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You’ve Been Promoted! (not in a good way)
March 3, 2020
When I say, “you’ve been promoted”, I’m not talking about the corner office. A promote, or carried interest, in joint venture structures, is a way that investments’ sponsors receive a disproportionate share of the profits, usually subordinate to a preferred return or hurdle rate. In this meaning of the word, being promoted is not necessarily a good thing! Of course, promote structures are nearly universal for LPs or passive investors, but that doesn’t mean that analysis and negotiation stop there. Promote structures should benefit investors by aligning the interests of GP and LP and incentivizing the GP to create outsized returns. Many investors, though, are wary of structures that encourage sponsors to seek risk in order to maximize pay. At the end of the day, the single strongest aligner of interests is cash out-of-pocket invested by the sponsor on the same terms as limited partners.
Preferred returns and promote structures are not all created equal (even if the numbers look the same). Two deals could both have 8% preferred return and 30% promote, but work differently in ways that meaningfully impact returns to investors. For example, preferred return can be compounding or not, and the rate at which it compounds can vary. Additionally, a sponsor catch-up could follow once the preferred return is paid. This provision is often under- explained and not always well-enough understood – “GP catch-up” structures can be costly and reduce investor returns more than expected.
A preferred return can also be implemented more like an IRR hurdle rate, dramatically changing the cash flows investors receive throughout the hold period of a cash flowing investment. An IRR hurdle structure subordinates sponsors’ promote not only to the hurdle rate but also to a 100% return of investor capital. This way, investors are promised a certain compounding rate of return including full return of capital before sponsor receives any promote compensation.
This IRR-hurdle type of preferred return is rare in widely syndicated multifamily deals, since investors are often unaware of it, and sponsors usually command terms. The common syndication structure sees the sponsor collecting promote on ongoing cash flows that exceed the preferred return rate – an arrangement frowned upon by institutional investors, since a sponsor could collect promote in a year of strong cash flows (or simply due to interest-only loan payments), then underperform the next year (or amortize) – while suffering neither penalty nor clawback of the previous year’s promote compensation.
In fairness, it is rare in today’s low-return environment to find investment opportunities with projected cash flows much above the preferred return rate, so ongoing cashflow promote in most deals is minimal. However, the ongoing cashflow preferred rate structure seen in syndications can be especially pernicious when sponsor “pre-raises capital” to meet their cashflow distribution requirements. The sponsor is then assured promote on cashflow since preferred distributions are a certainty (paid from the “pre-raised” capital). Still more dishonest, some sponsors then tout an asset management fee subordinate to the preferred return – a low risk move when the preferred return is paid out of pre-raised capital (how can we compete with that!?). Yes, I have been asked if our asset management fee is subordinate to the “pref” and of course I must concede it is not. This all goes to say that the desirability of a preferred return isn’t as simple as just the percentage rate – details matter and must be fully understood in order to accurately underwrite net returns to investors.
Other promote variations include secondary hurdles and IRR lookbacks. Promote structures often include a tier 2 hurdle at 15 to 20% IRR above which sponsor promote share increases, usually to 40–50%. Investors sometimes neglect to ask about this feature, which is unlikely to be front-and-center in investment summaries / presentations. A tier 2 hurdle should be a step below a “home run hurdle,” but should not be set so low as to be very easy to achieve. This means that a tier 2 hurdle rate should be based on 1) market rate for multiple-level promote structures and 2) projected returns of a particular project. For example, a fairly conservative value-add deal, with projected returns of 16%, could reasonably structure a tier 2 hurdle entitling the sponsor to 50% of the profits above an 18% IRR. This is because an 18% IRR is a terrific risk-adjusted return and above what the sponsor is reasonably projecting to achieve. Conversely, a 13% tier 2 hurdle rate would be unfair to investors since the hurdle may well be reached and dampen investor returns in a moderate upside scenario. Another wrinkle is whether sponsor begins receiving the higher tier 2 promote share when the project reaches tier 2 hurdle IRR, or when investors receive that rate. Of course, investors would want this threshold to be based on net returns – which is typical, but not always the case. Investors, for all deals and deal structures, should sensitize their net returns to see how a deal’s structure affects their economics in both upside and downside scenarios.
All of these various components to a joint venture structure can be complex and difficult to calculate by hand or from a blank spreadsheet, which is often required for more esoteric wrinkles. The standard method to calculate preferred returns and promotes is via a waterfall model – either a standalone workbook or built onto a discounted cash flow or underwriting model. Fortunately, I’ve built a waterfall module in my underwriting model which allows easy evaluation of net returns to investors and their various components to determine optimal structure from both GP and LP perspective. Both sponsors and investors would be well served to fully understand the structures they are creating and investing in.