real estate jv promote calculations: catching up with soft ... · look-back vs. catch-up the...

Real Estate JV Promote Calculations: Catching Up With Soft Hurdles Stevens A. Carey

This article supplements two previous articles published in the Spring 2003 and Summer 2006 issues of The Real Estate Finance Journal entiUed "Real Estate JV Promote Calculations: Basic Concepts and Issues" and "Real Estate JV Promote Calculations: Recycling Profits," respectively. Those articles discussed various issues that arise in a real estate joint venture between a capital partner and a service partner where the service partner receives a promote in the form of a greater share of profit distributions if an IRR hurdle is achieved. This article discusses a special type of IRR hurdle known as a "soft" hurdle.

Consider the following scenario: a local operator ("Operator") has tied up a real estate project at a below-market price and approaches an investor ("Investor") to form a partnership to acquire, refurbish and sell the project. (This article refers to "partnerships" for ease of reference but it applies equally to joint ventures conducted through limited liability companies.) Operator wants investor to put up all the money and Operator wants to receive 50 percent of the profit distributions (in other words, a promote equal to 50 percent of the distributions remaining after investor recoups its investment). Investor is generally willing to agree to this arrangement, but it is unwilling to let Operator keep any profit distributions to the extent Investor needs them to achieve a 20 percent lRR.

The 20 percent IRR requirement is often called a "soft" hurdle. This article discusses alternative ways to structure a soft hurdle and identifies certain dangers and common mistakes one may encounter in the process.

Stevens A. Carey is a transactional partner with Pircher, Nichols & Meeks, a real estate law firm w~th offices in los Angeles and Chicago. He can be reached at [email protected].

Hard vs. Soft Hurdles The difference between a hard hurdle and a soft hurdle is like the difference between a deductible and a threshold.

Hard Hurdle In the scenario described above, if the 20 percent IRR hurdle were changed to a hard hurdle, it would function like a deductible: Operator would not receive any promote (which, under the facts of the scenario described above, means it would not receive any profit distributions) unless and until Investor were to receive a 20 percent IRR and then Operator would receive only 50 percent of the balance remaining. In effect, the profit distributions required to achieve a 20 percent IRR would be deducted from all profit distributions in detcmlining the portion that is shared by Operator.

Soft Hurdle As a soft hurdle however, the 20 percent IRR functions only as a threshold that must be reached as a condition to Operator's retention of any promote:

• if 50 percent of the profit distributions were suf-

8 THE REAL ESTATE FINANCE JOURNAL/SPRING 2008

ficient (when added to the return of Investor's capital) for Investor to achieve a 20 percent IRR, then the threshold would be reached and Operator would get 50 percent of all profit distributions just as it would ifthere were no soft hurdle at all, and in that sense, the soft hurdle would go away; and

• if 50 percent of the profit distributions were not sufficient (when added to the return of Investor's capital) for Investor to achieve a 20 percent IRR, then the threshold would not be met and Operator would not get 50 percent of all profit distributions; instead, the 50 percent share of profit distributions that would otherwise go to Operator would go to Investor to the extent necessary to meet the threshold.

Uncertainty of Soft Hurdle A hard hurdle always reduces the amount of profit distributions that may be shared by Operator (if there are profit distributions to share), whereas a sofi hurdle is contingent and may not result in any reduction at all. Tn the scenario described above, we know that 50 percent of the profit distributions will go to Investor. However, the fate of the other 50 percent of profit distributions is uncertain: all or some portion could end up going to Investor and all or some portion could end up going to Operator depending on the extent to which Investor's 50 percent of profit distributions were sufficient to achieve Investor's 20 percent IRR. A fundamental question is what should be done with this money in the meantime? Should it go to Investor or to Operator?

Look-back vs. Catch-up The "soft" 20 percent IRR hurdle would typically be structured in one of two ways:

• Look-back for Investor: one approach is to give Operator 50 percent of the profit distributions from the outset with a so-called "Look-back": the parties look back at the end of the deal and to the extent Investor hasn't achieved a 20 percent IRR, Operator must turn over to Investor its promote distributions (in this case, all of Operator's distributions ).1

• Catch-up for Operator: another approach is to give Investor 100 percent of the profit distributions until Investor achieves a 20 percent TRR, and then give Operator its share with a so-called "Catch-up": after Investor achieves a 20 percent IRR, Operator gets 100 percent2 of all subsequenf profit distributions until profit distributions are in a 50/50 ratio.

