Discount Rate on Buyout of My Carried Interest
I have a 20% carried interest in a real estate development project. Conservative assumptions are that the project will distribute an additional $30M over the next 4 years, thus my un-discounted interest is worth approximately $6M. For personal reasons, I am considering selling my interest to my partners. What would be the appropriate discount rate to use in determining the present value of my interest given the following:
- Of the $30M, approximately $20M has already been realized and is Cash on the Balance Sheet.
- The remaining $10M is very low risk.
- It is very likely that the remaining project life will be less than 4 years.
- My partners who would be purchasing my interest have complete control over the timing of the $30M distributions.
My thought is that the discount rate should be very near that of treasury bills because of the low-risk profile of the distributions and the fact that my partners have complete control over the timing of these distributions.
I appreciate any thoughts on this. Thank you.
I'm assuming there aren't provisions for early buyout of your carried interest in your contract, correct?
A few follow up questions:
Have the partners discussed buying you out, or will this be a complete surprise when you as the question?
Is the carried interest dependent on the success of the project (ig. based on a waterfall)?
I find it strange that your partners would keep $20M as cash if it is truly realized. Why wouldn't they return this to investors?
Thanks for the response. As for your questions:
Correct, There are no provisions for an early buyout in the contract.
The possibility of a buyout was suggested by my partners when I inquired as to why we weren't distributing cash on the Balance Sheet.
The carried interest is fully vested. My estimate as to remaining cash to be distributed is conservative.
My best guess is that they are trying to "squeeze me" in order to justify a substantial haircut. I want to send them a simple calculation of what my interest is worth.
Could you walk me through how the $20M has been realized? Is this based off of fee generated revenue, or was there a capital event (ig. sale of part of the investment)?
What is preventing your partners from returning this to investors today? Are they concerned with future capital needs, therefore they are reserving this?
If you are so sure that the $20M has been realized and is fully vested, I would argue for no discount rate & for the partners to give you your share today (unless there is a good reason why they are holding back). And the remaining.... I have no clue cause I would need more info than "conservative estimates."
I've done something very similar to this for one of my partners to be bought out of a JV. I took our financial model and did a really basic exit cap sensitivity. From their I took this calculated promote (4 years from now) and then discounted this future CF to today using a range of discount rates of 6% up to the preferred return on the deal (low double digits). Completely arbitrary, but with the exit sensitivity, it gave a good range of promote potential (future, and then range for discounted to today). This was then used in partnership negotiations. super basic, but sometimes basic is better.
In this scenario, the cash flows were very unknown (development just started, so there was still A LOT to do before a promote was realized, if EVER. Maybe if you are so sure the money will be there in the future that you could argue for mid single digit discount rate?
TBills rate is too low (you have more risk than ZERO...you have real estate risk). More appropriate would be real estate based interest rates...aka...mortgage rates....so closer to 4%
This is a land development project that has been rolled out in phases. The $20M has been realized through the sale of lots in prior subdivisions.
There are no future capital needs because we have finished servicing our final subdivision. We have approximately 25 lots left to sell, thus the unrealized $10 million. The only ongoing expense is overhead, which runs at about $300,000 annually.
Unfortunately, I think they are intentionally keeping the cash on the balance sheet as a negotiating tool. They know I want/need my share. By not making distributions they are essentially trying to force me to take a large haircut when cashing out my interest.
Something isn't adding up here for me - is there a clause in the partnership agreement explicitly stating that they can hold back the residual equity from subdivision sale in a capital account? If not, they have to distribute the proceeds to you. The only thing they could do is subtract your pari-passu future potential of the outstanding 10 M from your share of the realized 20 M. In that case, to appease both parties I'd suggest discounting the 10 M at a higher rate since the next few years could be shaky, and discounting the 20 M at 0% since that's money accrued in the here and now. Let me know if I'm missing something....
The relevant clause in the agreement reads:
"Although the timing of equity distributions cannot be guaranteed, every reasonable effort will be made to distribute excess cash out of XXX, provided XXX will be able to continue to service its debt, and pay its operating expense for the foreseeable future. Notwithstanding the preceding sentence, the timing and amount of distributions will be at the sole discretion of the equity owners of XXX."
