Comments (29)

May 20, 2019

Probably the main difference is with which industry you are in. Carry/Promote is essentially the same thing just PE vs RE. A catch up is the odd one out here which I don't think could be used interchangeably.

There could be a differences in how they work, because a carry is usually a flat number like 20% of profits. A promote is usually a tiered waterfall split Pref,80/20,70/30.

A catch up might be the odd one out here just because how some of them work. Some function like this Capital returned Pref returned to LP then 100% of the remaining money goes to the sponsor until they have their equity caught up to the pref. Then afterward go into a Promote/Carry.

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May 21, 2019

Carried interest is a partner's ongoing equity in a deal.

Ex. As an Associate you are given 5% of the operator's "back end" equity on a deal (cash distributed after an exit through refinance or sale and a portion of ongoing cash flow if you hold).

Promoted interest or "promote" is when you are given a bigger split of the equity at the terminal event than you contributed originally.

Ex. As an Associate I contribute 5% of the equity required by the operator but get 10% of the returns therefore receiving a 5% "promote". That being said, many use this interchangeably with carry (incorrectly).

A Catch Up clause in a partnership agreement gives a disproportionate share of the proceeds (cash available after a sale or refinance) at a certain stage of the waterfall (negotiated order in which cash after a terminal event is split between partners)

Ex. The partnership agreement states that at exit both the Capital Partner (Limited Partner, normally contributes 80-90% of the total equity for a deal) and operator (General Partner) first receive their initial equity back. Upon receiving that and assuming there is additional cash remaining, the Limited Partner has a catch up clause which entitles it to a 12% return on that capital. Usually this is followed by further splits (20-80% then 30-70% between GP and LP depending on returns achieved). Say there was not enough cash remaining for the LP to get their full 12% return on capital, this would all go to the LP and none would be left over for the GP. This clause is usually in place under the capital partner as it lowers their risk in the deal.

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May 21, 2019

+1 great and concise summary. one thing to add - most have probably inferred from the examples above, but any three of these can be structured in an infinite amount of ways (in terms of hurdles). Also, the clawbacks can be applied to anything, so you should always look for these very carefully in the JV docs. For example, an LP might add in a clawback for the developer's development fee, management fees etc. if they do not hit their return thresholds. Very sad example to ilustrate below:

LP has priority return of capital + 7% preferred return before sponsor gets anything. Then sponsor get's capital back as well as 7% pref. Then the sponsor get all kinds of sweet promotes through a fancy waterfall structure that can be a simple or complicated as you imagine. LP also has clawback for the sponsor's $1.0mm development fee. So in this example, if the deal flops and only hits a 6% IRR, the sponsor will end up with none of the back end CF and will likely have to give part of it's development fee to the LP as well until it makes them whole for a 7% pref return. If there is anything left of the development fee after that, the sponsor can keep the remainder, if not they lost it all - yikes! Highest risk highest return!

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May 21, 2019

So, if I am understanding you correctly:

Carried Interest indicates that, as an associate of the sponsor, you are given an equity interest of the sponsor's equity. Ex: Sponsor puts up up $100. Associate is given 5% carried interest. Upon return of capital, sponsor receives 5% of all cash flow, refi proceeds and sale proceeds. In other words...the profits.

Promote indicates that, as an associate of the sponsor, after the sponsor and limited partner(s) receive their return of capital and meet their preferred return hurdles, the associate receives a portion of the promote above the hurdle rate.

Is the only difference that:
1. Carried Interest - Gives an interest of sponsor's profits.
2. Promoted Interest - Gives an interest after return of capital and preferred hurdles are met?

If I'm understanding that correctly, than a carried interest is preferable since the interest receives cash flow after return of capital, whereas promoted interest is after the preferred return?

Trying to dig in here because I have always used the terms interchangeably since I believes that they were synonyms.

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May 21, 2019

So you are taking the examples a little bit too literally and are twisting things up as you are focusing too much on the parties involved.

Carried interest is an ongoing equity position held by any partner with equity in the deal (on any level). A promoted interest is if any equity partner receives a higher percentage back than they contributed. No matter who the party is in either example.