Operator may favor the Look-back because a Catch-up could defer Operator's receipt and use of funds (especially if Operator believes there will be nothing to give

back under the Look-back). However, the Look-back is not likely to be favored by Investor for two reasons: first, if the soft hurdle comes into play, then Investor must chase Operator for Investor's deficiency (at a time when the money may be long gone and Operator may not have the credit to back up its obligation to refund the money); and second, even if Investor is successful in getting a refund from Operator, Investor does not get the use of the refund money until the Look-back, and consequently Investor's IRR may be reduced.4

Many investors feel they should get 100 percent of the first profit distributions necessary to achieve the soft hurdle, because Investor will always be entitled to retain this amount whereas if these profit distributions arc initially split 50/50, Operator may ultimately be required to turn over to Investor all or a portion of its share. If someone must get the money first, then given the issues associated with a potential Operator refund, Investor may insist that it be first in line.

Risk to Operator with a Look-back With the Look-back approach, Operator is betting that Investor's share of profit distributions before the Lookback (in this case, 50 percent) will be sufficient to achieve Investor's JRR. This wager is not without risk. In effect, Investor is loaning money to Operator (that would otherwise go to Investor to achieve its IRR). If Operator wins its bet, the loan is forgiven. However, if Operator loses, it may be obligated to repay all (or some portion) of this loan, together with interest at the IRR hurdle rate (in this case, 20 percent per annum). In fact, under certain circumstances, Operator may end up with less whole dollar profits using a Look-back than it would with a hard hurdle, as illustrated by the following example: EXAMPLE. Assume the following facts: (i) Investor contributes $100 million as of the beginning of Year 1, (ii) there are no other contributions, (iii) there is a refinancing distribution of $120 million as ofthe beginning of Year 2, and a final distribution of $2 million at the beginning of Year 3, and (iv) there are no other distributions. Compare the results (I) using a Look-back, (2) changing thc soft hurdle to a hard hurdle, and (3) using a Catch-up:

(1) Look-back. With a Look-back, the first $100 million of the refinancing distribution would be used to repay Investor's capital contribution. The remaining $20 million of the refinancing distribution and final $2 million would be split equally (before the Look-back). Consequently, Investor's share of the refinancing distribution would be $110 million. Immediately before the refinancing distribution, Inves~ tor's $100 million investment would have grown (for IRR purposes) to $120 million (based on a 20 percent annual return, assuming annual compounding) and therefore immediately after the refinancing

THE REAL ESTATE FINANCE JOURNAL/SPRING 2008 9

. !-

~ .

Real Estate JV Promote Calculations: Catching Up With Soft Hurdles

distribution, Investor would be $10 million shy of achieving a 20 percent IRR. One year later, immediately before the final $2 million distribution, this $10 million deficiency would have grown to

(2) liard Hurdle. With a hard hurdle, the entire $120 million refinancing distribution would be used to

(3) Catch-up. With a Catch-up, the entire $120 million refinancing distribution would be used to achieve Investor's 20 percent IRR. The final $2 mil-

To summarize: with a Catch-up, Operator ends up with $2 million of "whole dollar profits" (i.e., the amount by which its distributions exceed its contributions); with a hard hurdle, Operator ends up with $1 million of whole dollar profits; and with a Look-back, Operator ends up with no whole dollar profits at all! Under the Look-back approach, Operator takes $10 million out of the refinancing distribution that might otherwise have gone to Investor to achieve its 20 percent IRR. This leaves Investor with a $10 million deficiency in its 20 percent IRR. This deficiency grows to $12 million at the time of the final distribution and the $2 million retum component ends up wiping out the $2 million whole dollar profits Operator would have received under the Catch-up approach. It is as though Operator borrowed the $10 million from Operator at a 20 percent interest rate.

$12 million; and immediately after the final distribution to Investor of $1 million, Investor would be $11 million shy of a 20 percent IRK Thus, the Look-back would work as follows:

achieve Investor's 20 percent IRR. The final distribution would be split equally:

lion distribution would be paid entirely to Operator under the Catch-up:

Admittedly, with the Look-back, Operator would get the use of the funds that it must ultimately return and this is not reflected in the above charts. Uut Operator would need to earn 10 percent per annum (on the $10,000,000 portion of the Look-back payment that it held for one year) to get the same total dollars it gets with the hard hurdle, and 20 percent per annum to get the same total dollars it gets under the Catch-up. To make the results more dramatic, we eould assume that the final distribution were made after Investor's IRR deficiency had more time to grow. For example, assume that the final distribution were made at a time when Investor's 20 percent IRR deficiency (which was $10 million immediately after the refinancing distribution) had grown to $20 million (which would occur in less than four years after the refinancing, assuming a 20 percent annual rate, compounded annually), and that


the amount of the final distribution were $10 million. Under these modified facts, Operator would still end up with no whole dollar profits using a Look-back, but would end up with $10 million ofwholc dollar profits using a Catch-up, and $5 million of whole dollar profits using a hard hurdle.

