I am curious to know from those in the GP space, about the timing of the promote splits. I know its easier when you have fixed NNN lease, but how does it work when the cash flow is sporadic. Example:
Let's say there is a hotel, where the total equity from the GP/LP is $2 million.
The promote is 8% and then a straight split of 50-50 after that.
Since it is a hotel, cash flow may not be stable. At 8% promote, the total paid out is $160k excluding the split. Let's say its a hotel in a beach town, where the winter months are dead. It would be difficult to pay out a flat $40k every quarter. Is it okay if the distributions occur sporadically or even the next year for the current year? Or will the distribution earned only count for that year? Same question applies to the split, because it will be difficult to determine the distribution for split until really the year end.
I know this is much easier for NNN leases, but was curious how it works on irregular monthly cash flow. In my example, the split is simple, but if their are different tiers it gets even more complex. Thanks.
I think the answer to your question depends on how the deal was documented. Usually, this is spelled out in great detail in the operating agreement. How often capital will be distributed, how the return to the GP/LP will be calculated, etc..
At any given moment in time there is a dollar amount that could be distributed to the LP that would satisfy the first return hurdle. As soon as they receive all those dollars, all the additional capital will be split 50/50. it really doesn't matter if you get $250k every month or $1.5 MM every six months. The timing might move the needle slightly if the LP's interest compounds, but nothing too material over this shorter timeline.
Maybe, I'm not understanding your question are you more concerned about annual cash yield? Also when you say 8% promote do you use that to mean a 8% preferred return?
here is some language from a term sheet that may help you out...
Distributions: Cash flows will be distributed as outlined below:
a) First, 100% to the Members until they have been returned their entire equity investment pari-passu,
b) Second, to repay any Cost Overrun Loan plus interest accrued thereon,
c) Third, pari passu to the Members until the Members have achieved an IRR of 12% and an equity multiple of 1.35x;
d) Fourth, after achieving an IRR of 12% and an equity multiple of 1.35x, profits will be split 80% to the Members until the Members receive a 20% IRR and a 1.75x equity multiple, with 20% of profits being allocated as promoted interest to the Managing Member;
e) Thereafter, profits will be split 70% to the Members and 30% of profits will be allocated as promoted interest to the Managing Member.
one thing I would like to point out is that this manner of distributions is a true 20% irr to the equity and then a promote occurs above that...some promotes are calculated on a 20% irr to the equity as if it still held 100% interest in the project...
feel free to reach out to discuss further...
Ouch, those are pretty rough terms, particularly the pref hurdle.
So let me get this straight. Basically the GP doesn't collect a single penny until the LPs are fully paid out on their invested amount. So the GPs pretty much don't make any money until the equity is all return and with a 1.50x multiple. Is this a real estate flip deal? I can't imagine these terms existing on a commercial real estate deal.
Can you expand on this? I am confused... promote begins beyond 12% IRR... regardless, what do mean by some promotes are calculated on a 20% irr to the equity as if it still held 100% interest in the project?
My apologies I meant pref not promote.
investREanalyst hit the nail on the head. Exactly how pretty much every single deal is structured with the only variable being when the tiered splits occur and what they are.
Typically the general partner will co-invest with the limited partners. Common equity % breakout (if you have a strong sponsor,) is something like 90/10 (LP =90%, GP coinvest =10%), or 95/5... All LP investors receive the following prior to any promote being paid:
After that, you then go into a typical waterfall structure where the GP gets a disproportionate share of the upside based on the project meeting certain IRR hurdles like: 80/20 until a 15%, 70/30 to a 25%, 60/40 thereafter. For the hurdle of 80/20, the general partner takes 20% as "promote" and the LP investors take 80% of cash flow up until a certain IRR hurdle. Notice I said LP investors, and in the scenario above, the general partner is both an LP + GP (due to their co-invest).
So, to answer your question, the general partner does not start receiving any promote until all capital has been returned and all preferred returns have been paid. However, they can be collecting cash along the way if they co-invest, but more importantly, the GP will be collecting fees (development fee, Asset Management fee, leasing fee, etc.) to "keep the lights on" and run the business.
Lastly, given that developers are time sensitive, they typically want to sell right after stabilization to maximize profits / promote dollars.... So normally promote isn't paid until the sale.
Gentleman and Scholars,
Thank you for the details. What I would like to also know is how are the tiers exactly calculated. My general understanding is that cash on cash in simply the net cash flow over the equity contributed. However, IRR encompasses the cash on cash in addition to the any additional proceeds left after the sale. Or is this incorrect?
How can we have tiers each year for IRR, if a true IRR number is unobtainable until a sale?
Can you give a simply breakdown of a tiered structure. I understand the simply pref + 1 promote structure, but would like to have clarity on how it is calculated.
