Interesting question for discussion… to set the scene, assume you're looking at buying a core/core plus deal with a long term hold strategy, so your investors care more about cash on cash than IRR/equity multiple and you need to show that metric net to the LP. You're using a standard IRR hurdle waterfall structure.
Let's assume the deal is strong and operating cash flows are paying down the annual pref and chipping away at the remaining balance to get into the promote, so you've got a lower capital balance in the first waterfall tier than your original equity, but no refi has occurred.
How do you determine the outstanding equity balance in this scenario for the purpose of calculating cash on cash? Do you treat excess operating distributions above the accrued pref as a "return of equity" and reduce the equity balance accordingly? Do you leave the equity balance as is until a refinancing and adjust based on that? If the latter, how do you figure out the new equity balance if the refi proceeds get into the promote and are diluted accordingly (I.e. can't do a 1:1 reduction)? This option would also be misleading and confusing to somebody numbers savvy as the accrued pref appear low relative to the equity balance.
Been stumped on this for awhile now, wondering how others think about it.
This is more of an accounting question and the answer is usually, it depends on your LPA or OA. At both the very large manager I was at and our current small fund, it is as you describe, distributions in excess of pref go towards reducing investor capital account balances. As such, you could calculate a true cash-on-cash as the (net distributions within time period, annualized) divided by (weighted average investor capital account balances for the period). We would do a daily weighted average balance calc based on the days of the distributions. However, in my experience, it is very difficult to model something like this when underwriting b/c (I) you can’t predict when you will need to distribute/withhold excess distributions, (II) can’t predict when you will refi or if the environment will allow it, and (III) or if you will choose to fund future CapEx with recurring distributions. So when we model, and for marketing materials, we just calculate that the denominator in cash-on-cash is just the initial equity commitment amount. That is also how most investors think about it, if they commit $100 and they are getting $7/yr back per year, regardless of if your hurdle is 5%, they see this as 7% CoC.
Each firm will do it differently. Just pick what makes sense to you and your firm / story. Give it to the LP. The LP will make their own adjustments.
This question sounds ludicrous to me. Who would ever consider operating cash flows over their pref hurdle as return of capital?? Not trying to be condescending, can’t aee anyone looking at it that way for analyzing returns
I'm going to entertain this question to help you here - random numbers picked for this example... Let's say I contributed $30M upfront equity and earn $5M in pref over 4 years, but the property distributes $8M to me in that same time. I'm on an IRR-based waterfall, so the GP still hasn't earned a single dollar of promote.
In this case, my capital balance from a waterfall perspective is going to be $27M ($30M + $5M accrued pref - $8M distributed). There hasn't been a capital event, so are you saying my equity balance is still $30M? That doesn't make much sense either. I'm not accruing my pref on $30M any more, it's accruing on the outstanding $27M.
If the next day there's a refi and the total distributable cash to the LP is $30M, the actual distributions would be less than $30M because there's only $27M outstanding before the GP starts earning a promote. For simplicity's sake, lets say the LP gets $29M and GP gets $1M. What's my actual return of capital there? I had a $27M outstanding balance to an X% IRR in the first hurdle, which by definition means my capital has been returned and I've earned $1M above and beyond that. It wouldn't make sense to say my equity balance is still $1M in this case. So how do you look at that?
Still think it's a ludicrous question?
That's how I've seen it done, capital accounts don't move until there is a capital event, any additional cash flow goes to LP pref and then LP/GP pari passu. Only when you refi/sell do you apply those cash flows to the capital accounts.
We do not incorporate the waterfall into our cash yields. Cash yield = deal-level CF / deal-level equity
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