What about an Escrow? Must the distributions in question (i.e., 50 percent of the first profit distributions that are necessary to achieve the 20 percent IRR, which would be distributed to Operator under the Look-back approach, but would be distributed to Investor under the Catch-up approach) go to Investor or Operator? One might ask whether it makes sense to deposit these distributions in cscrow until their ultimate disposition is certain (i.e., when the 20 percent IRR is achieved without these distributions or at the end of the deal). Howcver, if the money were going to an cscrow, then it would not be a distribution to Investor that would be applied towards the 20 percent IRR, and Operator would get the worst of both worlds: as with a Catch-up, Operator's reccipt of funds would be deferred, and as with a Look-back, Investor's IRR deficiency would be allowed to grow larger and reduce Operator's share of whole dollar profits.

In each of the alternative distribution waterfalls below, Investor receives a first level distribution to recoup its capital,6 Investor also receives its 20 percent IRR befi)re Operator receives any distributions and there is some form of Catch-up which, if there are sufficient distributions, is (was) intended to result in a 50/50 split of profit distributions.

Operator may prefer a Catch-up to either a Look-back or an escrow because it wants Investor to hit its IRR hurdle as fast as possible and maximizc Operator's share of whole dollar profits. For the balance of this article, it is assumed that the Catch-up approach has been adopted.

The Catch-up How docs the Catch-up work? This article next considers a number of distribution waterfalls with Catch-ups actually encountcred by the author with facts modified to fit the following example.5 EXAMPLE. Assume the following facts: (i) Investor contributes $100 million as of the beginning of Year I, (ii) there are no other contributions, (iii) there is a distribution of $200 million as of the beginning of Year 2, and (iv) there are no other distributions.

With a soft 20 percent IRR hurdle, the intended result would be that $100 million would go to Investor to recoup its contributions and the remaining $100 million would be split equally because Investor would achieve its 20 percent JRR without the soft hurdle:

A Dangerous Waterfall (that Never Catches Up) In one partnership agreement, the drafter provided for a first level of distributions to Investor to recoup capital followed by a second level to Investor to achieve a 20 percent IRR. The drafter created a third level of distributions to Operator intended to recoup the second level distributions that were diverted from Operator due to the soft hurdle (i.e., 50 percent of the second level distributions). The distribution waterfall looked something like this:


,'. :~


Distribution Waterfall No. 1 (Defective)

(Catch-up level equal to 50 percent o/Investor's pre/erefltialpr(ifii(li$trib~tions): irst L~vcl (Investor's Preferential Ca ital Distributions): 100 percent to Investor pntH Investor has recouped al f its capital; . . " •..•...•..... , •

Second Level Jnvestor's Preferential Profit Distributions : 100 percent to'InVe~tor;,pntillnvestor has received nvestor's then "20 percent]RR Deficiency" (i.e., the amount then necessary.;fOr1nvestdr.to achieve a 2 ercent IRR)" . . ......• '. .' hirdLevel 'Operator's Catchwu }: 100 percent to Operator until it hasreceived'S()·percent of the distribution,

nderthe second level above; and . . ourlh Level: 50 percent to Investor and 50 percent to Operator.

Under this provision, the distribution splits would be as follows:

Somchow Operator got shorted out of $5 million. How did this happen? Investor effectively received $JO million of what would otherwise (absent the soft hurdle) have been Operator's distributions in the second level. To put the parties back in balance, Operator should have received $10 million back from Investur (by getting the next $10 million of Investor's distributions). Instead, it got $10 million back from the partnership (by getting the next $10 million of distributiuns); but 50 percent of these distributions would have gone to Operator anyway so (under the provisions above) Operator picked up only an extra $5 million (i.e., 50 percent of$10 million). That is why the $10 million distribution Icft Operator $5 million short.

Confusing the Source of Payment The error made in Distribution Waterfall No. IS a

surprisingly common mistake in distribution calculations, namely, confusing the partnership and a partner as the appropriate source of payment. Specifically, when one partner is entitled to a payment from the other partner, whether as a Catch-up or otherwise, a distribution level in the amount of the payment may not work, because it makes the partnership the source of the payment: it may reduce the distributions that the recipient partner would othcrwise receive and thereby effectively have such partner pay itself for a portion of the payment.

