Question to the GP/LP monkeys out there.
So lets say you put in place the typical JV with IRR promotes at 20 over 10, 30 over 15 or whatever they may be for a development play. You buy your asset, build it out, potentially lease up and hold for a bit, sale - boom, profits realised and promotes crystalised, happy days and celebrations all round.
In the above scenario were instead of a sale, the LP has decided on build completion to hold it for 10y because the asset is a cash cow, but GP still needs to realise their promotes and the longer term hold is eating away at those higher IRRs - which leads me to my question;
What is the happy medium that people here are happening to see/experience in the market? - I don't think any Catch Up/Look Back/Clawback provisions are going to help...I could be wrong? Is there any sort of mechanic for a front loaded promote or is it simply a condition of renegotiation of the JVA in the case this scenario arises?
Following
This already exists and it's crystalizing the promote in the refi at stabilization assuming you are using bridge debt for value add acquisitions or construction loan for development. The ownership % would adjust in favor of the GP and the cash flows would then be prorated based on the new equity %'s. There would then be no promote structure at disposition but instead would be a prorated return of cash flows and dispo/refi proceeds throughout the lifecycle of the deal.
I mean, in the first case, the GP should lose out because anyone stupid enough to not build in a buy/sell agreement, or to give those kinds of major decision rights to an LP, is being a fool in the first place.
But to answer the question, you can have a phantom sale, crystallize your promote, and then cram down your LP. You have to have a mechanism for it in your operating agreement, but even if you don't I can't see a world in which your LP wouldn't do this. If the asset is worth holding, it'll be worth holding 80% of the equity instead of 90%. The nightmare scenario is that you force a sponsor to stay in the management role and they just lose interest in the asset because they're not getting paid, and all of a sudden the place is falling apart and there's nothing to be done.
Generally speaking JV agreements and all those things are more important when things go wrong than when things go right; if everything is hunky dory at the asset level, it's hard to imagine a scenario in which an amicable solution can't be reached. And to reiterate, if you're a GP and you've done nothing to either memorialize how you get paid or protect yourself from being booted as the managing member, you've done a bad job and probably deserve what is coming.
Are you the mysterious “equity cram down” poster from a few weeks ago?
Not unless I'm sleepwalking! It's just a typical phrase for diluting a partner.
Other option, as you alluded, is to crystallize the promote at reset percentages going forward based on a valuation at stabilization or capital event (refinance). In this instance, the GP is paid for the risk and execution without further dilution of time through a prolonged hold period.
Could you share hypothetical scenario with number on % reset based on valuation or refi? If I understand it right, the GP wants to get cash, which refi may provide but ownership % change would not provide a lump sum - just trying to understand better the value proposition of % reset of ownership v. promote cash option
Appraisal mechanism in the JV to crystallize a promote at month [60]. If stable asset, can buy your partner out
Most deals I worked on back in my banking days and all deals I've sponsored, we've used two waterfalls - one for operations and one for capital events. Maybe this is a more old-school method or won't fly with institutional LPs, but it seems like the best method to me. Can have hurdles be simple, cumulative non-compounding or cumulative compounding. Capital event waterfall can even include an IRR or EM hurdle if desired. Only difference is return of capital only occurs in capital event waterfall. In the case of a "cash cow", maybe you can hit final splits in operation waterfall. If LP is worried about GP earning promote during operations and being short-changed in sale, add clawback provision. But ultimately, the big payday/promote of GP is still "invested" and will only be collected after LP receives their capital back.
This also keeps original economics in place down the line. If there's a refi and half the equity is returned, the unreturned capital is still earning the pref and other hurdles. If there's a subsequent capital call years later and everyone contributes their share, they earn the pref and other hurdles on their net investment at their original ownership %. I haven't seen partnership docs that include a crystallization of the promote and change the ownership %, so I'm not sure how that works compared to the method I'm describing.
It's pretty standard that this would be covered in both (A) Buy/Sell provisions of JV, and (B) Hypothetical Liquidation rights, usually a one time right to the GP. What you are asking about is the latter. There are many ways to cover it, but typically appraisals are involved and there can be holdbacks to meet certain milestones, cost overrun provisions, claw backs if certain things aren't met, etc. Could be arbitration (of contentious), or could be a check the box process.
