A private mortgage fund runs the distribution framework against the fund’s operating agreement on a defined distribution cycle — the quarterly cycle on the standard. The distribution framework runs the cash from the fund’s mortgage portfolio against a tiered allocation framework — the waterfall — that runs from preferred return through return of capital, catch-up, promote, and residual split. The waterfall framework runs the fund’s economic discipline against the lender-investor base and runs the tax reporting framework on the annual K-1 cycle against the IRS. This article walks the waterfall framework from the operating-agreement framework through the four tiers, the reserve framework, the K-1 framework, and the common waterfall execution framework against a private mortgage fund.

What the waterfall runs

The waterfall runs the priority framework against the fund’s distributable cash. The framework runs the distributable cash through a tiered allocation framework where each tier runs in priority against the next tier — cash runs to the first tier on a defined framework, then cash runs to the second tier on a defined framework, and so on through the residual tier. The waterfall framework runs against the fund’s operating agreement and runs the economic split between the lender-investor base (the limited partners or members) and the fund manager (the general partner or manager). The waterfall runs the fund’s economic discipline against the fund’s capital-account framework on each distribution date.

Tier 1: Preferred return

The first tier runs the preferred return framework against the lender-investor capital base. The framework runs a defined preferred return rate — the standard runs a single-digit annualized rate on the cash-on-cash framework or the accrued framework — against the investor’s unreturned capital base. The preferred return runs against the lender-investor base before the fund manager runs any economic interest against the distribution cycle. The cash-on-cash framework runs the preferred return against the actual cash distributed on the quarterly cycle. The accrued framework runs the preferred return on a cumulative framework — the unpaid preferred runs to the next quarter and runs the preferred-return arrearage framework against the fund’s investor-reporting cycle.

Tier 2: Return of capital

The second tier runs the return-of-capital framework against the investor’s contributed capital. The framework runs the contributed capital back to the investor on a defined cycle — the fund-life framework on the closed-end fund or the redemption framework on the open-end fund. The return-of-capital framework runs the investor’s capital-account balance down on each distribution and runs the preferred-return framework against the reduced capital base on subsequent quarters. The investor’s capital account runs against the cumulative return-of-capital distribution on the fund’s recordkeeping framework on each distribution date.

Tier 3: Catch-up and promote

The third tier runs the manager’s economic interest framework — the catch-up and the promote (carried interest). The catch-up framework runs the manager’s pro-rata share of the preferred-return-and-promote-equivalent against the cumulative preferred-return distribution. The catch-up runs the manager to the economic-split target before the residual tier runs. The promote framework runs the manager’s carried-interest share — the standard runs a defined percentage of profits above the preferred-return hurdle — against the distribution cycle. The promote runs the manager’s incentive framework against the fund’s performance discipline.

Tier 4: Residual split

The fourth tier runs the residual-split framework against the remaining cash after the first three tiers. The framework runs the residual cash on a defined split between the lender-investor base and the manager — the standard runs an eighty-twenty or seventy-thirty split on the residual tier. The residual split runs the fund’s performance-aligned framework on the upside and runs the manager’s downside-protection framework on the preferred-return-and-return-of-capital tiers. The residual cash runs against the investor’s capital-account framework on a distribution-rather-than-allocation framework on each quarter.

The reserve framework

The fund runs the reserve framework against the distributable cash before the waterfall runs. The reserve framework runs against four categories. The first runs the loss-reserve framework — a defined percentage of fund assets reserved against the mortgage-portfolio loss framework. The second runs the liquidity-reserve framework — a defined cash position against the fund’s operational-liquidity framework. The third runs the recapture-reserve framework — the cash held against the fund’s tax-recapture and audit-adjustment framework. The fourth runs the opportunity-reserve framework — the cash held against the fund’s pending-acquisition framework. The reserve framework runs against the operating-agreement discipline and runs the manager’s good-faith framework against the lender-investor base.

Cash-on-cash vs accrued preferred

The preferred-return framework runs against two primary frameworks — the cash-on-cash framework and the accrued framework. The cash-on-cash framework runs the preferred return against the actual cash distributed on the quarterly cycle — no preferred-return arrearage runs against the framework. The accrued framework runs the preferred return on a cumulative framework — the unpaid preferred runs to the subsequent quarter and runs the preferred-return arrearage framework against the fund’s investor-reporting cycle. The accrued framework runs the lender-investor base on a higher economic-priority framework against the fund’s performance discipline. The cash-on-cash framework runs the fund’s simpler reporting framework against the quarterly cycle.

