10% Loss; y=7.5%
Tranche 1 1st Senior; y=6%
Wat
erfa
ll
Roger Staiger rstaiger@gwmail.gwu.edu
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