Investor as the Source of Payment A correct way to draft the distribution splits in Distribution Waterfall No. I would be to have the same Catch-up amount paid solely out ofInvestor's distributions as follows:

Distribution Waterfall No. 2

(Catch-up paid out o(Jnvestor distrihutions equal to 50 percentolInvestor's preferential profit distributions):

First Level (Investor's Preferential Capita] Distributions): 100 percent to Investor uutil Investor has recouped al of its capItal;, Second Level (Investor's Prcferential Profit Distributions): 100 percent to Investor in an amount equal to the then 20 perccnt IRR defiCIency; and fhird Level: 50 percent to Operator and 50 percent to Investor; provided, however, that all distributions under this hird level that would otherwise be paid to Investor shall be paid instead to Operat()r until Operator has received from the distributions that would otherwise have been made to Investor under this third level an amount equal to 50 percent of the total distributions under the second level. ..


Under this provision, the distributions would be allocated as follows (where the Catch-up, which is the

Partnership as Source of Payment To repeat, Distribution Waterfall No. I had a $10 million Catch-up payment by the partnership, which resulted in a $5 million net gain to Operator (because Operator effectively bore 50 percent of the payment). Distribution Waterfall No.2 fixed this problem by changing the source ofthe payment. This problem can also be fixed, without changing the source of payment, by increasing the Catch-up level (under the facts in our example) to $20 million (so that it covers not only $10 million of distributions that would otherwise have gone

proviso in the third level, is indicated below on a separate line):

to Investor, but also the corresponding $ J 0 million of distributions that would have gone to Operator anyway). In other words, this alternative solution increases the Catch-up level so that it covers not only 50 percent of the distributions under the second level but also 50 percent of the Catch-up distributions themselves (i.e., 50 percent of the total distributions under the second and third levels). In this way, the goal of the Catch-up level is clearly achieved, namely, to increase Operator's share of all profit distributions (i.e., all distributions above $100 million) to 50 percent.

Distribution WaterfalJ No.3

(Catch-up level equal to 50 percent of all profit distribution until caught up):

First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped all of its capital; Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20 percent IRR deficiency; Third Level (Operator's Catch-up): 100 percent to Operator until the total distributions it has received under this hird level equal 50 percent of the total distributions under the second level above and this third level; and

Fourth Level: 50 percent to Investor and 50 percent to Operator.

Under this provision, the distributions would be allocated as follows:


· .. ,~,,-

< \


Distribution Waterfall No.3 can be simplified or complicated (depending on your perspective) by using some simple algebra to identify the amount of the Catch-up as a percentage of the second level distributions. If we let x equal the Catch-up amount, and let S equal the total amount of the distributions under the second level, then (using the formulation in Distribution Waterfall No.3):

x = 50 percent (x + S)

One can easily solve this equation to sec that x equals S, so that the third Catch-up level to Operator should equal the second level to Investor. The numbers in our example are simple enough that it is obvious without any calculation that the second level and the third level should be equal,7

Distribution Waterfall No.4

(Catch-up level equal to the appropriate percentage 4 investor's preferential profit distributions):

First Level(lnvestor's Preferential Capital Djstribution~: 100 percent to Investor until Investor has recouped all of its capital; Second Level(lnvestor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20 percent IRR deficiency; Third Level (Operator's Catch-up): 100 percent to Operator until the total distributions it has received under this hird level equal 100 percentS of the total distributions under the second lcvel above; and

r.'ourth Level: 50 percent to Investor and 50 percent to Operator. ..

Under this prOVISIOn, the dlstnbutlOns would be allocated as follows:

The problem with this approach is that when the numbers are more complicated, it may be difficult to see how the percentage (of second level distributions) was derived. Distribution Waterfall No.3 may be preferable for this reason.

Getting Lost in the Words Some .IV documents do not specify distribution levels to establish the soIl hurdle, and instead simply use the proviso approach as follows:

Distrjbution Waterfall No.5 (Ambiguous"!)

(Catch-up level equal to amount Operator failed to receive due to soft hurdle):

!First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped al pf its capital; and .. Second Level: 50 percent to Operator and 50 percent to Investor. !Notwithstanding the foregoing, in no event shall Operator be entitled to any distributions until Investor has eccived Investor's then 20 percent IRR Deficiency, and when there is no 20 percent lRR Deficiency, all distribuions will be made to Operator. until it has received the amount by which (A) the aggregate amount which would

Ihave been distributed to Operator but for the operation of this sentence, is greater than (B) the aggregate distribu-ions received by Operator.