Keep in mind there are typically two pools of equity that need to be raised for a real estate deal:

  1. Project level - equity requirement needed after accounting for bank loan.

Example - A real estate development costs $100 to complete. A construction loan is obtained for $60 leaving $40 in equity that needs to be raised. Partnerships usually include two parties - the General Partner (GP) and Limited Partner (LP).

General Partner is usually the operator who does not have much money and contributes a minority of the equity needed (10-20%). They do theoretically have the expertise, relationships and know how needed however to execute the project so they are the managing member and run the deal while making most major decisions.

Limited Partner is usually the investor who contributes most of the equity (80-90%) but is the "silent" partner aka they typically don't do much besides look after GP.

So assuming the LP contributes 90% of the project level equity required in the previous example they would put $34 of cash in and the GP would put $6 of cash in so if we go by strictly cash contributions, LP owns 90% of the deal and GP owns 10% of the deal - their carried interest.

If, however, the GP negotiates that they will receive 20% of the proceeds (cash available after a sale or refinance after paying off the construction loan, closing costs and any other debts) then they have a 10% promoted interest.

  1. Partner level - equity requirement of each partner.

Now staying with the above example, LP has $34 and GP has $6 to raise. They will go out to their network of friends/family, institutional investors as well as key employees to raise this money. So continuing with the GP, they need to raise $6 - I as the Associate am allowed to participate so I contribute 10% ($0.6) of the cash needed. Say my boss loves me and I am really pivotal to this deal's success so he offers to give me a 20% interest upon exit. This would mean I have a 10% promoted interest.

So as you can see it does not matter the level of equity raise, any equity partner in the deal can have a carried or promoted interest.

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May 21, 2019

Also to address two other important points:

  • Endless options - as @brosephstalin critically pointed out, carried interest, promoted interest and preferred return (all different things) can (and do) come in all different iterations because they are independently negotiated between parties. So there is no restriction or limitation to who receives what money first, who gets paid what return when, who and what expenses get clawed back, etc.
  • No necessarily distinct advantage between carried, promoted interest and/or preferred return - sounds stupid but the person/partner that is guaranteed to receive the most money back the quickest has the strongest position. Any of the above can be negotiated to be more advantageous - for carried interest I contribute more so I get more back (like for like, I put in 90% and get it back); for promoted interest I put in 5% but receive 90% of the profits; preferred return I contribute 1% of equity but receive a priority 100% return on capital. All ridiculous circumstances but you see what I mean. This is partially the reason the lucky few of us get hired is someone usually needs to model out these subtle changes in the capital stack/waterfall and see how they impact us as the GP or LP.
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Jun 20, 2019

A catchup is not an LP protection measure. The 12% clause you mention would be a preferred return, not a catchup. A catchup is typically a GP incentive where above the pref (e.g., the 12% return you mention) the GP gets an outsized share of profits until they reach a certain percentage of profits.

The main difference from a typical waterfall hurdle is that it's based on the % of profits, not an additional IRR hurdle to get to the next stage. Anecdotally catchups are almost exclusively used in crossed waterfalls (i.e., fund waterfalls) where you have multiple deals/capital events before the promote is earned.

An example would be as follows:

Tier 1 - Equity is returned
Tier 2 - Pari Passu to each investor until an 8% return is reached
Tier 3 - 50/50 to LP and GP until GP reaches 20% of total profit
Tier 4 - 80/20 to LP and GP thereafter

The catchup mechanism allows the GP to be guaranteed a certain percentage of profit once the preferred return is met, which from my limited understanding is similar to how hedge funds are structured.

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May 24, 2019

I want to clear something up that is inherently confusing to most people. The LP investor is promoted by the developer/GP whereas the GP receives a larger portion of cash flow ditributions than their share of common equity. The developer/GP is not the one promoted...

May 25, 2019

Typically, the GP should earn the promote (i.e. be promoted from a smaller share of profit interest to a higher one).

GP puts up 5% of equity; LP 95%. After capital returned and pref is paid, the GP's share of the profit interest may be 10% (a 5% promote over his 5% base contribution).

An LP promote in this case would leave the GP with less than he put in on an equity claims basis. What you say may not be impossible, but is not standard, either.

May 28, 2019

No, this is wrong. When GP receives a profit share above pari passu (their base capital contribution share), the LP is being promoted. It does not make sense linguistically, but this is how a promote is defined. The same math applies, but the LP is the one promoted, not the GP.

Jun 10, 2019