Modeling Promotes - real estate deal

Approaching a deadline and could use some help. Structure is a 96/4 to a 9% with the first tranche a 70/30 split to a 13%. How do I calculate how much of the 30 in the second tranche is promote vs how much of it is "equity".

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Feb 11, 2015 - 12:36pm

If you truly want understand how much of the breakout is lowering your equity basis, you would need to segregate the LP & the promote entity. So you would have 1 LP at 96% equity contribution, 1 LP at 4% equity contribution, & 1 GP that only collects promote.

This is because as an LP you are earning a return on your 4.0% equity contribution at 9%, and again at 13% for the 2nd hurdle. So to just take 26/30 x whatever return you calculate is going to skew how much is actually earned from promote, real promote would be something less.

Feb 11, 2015 - 3:51pm

Technically, the amount that is considered promote ultimately depends on whether the GP equity is diluted like the LP equity (i.e. "promoted"). The first step in calculating the promote % is to take the GP's share of cash flow in the tier (30%) and subtract the GP's equity ownership (4%), which gives you 26%, then divide this by the LP equity % (96%), which gives you 27.08% because the GP is taking 27.08% of the 96% that would be distributed to the LP.

If the GP equity is promoted, then the same 27.08% is taken from the GP's 4% equity share such that the GP's equity share is actually 2.92%. Adding the GP's 27.08% promote share to the GP's 2.92% equity share yields the same 30% cash flow to the GP.

If the GP's equity is non-promoted, then the GP's equity share remains at 4% through the waterfall. Subtracting the 4% from the GP's 30% cash flow distribution means that 26% is promote.

The impact of this distinction is of much more importance when the GP's ownership % of the JV is higher. For example, if the JV equity is structured 50% LP / 50% GP, and the GP gets 75% of the cash flow at a tier, then, if the GP's equity is non-promoted, the promote is 25% (since the 50% GP equity remains the same), whereas the promote is 50% if the GP equity is promoted.

Mar 5, 2015 - 8:58pm

I recognize my comment comes after the fact given the original question was asked with respect to a looming deadline. However, I hope this is beneficial for those with similar questions that look to this thread for the correct answer. H Roark is correct. 26 is not the correct answer, and the thinking behind that is a common misconception. The true promote is 2nd tier GP % less 2nd tier LP % divided by first tier LP % times 1st tier GP %. In this case 30% - (70% / 96% x 4%) .

Mar 6, 2015 - 10:28am

NYRealEstatePE Sr Assoc:

I recognize my comment comes after the fact given the original question was asked with respect to a looming deadline. However, I hope this is beneficial for those with similar questions that look to this thread for the correct answer. H Roark is correct. 26 is not the correct answer, and the thinking behind that is a common misconception. The true promote is 2nd tier GP % less 2nd tier LP % divided by first tier LP % times 1st tier GP %. In this case 30% - (70% / 96% x 4%) .

Alright, this has been bugging me. The OP asked, "How much of the 30 is promote?"

Or, inversely, "How much of the 30 is 'true' equity?" You're saying less than 4 of that 30 is true equity? And that, therefore, the LP claims more than 96 as true equity?

Best Response
Mar 13, 2015 - 12:31am

Yes, assuming a common structure in which 100% of the JV equity is invested on a promoted basis and all distributions are made pro rata pari passu, both the LP's and the GP's invested capital gets diluted when cash flow goes towards paying a promote to the GP sponsor.

I think it is easier to understand if you think about it in black and white terms: assume that cash flow distributions are bifurcated between Silo A and Silo B. Silo A represents return on invested capital, while Silo B represents the promote (i.e. performance fee). Distributions into Silo A are shared by the JV members (i.e. LP and GP) based on their relative equity contributions, while the GP sponsor receives 100% of the distributions into Silo B. Until the first hurdle is achieved, 100% of cash flow is distributed into Silo A, while 0% goes into Silo B. Once sufficient cash flow is distributed into Silo A for the LP to reach the first hurdle, some amount less than 100% of available cash flow goes into Silo A and some amount more than 0% goes into Silo B.

Here's an example to better illustrate the concept:

Let's assume the JV is structured such that all of the JV equity contributions are invested on a promoted pari passu basis, with the LP contributing 80% of the JV equity and the GP contributing 20%. Silo A distributions are shared by the JV members pro rata, so the LP receives 80% of Silo A distributions, and the GP gets the remaining 20%.

Assume a simple two-tier waterfall structure in which a 40% promote is paid over a 15% IRR. In other words, 100% of distributions go into Silo A until the JV members earn a 15% IRR on their invested capital. Thereafter, 60% of cash flow is distributed into Silo A (i.e. 100% less the 40% promote), and 40% goes into Silo B.

Here is the summary:

JV Equity Contributions: 80% LP, 20% GP

Tier I Distributions: 100% into Silo A, 0% into Silo B

Tier II Distributions: 60% into Silo A, 40% into Silo B

In each tier, the LP receives 80% of the cash flow distributed into Silo A, and the GP receives the other 20% of Silo A distributions PLUS 100% of Silo B distributions.

In Tier I, 100% of the distributions go into Silo A, so the LP receives 80% of the cash flow distributed (i.e. 80% of the 100% into Silo A), while the GP receives 20% of the cash flow (i.e. 20% of the 100% into Silo A + 100% of the 0% into Silo B). If we assume that $100 of profit is distributed in Tier I, the LP gets $80, and the GP gets $20.

In Tier II, 60% of the distributions go into Silo A and 40% go into Silo B. Now let's assume that $100 is also distributed in Tier II, meaning $60 is sent into Silo A and $40 into Silo B. Silo A distributions are split pro rata, so $48 is distributed to the LP (i.e. 80% of the $60 into Silo A = 48% of Tier II), while the GP gets the other $52 distributed in Tier II, including $12 from Silo A (i.e. 20% of the $60 into Silo A = 12% of Tier II) PLUS $40 from cash flow into Silo B (i.e. 100% of Silo B's $40 = 40% of Tier II).

Occasionally, the GP's equity is invested on a non-promoted basis, meaning that it does not get diluted when a promote is paid. In the above example, this means that the GP equity receives 20% of distributions in each tier, such that the GP would be paid the same $52 in Tier II as before, but the amount of that considered the promote would be only $32, or 20% less than the $40 considered promote above. This distinction may seem small, but it can be of major importance when the GP itself is a JV between the sponsor and investors because the GP JV can be structured such that investors within the GP may be entitled to less than their pro rata share (or even 0%) of any promote cash flow.

Mar 13, 2015 - 1:29pm

H. Roark:
First of all, this is awesome, thank you.

I just had a colleague who has waterfalled himself to death, many times, go through this with me. Apparently the real answer here for the OP is that nobody does a 70/30 tranche in a 96-4 arrangement. The whole premise is worded wrong. If it's a 96-4 agreement, then if they want a 30, they do a 67.2 / 32.8.

Mar 16, 2015 - 8:13am

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