This provision could have been written with distribution levels (without a proviso) as follows:

First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped all of its capital;

Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20 percent lRR deficiency;

Third Level (Operator's Catch-up): 100 percent to Operator until it has received the amount by which (A) the aggregate amount which would have been distributed to Operator (under the Fourth Level below) but for the operation of the second level above and this third level, is greater than (B) the aggregate distributions received by Operator; and

Fourth Level: 50 percent to Investor and 50 percent to OperatoL

The problem with Distribution Waterfall No, 5 is that it is not clear, It is not dissimilar to having a Catch-up in the amount necessary to put Operator in the same position it would have been in without a soft hurdle. In theory, this is fine, but the provision doesn't tell you how to do it. Gregg Hanks, a very careful and thoughtful attorney in Arizona, once encountered this provision, and was concerned with a potential ambiguity in determining (in clause (A» what "would have been distributed to Operator." Distributed from what? If the quoted language were read to refer to what "would have been distributed to Operator" from all the profit distributions prior to the Catch-up9 (i.e., the 2nd level distributions in the restated provision above or equivalently the first $20 million of profit distributions in our

, ,

example), then the language would be the equivalent of Distribution Waterfall No.1: Operator would receive a Catch-up equal to $10 million of profit distributions. But Investor would have already received $20 million of profit distributions. Thus, although Operator would receive what it would have received from the first $20 million of profit distributions, Investor would have received more. Gregg wanted to make sure both Investor and Operator received the profit distributions they would have received in the absence of the soft hurdle (namely, equal amounts alter Investor recoups its capital). While the accountants arc likely to do a better job than the lawyers in reaching the correct result, it is generally preferable to avoid any doubt as to the ultimate outcome. Faced with this issue, Gregg might have substituted Distribution Waterfall No.2, 3 or 4, but he was also faced with the common elient mandate of working with (and doing as little damage as possible to) the language before him. He therefore did what is generally advisable in such situations: eliminate perceived ambiguities and do an example. To assure the correct result, Gregg wanted the amount that "would have been distributed to Operator" to be based on grossed-up profit distributions that would yield what Investor actually received (when received) and an equal amount of profit distributions for Operator, as indicated in the next Distribution Waterfall. Thus, Distribution Waterfall No.5 may be fixed by revising the Catch-up so that it gives Operator what it would have received from hypothetical distributions (without the soft hurdle) that would have given Investor what it actually received, when received:


(Catch-up level equal to amount Operator would have receivedfrom profit distributions, without soft hurdle, tha would have generated the aC,ttlal amolmts received by Investor when received):

First Level (Investor's Preferential Capital Distributions); 100 percent to Investor until Investor has recouped al pf its capital; and " Second Level: 50 percent to Operator and so percent to Investor. !Notwithstanding the foregoing, inno evel1t shall Operator be entitled to any distributions until Investor has eceived the then 20 percent JRR Defici¢J1cy;un4wheIlJhere is t10 20, percent IRR Deficiency, all distributions will

be made to Operator until it has received the ,ariIotintby which (A) the aggregatcamount which would have been distributed to Operator if (x) this sentence did not existand(y) the, amounts distributed resulted in lnvestor receiv . ng the same amounts that Investor did in: fact receive (when received), is greater than (B) the aggregate distribuions previously received by Operator. "

Under Distribution Waterfall No.6, the first $120 million would be distributed 100 percent to Investor to satisfy the soft 20 percent IRR hurdle. How should the Catch-up distribution be calculated? In order for Investor to have received $120 million without the soft 20 percent IRR hurdle, there would have been distributed an aggregate amount equal to $140 million (so that Investor would have received the first $100 mil-

lion and 50 percent of the next $40 million, which would add up to the $120 million total actually received by Investor). The Catch-up would therefore be the $20 million Operator would have received from this hypothetical $140 million distribution.

Thus, the distributions would be allocated as follows:



This or course is the correct result, because we have grossed up the distributions (in clause (A) above) to make sure the amount Operator receives is consistent with the ultimate 50/50 split we are trying to achieve. However, the wording may be confusing and one of Distribution Waterfall No.2, 3 or 4 may be easier to understand.

Distribution Waterfall No.5 could also be fixed by using the Catch-up amount interpretation Gregg wanted to avoid, but making Investor the source of payment, as was done in Distribution Waterfall No.2:


(Catch-up fiwn Investor equal to amount Operator would have received from second level distributions, withou soft hurdle):

!r,-irst Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped al 101' its capital; and Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor in an amount equal to the ther 120 percent IRR deficiency; and trhird Level: 50 percent to Operator and 50 percent to Investor. Notwithstanding the foregoing, all distributions that would otherwise be made to Investor under the third level \Shall be made instead to Operator until Operator has received from the distributions that would otherwise have Ibeen made to Investor under the third level an amount equal to the distributions Operator would have received, i here had been no second level above, from the amounts actually distributed under the second level above.