The K-1 framework

The fund runs the tax reporting framework against the lender-investor base on the annual K-1 cycle. The K-1 framework runs the partnership taxation framework under IRC Subchapter K against the fund’s pass-through entity classification. The K-1 framework runs the income-and-deduction allocation framework against the investor’s capital-account framework — the allocation framework runs separately from the distribution framework. The fund runs the K-1 framework against each lender-investor on the annual cycle and runs the K-1 issuance against the March fifteenth deadline on the standard. The fund runs the tax-distribution framework against the investor’s tax framework on a sufficient-cash framework against the K-1 allocation.

Common waterfall execution mistakes

Five mistakes recur on the waterfall execution framework. The first runs the preferred-return framework against the wrong capital base — the fund runs the preferred return against the original capital rather than the unreturned capital. The second runs the catch-up framework on a thin discipline — the fund runs the promote tier before the catch-up tier runs the manager to the economic-split target. The third runs the reserve framework against an undocumented discretion framework — the manager runs the reserve level on an ad-hoc framework rather than against the operating-agreement framework. The fourth runs the K-1 framework on a distribution-equals-allocation framework — the framework runs the allocation separately from the distribution on the partnership-tax framework. The fifth runs the investor-reporting framework on a thin disclosure framework — the fund runs the waterfall calculation against the investor on a defined transparency framework on each quarter.

Want to set up your mortgage fund the right way?

Quarterly waterfall distributions run against the fund’s operating agreement, the partnership-tax framework under IRC Subchapter K, and the subservicer’s investor-reporting framework. Note Servicing Center runs the fund subservicing framework against the investor-reporting framework, the loan-level remittance framework, and the fund-administrator coordination framework against the waterfall execution cycle.

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Frequently Asked Questions

What does the waterfall run?

The waterfall runs the priority framework against the fund’s distributable cash on a defined tiered allocation framework. The framework runs the cash through preferred return, return of capital, catch-up, promote, and residual split — each tier runs in priority against the next tier on the operating-agreement framework.

What is the preferred return?

The preferred return runs the first-tier framework against the lender-investor capital base. The framework runs a defined annualized rate against the investor’s unreturned capital on each quarter. The preferred return runs before the manager runs any economic interest against the distribution cycle.

What is the catch-up framework?

The catch-up framework runs the manager’s pro-rata share against the cumulative preferred-return distribution. The framework runs the manager to the economic-split target before the residual tier runs. The catch-up framework runs the manager’s incentive framework against the fund’s performance discipline.

What is the promote?

The promote framework runs the manager’s carried-interest share against the distribution cycle — the standard runs a defined percentage of profits above the preferred-return hurdle. The promote runs the manager’s economic incentive framework against the fund’s upside.

How does the K-1 framework run?

The K-1 framework runs the partnership taxation framework under IRC Subchapter K against the fund’s pass-through entity classification. The framework runs the income-and-deduction allocation against the investor’s capital account on a separate framework from the distribution. The fund issues the K-1 against each lender-investor on the annual cycle.

What is the difference between cash-on-cash and accrued preferred?

The cash-on-cash framework runs the preferred return against the actual cash distributed on the quarterly cycle — no arrearage runs against the framework. The accrued framework runs the preferred return on a cumulative framework — unpaid preferred runs to the subsequent quarter and runs the preferred-return arrearage framework against the fund.

What are common waterfall mistakes?

Five mistakes recur — preferred return against the wrong capital base, promote before catch-up, reserve on an undocumented discretion framework, K-1 allocation equals distribution, and thin investor reporting against the waterfall calculation. The corrective runs against the operating agreement on each framework.

This article is educational and does not constitute legal, tax, or investment advice. The waterfall framework runs under the fund’s operating agreement, the partnership-tax framework under IRC Subchapter K, and the Investment Company Act §3(c)(1), §3(c)(7), or §3(c)(5)(C) framework against the fund. Consult qualified legal, tax, and SEC counsel on the specific waterfall framework against any private mortgage fund.

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