Unfortunately, despite having paid off all of the debt on the balance sheet, having no significant capex remaining on the project, and approximately $20M in the bank earning 1.45%, my partners are not making distributions.
What's the entity structure of the 'partnership'? I also don't understand how that kind of cash can be retained on the balance sheet. So, there have been no distributions?
You say that it will distribute $30MM over the next 4 years...then suggest that it's already generated $20MM and there will be another $10MM in the future. So, to confirm, there will be a total of $30MM in cash to distribute at a future date with $20MM of that amount already in hand (but retained/not distributed)? Over what course of time has that $20MM accrued?
It seems that the waterfall structure is important in determining the overall value...unless you plan to discount from that projected amount...taking into consideration the waterfall.
Something either appears very strange here or I'm failing to understand the situation correctly (which is possible).
The agreement is not a partnership agreement in the strict sense. It is just an agreement that allows me to participate in distributions made to the equity holders (my partners). I am not an equity holder.
Only $2M has been distributed in the last 6 years.
Your understanding is correct.
The $20M has accrued over the past 6 years.
I understand your confusion. I am also at a loss to explain why they are refusing to make distributions. The only explanation I can come up with is that they are holding back on making a distribution in order to force me to accept a large haircut on my interest in the project.
Can they not give you your carry if you're terminated? These guys are treating you like shit, you should return the favor. Take it easy. Play some golf. Don't kill yourself to get anything done. Consult a lawyer about recourse if you have to use the courts to get your distribution.
Looking for a rate near to the T-bill seems really low with a third of the distributions left to be made, there has to be SOME kind of risk premium involved.
Edit: After reading all of your comments it seems like you're also lacking pretty much any leverage in the negotiation (as per the clause you cited), so you may have to just negotiate for as little a haircut as possible.
One big question in determining your value might involve the tax implications. Have taxes been paid on the retained earnings to date? I cannot see a situation in which taxes haven't been paid unless the holding entity is an LLC and there have been very substantial upfront expenses and/or equity contributions. Does your agreement mention this aspect at all? I imagine that the $20MM that is retained must be post-tax.
I'm going to guess that equity holders want to get you out of the deal and then use that same entity to acquire another deal. That's the only reason that I can see for them retaining all of those earnings on the books...apart from placing pressure on you. It's an odd situation for the equity holders to have no interest in taking distributions.
As others have noted...you're going to take a haircut. There's no way around it. The second sentence in the distribution clause completely voids the first sentence.
Personally...I would arrive at a figure and take distributions over the course of multiple years. Your tax liability should be the same whether you take a lump buyout or take installments as you should be paying capital gains rate. However...with an installment structure you can likely get better terms and take less of a haircut.
One bargaining point might involve asking for a portion of depreciation or deductions...if there are some available based on the deal. Since it's sounds like a land deal...there probably isn't any depreciation. On second thought...there probably isn't much to play with here...but others might be more qualified to speak to this aspect.
I don't think he needs to take the haircut necessarily. If he has a life event which requires him to have liquidity, he can most likely get a personal loan with the equity as I mentioned above. If that's the case, the biggest question mark is what the pref return % is.
Since he's not an 'equity holder' that means he's considered either a preferred/silent equity position or a creditor, which means that the partners can't stop his accrual.
If he can get financing for a number that is marginally better than what that pref is, just do that, let it ride, and let them eat cake. If they are that stupid to let the pref accrue over a few year period, what does OP care as long as he has liquidity when he needs it? At that point, the dumb-asses are just eating into their own returns assuming there's no more upside on the 20 M that's accrued.
As to the last sentence overriding the preceding, I think that's bullshit - it says the equity owners have discretion 'Notwithstanding the preceding sentence', which means that they need to make Every reasonable effort to distribute. If OP can prove that there is not a project-level reason for them to be holding the equity in limbo, I'd bet they legally have to release it.
Is it common to have clauses where if they don't have a reason to distribute and do not it accrues at the pref % (ie say 9% a year that was thrown around in comments above)?
Does OP have an update?
Unfortunately, I was forced to take a huge haircut in a buyout of my interest.
how much?
Can you share (broad strokes) how the conversation went, where the discount landed, and how it got there? Did you end up seeking the advice of an attorney?
Monkey shit cause I sold mine at a 15% discount
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