Distribution Waterfall No.7 may still be confusing and one of Distribution Waterfall Nos. 2, 3 and 4 would be preferable. If forced to use a Distribution Waterfall such as No.6 or 7, an example is highly recommended.

Summary of Catch-up Alternatives 1n sum, the amount of the Catch-up should take into account the source of payment and the language should be clear for future readers of the partnership agreement; if confusing language cannot be avoided, there should be an example. Distribution Waterfall No. I contains a faulty Catch-up: it uses the partnership as a source of payment for a Catch-up amount that would be correct only if the source of payment were Investor.

This problem is solved in each of Distribution Waterfall Nos, 2, 3 and 4. Distribution Waterfall No.5 contains potentially ambiguous language which, without an example, might lead to the wrong result. Distribution Waterfall Nos. 6 and 7 are an improvement over Distribution Waterfall No.5, but still may need an example to avoid confusion. The author's preference is Distribution Waterfall No.3 because it explains the methodology without obscuring the intent of the parties.

For the scenario described in this article,W some of the possible Catch-up formulations can be outlined as follows:


Conclusion Soft hurdles and Catch-ups frequently find their way into real estate joint venture documentation. Whi Ie they involve simple concepts, they are sometimes complicated and obfuscated in their wording and application. With a little patience and thought, they can and should bc crafted in a manner that is easy to understand and implement.

APPENDIX

Generalized Scenario for a Single Promote Hurdle This Appendix considers a generalized scenario assuming a single promote hurdle (after all capital is recouped) that is soft, and in this generalized contcxt:

• describes alternative Catch-up fommlations; and

• compares Investor's IRR and whole dollar returns under the Catch-up approach and Look-back approach.

Generalized Assumptions Assume the following facts: (1) there is a partnership between two partners, an investor ("Investor") and an operator (' 'Operator' '), which contribute all the capital ("C") to the partnership in accordance with their partnership percentages, (2) distributions are to be made first to the partners "pro rata" (i.e., in accordance with their partnership percentages) unti I they get all their capital recoup, and Operator is entitled to a promote equal to "p" (this is a percentage) of all profit distributions (with the balance of the profit distributions distributed pro rata), subject to a single promote hurdle (after all capital is retumed) which is soft, and (3) (unless otherwise indicated) there arc sufficient distributions to complete the Catch-up.

Generalized Distribution Waterfall If a Catch-up approach is used, the distributions described above could be written as follows (using provisions similar to Distribution Waterfall No.3):


""I~~~; " ~'

'''~, .. '' ·'f'}~ :~~~:~\'

¥~; '~~~~

~i1(


'''~~n~nilizedOistrib .. tion Waterfall Usingeateh~~p ,

, irst LeveE To the pa~ersprorat\untilall ,capital is recouped; econclLeycl:. To the partners pro rata until they receive the soft hurdle; ... " "'·i ....... .

hird Level.: tOO. perc"ent t6((? OP<::t;atot as promote until the to~af.distribut~ons "it has.reyeivedunder this thir eveP equal pof the total disttibutionsurider.the second level above arid this thirdlevel~ aiid ourth.Level: . (l~p ) to the partners pro bta imd p to Operator asptoffiote: . ..' .. .

As was done in Distribution Waterfall No.4, we can reword the Catch-up amount in the third level above as a percentage of the second level distributions. Ifwe let x equal the Catch-up amount, and let S equal the total amount of the distributions under the second level, then

Comparison of Catch-up and Look-back To help illustrate the differences between the Catch-up approach and the Look-back approach, the following

x = p(S + x). Solving for x, we see that x = (p/[l - p)) S. In sum, some of the possible Catch-up fonnulations under the more generalized facts above can be outlined as follows:

chart shows how each level under the Catch-up approach would be distributed under the Look-back approach:


p = s. -. B ~

L -

~: This· the case. ... .

The Transposition under the Catch-up Approach The heavily shaded distributions in the above chart arc equal in amount-·· but one goes to Operator as a promote (second level shaded portion) and one goes to the partners in accordance with partnership percentages (third level shadcd portion). Thc soft hurdle, when using the Catch-up approach, simply reverses the order (i.e., transposes the recipients in the second and third level shaded portions): Operator's promote share of the second level (i.e., the heavily shaded portion) is diverted to the partners (in accordance with partnership perccntages) to pay the soft hurdle and then the non-promote share of the third level (the heavily shaded portion) is diverted to Operator (to effectuate the Catch-up). It is a perfect match and therefore, as long as the distributions are adequate, reversing the heavi Iy shaded distributions accomplishes the same total distrihutions (ignoring the time value of money)

To see this, note the following: Prior to the Look-back Payment. The side-by-side chart above shows that the distribution amounts under each approach will be equal if there is enough to distribute, but Investor gets its money at the same time or sooner under the Catch-up approach. Therefore, before any Look-back payment, Investor's whole dollar return (i.e., the whole dollar amount of the distributions

to each Member as though there had been no soft hurdle.