For example, lets say the pref is 10% and the 1st tier split is 80-20 until IRR of 15%. 2nd tier split is 60-40 until IRR of 20%. 3rd tier split is 50-50 until IRR of 25%. Let's say the total equity contributed is a $1 million with a 90/10 LP/GP split.
So how would the IRR be calculated and split. If we have a $100,000 left after the promote is paid. What about a $150,000?
Thanks for the help.
I think it would be best for me to replicate your scenario, and run with a potential outcome.
For starters, you can't just have $100k "left after the promote is paid". Promote can never be paid, and then you have $ left over.... The whole idea of the waterfall is to provide incentive for the developer to have a successful project. If the project is uber successful, the GP will make TONS of money.
Assumptions: 1. Equity Breakout: 90% REPE (LP) & 10% Operator (LP) 2. Assumes we purchase building for $1.0m 1/1/2014 ($900k REPE & $100k Operator) 3. Waterfall is as follows: 10% pref -> 80/20 to 15% -> 60/40 to 20% ->50/50 there after
Visual Representation of a Waterfall: Pref Tier LPs $$$$$$$$$$$$$$$$$$$$$$$ - 10% pref GP-------------------------------- nothing Tier 2 LPs ------------------------------$$$$$$$$$$ -80% CFs until 15% IRR GP ------------------------------$$$$$$$$$$-20% cash flows until LPs get 15% Tier 3 LPs -------------------------------------------$$$$$$$$$$ -60% CFs until 25% IRR GP -------------------------------------------$$$$$$$$$$-40% cash flows until LPs get 20% Final Split LPs --------------------------------------------------------$$$$$$$$$$ 50% go to LP's GP --------------------------------------------------------$$$$$$$$$$ 50% cash flows go to GP
A few things to keep in mind with what happens in REALITY vs. underwriting: 1. Typically you have very few points of cash inflows and outflows.... Sometimes just 1 outflow and 1 inflow (purchase building, sell building later) 2. When you are underwriting, normally people just assume cash flows occur monthly, which flow through into their waterfall. Our funds have a TON of investors. if we tried to call capital from them every month, it would be a nightmare. Given this, typically capital is called quarterly, or on an as needed basis.
For demonstraion, let's assume that on 12/31/16, building sells for $10.0m net for whatever reason. Project Level IRR (with only one inflow & one out flow) is 129% IRR. If we are assuming the waterfall is pari passu (contribution & also LP distribution), CFs would be as follows:
Pref Tier LP investor receives $1.2m to get to 10.0% IRR LP Co Invest receives $133k to get to 10.0% IRR GP nothing Tier 2 LP investor receives $171k additional ($1.37m cumulative) to get to 15.0% IRR LP Co Invest receives $19k additional ($152k cumulative) * to get to 15.0% IRR GP receives $47k Tier 3 LP investor receives $186k additional *($1.55m cumulative) to get to 20.0% IRR LP Co Invest receives $21k additional ($173k cumulative) to get to 20.0% IRR GP receives $138k, or $186k cumulative Final Split LP investor receives $3.64m, or total of $5.2m LP Co Invest receives $404k additional, or total of $577k GP receives $4.1m, or total of $4.23m
The general partner takes a big chunk of profits and brings the IRR of 115%to a 79% IRR.
In your experience, have you seen LPs that prefer multiple tiers or just one tier? It seems one pref + one promote split is simple and easy to calculate. I know it does cap the GP's upside, but as far as calculation goes it seems much easier.
LPs are willing to give multiple tiers and GPs certainly want them because they want a disproportionate share of the ups if they outperform. LPs don't structure based on how hard it is to calculate and once you've modeled one of these they aren't bad.
I have seen waterfalls one teir, some more favorable to GP (8% pref -> 60/40 thereafter) and others not (10% pref -> 75/25 thereafter). Majority of institutional investors, however, almost always have a multiple tiered structures. Once you understand a 1 tiered structure (beyond the preferred return) it's relatively simple to understand a multiple tiered structure. I can build a waterfall from stretch with 5 tiers in 15 minutes (not to boost, just to say that once you understand it, and you are good with excel, you can build it relatively quickly).
All of this discussion doesn't really even touch the tip of the iceberg on waterfall calculations. The typical GPLP Coinvest is definitely the most common, however, I am seeing more LP investors propose preferred and common equity waterfalls (ones where the pref participates in upside, ones where they don't), waterfalls with multiple tests or general partner catch up provisions, how / if your hurdle tiers are compounding (is effective = nominal, or effective > nominal), etc.
Cool. Do you know any where I can find a multi tier excel model? Nothing fancy, but just want to see a basic model so I can fully grasp it all. Thanks.
I'll take this opportunity to repost this link. Incredibly helpful reading material. In general the Real Estate Finance Journal does a great job covering a lot of topics in a great amount of detail.
http://www.pircher.com/media/publication/50_SACArticle.pdf
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