Most institutional players will need to mark to market their assets on a quarterly basis, the starting point is with the developer /operator setting values, validated by market players and likely appraisals annually based on fund requirements. As such, the developer more or less has a good idea of where they are at. Question then becomes whether or not you should cash out now for that check, or wait until all investment(s) are stabilized. Often times you are giving up value on some in exchange for a cash out today.
Pretty new to real estate and trying to soak up as much as possible. Can someone illustrate what exactly a promote crystallization would look like?
GP / LP sign up to a 5 year business plan for a multifamily development asset to be held to stabilization. LP decides for whatever reason they would like to hold it long term which would obviously drag the project IRR down. If the GP has negotiated their docs correctly, they should have an ability to calculate the promote at an agreed window (say 3 months post stabilisation to replicate sale timeline), at which point a 3rd party valuation would be used to calculate a notional sale value. This value would be used to calculate the promote on the assumption the sale has taken place. Where I have seen this structure included before, the GP also has the right to put their equity to the LP (based on the valuation) if they don't wish to stay in the project at this point.
In this hypothetical/synthetic sale on stabilisation calculation - are we assuming the LP is contributing more cash to pay out GP? If yes, what if LP does not want to pay out cash - what provisions can GP rely upon?
Excellent explanation, McLovin.
/f
Thanks Mclovin, you're a pal
I don’t think this answers the question, however I was looking into unique ways to structure deals because we were looking to partner with HNW individuals looking to hold for the long term. The reason being is that something like even an 8% pref becomes a very large number after 10 or more years of holding.
One deal structure was
-they funded the 20% bank loan at an 8% PREF for 3 years.
- they got access to all the depreciation (I realized that very high net worth individuals cared a lot about this). Roughly 20-30% of the asset could be depreciated in the very first year of operation. So say it’s a $20M deal, they would put down $4M and get $4-6M in depreciation the first year of operation - roughly 2-3 years later
- try to refi at completion to return all capital + pref to investor. If short of pref - excess cash flow from operations would be returned to investor
- after the pref, they get 30% of all profits
- no personal guarantee by the LP
Now obviously no family office would take this deal, but for a high net worth individual, this beats the stock market.
Why is the 8% pref growing so large over the 10 years? Is there insufficient cash flow to actually pay it? If so, is this a deal worth pursuing?? Also, why not use separate watertfalls for operations and capital events? No need to overcomplicate it. 8% cumulative noncompounding preferred return for instance with 70/30 split thereafter to align with what you posted. Pref accumulates during development and gets paid down through operations or capital event. Refi at completion, return all capital and pref and now all operating CF is split 70/30, or if there's remaining accumulated pref, that'll get paid off first prior to the split. On depreciation, aren't you going to want your "fair share", especially if you're a real estate professional tax status? Just have profit/loss allocations follow the waterfalls essentially. Depending on how large the initial depreciation charge is and what kind of leverage you're using, you may have a higher allocation of losses due to minimum gain as the guarantor.
It is a compounding return that we are underwriting. Unless my math is wrong, $2,000,000 at an 8% IRR is $4.3M after 10 years.
$10,000,000 is $21.6M after 10 years.
That's why the long hold is tough. Plus, we don't really have a set date to sell. We could certainly do a noncompound return, but that's a pretty low return. especially with the risk free return being so high now.
Agreed. That was the plan to a T. I must not have made that idea clear, although you have said it a bit more straightforward than I did.
One of our partner's in the group pushed back on this, but the other three members don't care as much. We are involved in several other projects with a large % ownership and we get a nice chunk of depreciation from those, so losing one project isn't so bad a hit... Now there may have come some moaning and griping when the tax bill were to come due.
In the end, the group we presented to passed. I think it was a combination of them not really liking the deal, plus expansion within their own line of business which they certainly understand better than multifamily.
Long term deals should keep it simple and do it over an equity multiple. You’ll hit the multiple eventually. And then own a disproportionate share of the deal. You can’t really fail unless you severely overpay or give back the asset. A percent based hurdle on a long term hold makes no sense. That’s why core funds don’t really charge a promote and only charge a fee on AUM.
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