IRR and Whole Dollar Comparisons Thus, assuming that distributions are sufficient to complete the third level, the same amount will be distributed to Investor under each approach through the first 4 levels and the only differences between the two approaches will be timing (as to the second and third levels) and the Look-back payment. (For simplicity we refer only to Investor for the balance of this Appendix, but the statements made apply to all capital on a pro rata basis.) Moreover, based on the generalized assumptions in this Appendix, and assuming there are no contributions after distributions, it follows that the IRR and whole dollar returns of Investor satisfy thc following relationships (where "CU" means Catchup, "LH" means Look-back and "WDR" means whole dollar return):

ignoring the time value of money) and IRR under the Catch-up approach cannot be less than what they are under the Look-back approach. 19 Does the Look-back payment change these relationships? After the Look-back Payment - IRK Assuming no contributions are made alter distributions, t.he IRR n:lationship should not change because the Look-back payment can't make the Look-back I RR any greater



than the target IRR (assuming it is worded to cover no more than the deficiency in the target IRR):

• If the Catch-up IRR were not achieved, then all distributions would ultimately be pro rata under both approaches, but the pro rata distributions would he received at the same time or sooner under the Catch-up approach (so for Investor, CU IRR ~ LB IRR); and

• If the Catch-up IRR were achicved, then the Look-back payment would at most result in the same IRR (so for Investor, CU IRR ~ LB IRR).

Remember that we are assuming that no contributions are madc after distributions. The results may be different otherwise: it is possible that Investor ends up with

Under this example, there is a $20 IRR deficiency at the end of the dcal (before the Look-back payment). This IRR deficiency would be recoupcd under the Look-back approach to achieve the target 20 percent IRR hut Investor would be left with the deficiency under the Catch-up approach (assuming thcre is no clawback).20 After the Look-back Payment - WDR. What about the whole dollar returns? Before the Look-back payment, the distributions under the Look-back approach are less than or equal to the distributions to Investor under the Catch-up approach. After thc Look-back paymcnt, this relationship is reversed, with the Look-back distributions to Invcstor (including the Look-back payment) being greater than or cqual to the distributions to Investor under the Catch-up approach:

• If the required Look-back payment were zero (whiCh means the target IRR were achieved without a Look-back payment or there were no profit distributions), then it is obvious from the side-by-side chart above that the pro rata distributions under either approach would be equal (so for Investor, CU WDR ::::; LB WDR).

• If the required Look-back payment were positive and after the Look-back paymcnt, the target IRR were achieved, then the total pro rata distributions received under the first three Look-back

a deficiency under the Catch-up approach (if there is no clawback) and achieves or gets closer to its target IRR under the Look-back approach. For example, using the facts in the scenario described at the beginning of this article (i.e., a partnership between Investor and Operator where Investor puts up all the capital and distributions are made 100 percent to Investor until Investor recoups its capital and then profit distributions are split SO/50 subject to a 20 percent per annum soft hurdle preference to Investor), further assume a $100 contribution at the beginning of Year I followed by a $140 distribution at the beginning of Year 2 and a $20 contribution at the beginning of Year 3 just at the time of dissolution before the Look-back:

levcls and under thc final Look-back payment level would be at least as much as the amount of pro rata distributions under the first three levels of the Catch-up approach, because the lattcr amount was necessary to achieve the target IRR under the Catch-up approach and would be received at the same time or later under the Lookback approach (so for Investor, Cll WDR ::::; LB WDR).

• If the required Look-back payment were positive and after the Look-back payment, the target IRR were not achieved, then all profit distributions would go pro rata under the Look-back approach (i.e., all promote distributions are refunded) and obviously, this amount can't be less than the pro rata profit distributions under the Catch-up approach because it is the maximum possible amount (so for Investor, CU WDR ::::; LB WDR).

As shown in the body ofthis article (under the heading "Risk to Operator with a Look-Back"), it is possible for Investor to get significantly more distributions (ignoring the time value of money) under a Look-back approach than under a Catch-up approach. Such a result assumes, of course, that Investor is able to collect the Look-back payment. In the author's experience, most investors would prefer not to take that collection risk and instead receive their money sooncr and boost their IRR. And this is generally fine with many,


if not most, operators by reason of the same analysis: as long as there are no contributions after distributions, Operator may get its money sooner with a Look-back, but it will never get less and may get more with a Catch-up.

