Promote vs Cash Flow Splits
Can someone help me understand the economic difference between the two following structures when the capital in contributed 90% by LP and 10% by GP in a direct real estate development deal?
Structure 1: Single LLC / All Equity
First: An 8% preferred return to all equity
Second: A return of capital pro-rata to all equity
Third: Above the 8% preferred return and return of capital, then 80% of cash flow to Class A Members and 20% to the Class B Member until Class Members have earned a 17% cumulative internal rate of return (IRR)
Fourth: Above a 17% cumulative IRR earned by Class A Members, then 60% of cash flow to Class A Members and 40% to the Class B Member
Structure 2: Sponsor as Class B
First: An 8% preferred return pro-rata to Class A Members and the Class B Member
Second: A return of capital pro-rata to Class A Members and the Class B Member
Third: Above the 8% preferred return and return of capital, then 80% of cash flow to Class A Members and 20% to the Class B Member until Class A Members have earned a 17% cumulative internal rate of return (IRR)
Fourth: Above a 17% cumulative IRR earned by Class A Members, then 60% of cash flow to Class A Members and 40% to the Class B Member
This question is based a bit off a Crowdstreet article (I can't post the link but the title is "Understanding Real Estate Private Equity Structures". It sounds like these two scenarios would have different economic outcomes (which is why in the article they decrease the split to the GP in structure 2).
Many thanks in advance!
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Is there a difference?
Promote is what the GP gets beyond their economic ownership in the deal. A waterfall written based on a pure promote at certain hurdles can be rewritten as a split and vice versa.
For instance, say GP owns 5% of the Project and LP owns 95% (GP and LP together = Venture) Cash flows after a 9% preferred return go 20% to GP and 80% to Venture pro rata. 20% = the GP’s pure promote %. That same waterfall can be rewritten as Cash flows after a 9% preferred return go 24% to GP 86% to LP. GP’s split % = 20% promote + 5%*80%.
so you can derive the implied promote from a stated split and derive a split from a stated promote. Hope that is helpful.
Thank you so much for the response! I believe what you said makes sense. To confirm, do these two scenarios have the same economic outcome? The GP's capital still earns a preferred return on their capital in both scenarios correct?
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