I Other fonnulations of the Look-back arc possible, but this is a common fonnulation encountered by the author. All references to the Look-back in this article assume this formulation.

2 Some investors require a percentage (greater than Operator's normal promote share, which promote share is 50 percent under the scenario described in this article) that is less than 100 percent. For simplicity (and given the assumptions in this article), it is assumed that thc Catch-up percentage is 100 percent.

3 All "subsequent" profit distributions may be misleading. The Catch-up normally applies only when the hurdle is satisfied. Thus, if there were a subsequent contribution by Investor, there might be a new hurdle deficiency and the Catch-up would stop until the new hurdle deficiency were satisfied.

4 This problem could be solved by imposing an interest factor, but most operators would ratber use a Catcb-up approach than have an obligation to repay all of their promote distributions plus interest (especially at 20 percent per annum). Also, although Investor's IRR may be enhanced by the Catch-up approach, its share of whole dollar prolits may be reduced becausc it is not kecping its money working as long at a 20 percent rate, as illustrated in the next section. See Appendix for general discussion oftbe relative IRR and whole dollar returns under the two approaches.

Ii This example is given in the context of thc scenario described at the outset (in the first paragraph) of this article.

6 The recoupment of capital is a hard hurdle. The return component of the 20 percent IRR requirement (i.e., the amount of profit distributions necessary to achieve a 20 pcrccnt IRR) is in effect the actual soft hurdle.

7 Howcver, thc numbers will not always be so obvious. For example, if Operator's promote were 20 percent instead of 50 percent, then, Operator would be entitled to 20 percent of the total distributions under the Second and Third Levels so that x equals 20 percent (x + S), in which event x equals (20 percent/SO percent) S, which equals 25 percent S. See Appendix for a more general formulation.

S This percentage will vary depending on the deal. For example, under the facts presented in endnote 7 above, the appropriate percentage would be the percentage equivalent of20/80, which is 25 percent.

D Another interpretation, which would lead to the correct result, is that the quotcd language refers to what' 'would have

been distributed to Operator" from all profit distributions until the Catch-up is completed.

10 See Appendix for more generalized scenario.

n This is similar to a word version of the Catch-up formula in Distribution Waterfall No.2.

IZ This is similar to a word version of the Catch-up formula in Distribution Waterfall No.3.

13 See Distribution Waterfall No.2.

14 See Distribution Waterfall No.3.

15 See Distribution Waterfall No.4. 16 See Endnote 2 above.

17 In the body of this article, Investor contributes 100 perccnt of the capital, so that all distributions to Operator are promote distributions. In this Appendix, Operator contributes a pro rata share of the capital, and is cntitled to both (I) a pro rata share of the distributions (along side of Investor) on account of its capital contributions and (2) promote distributions. Basically, all the capital is treated alike, but Operator has two roles, as (I) an investor, and (2) a promoter, and it is important to distinguish the two. In any case, the soft hurdle relates only to thc promote and therefore the amount received as the Catch-up includes only promote distributions. This can be a source of confusion when the Catch-up level is not 100 percent (see endnote 2) and Operator is receiving pro-rata (non-promote) distributions at the samc timc it is receiving the Catch-up.

IS If Investor contributes 100 percent of the capital, the source in this column is Investor's distributions aftcr it has achieved thc soft hurdle. If Investor and Operator both contribute capital, then thc source in this column is Investor's and Operator's prorata (non-promote) distributions after they have achieved the soft hurdle.

19 It may seem intuitively obvious that if the same amount of distributions is received sooner, then the IRR will increase. But with positive and negative cash flows (where distributions arc positive cash flows and contributions are negative cash flows), it is possible not only to have multiple IRRs, but also in some cases, to reduce one of the IRRs (in some cases, the lowest, and in some cases, the highest) by accelerating distributions. To avoid these complications, this Appendix assumes that contributions do not occur after distributions (so there is no more than one change of sign among the cash /lows). With this assumption, it is not difficult to show that an acceleration of distributions increases the IRR, but the proof is beyond the scope of this article. For more on multiple IRRs, sec Carey, "Real Estate IV Promote Calculations: Recycling Profits," Real Estate Finance Journal (Summer 2006) at Appendix.

20 The Look-back described in this article is a fonn of clawback, but it may not elfectuate a complete adjustment. See Example I in Carey, supra, for which such a clawback would have no elrect.


Copyright © 2008 Thomson/West. Originally appeared in the Spring 2008 issue of Real Estate FinanceJournal. For more information on the publication, please visit http://west.thomson.com. Reprinted withpermission.

real estate jv promote calculations: catching up with soft ... · look-back vs. catch-up the...

Documents