In equity joint venture transactions, it is often the case that the profit sharing split thresholds, which trigger the sliding of cash flow distribution shares successively in greater favor of the transaction’s Sponsor, are determined by the performance of the Third Party Investor’s capital. There are two ways this typically works: where the thresholds are IRR-based, and where they are Equity Multiple-based.
What’s the difference? The difference is simply that the measuring stick that is used in the IRR situation is the IRR achieved by the Third Party Investor’s dollars, whereas in the Equity Multiple situation, the measuring stick that is used is the number of times the Third Party Investor has received their original investment back (i.e., their multiple on equity).
As we know, the IRR is not a perfect, pure measurement of equity investment performance in that it is potentially highly biased by the timing of cash flows. In an instance where the transaction achieves a very high IRR impacted heavily by timing (for example, if condominium units are absorbed at twice the projected rate due to a hot market), the Sponsor can be too enriched in the eyes of the Third Party Investor because the Investor’s cash flows blow through the IRR hurdles with ease, causing “too much” of the transaction profits to be split at the final tier, where the Sponsor gets the sweetest deal.
The Equity Multiple Hurdle serves as a more conservative alternative to the IRR-based hurdles, as it measures actual “chunk dollars” received by the Investor, and triggers the splits based on those whole dollar returns above and beyond the return of the original equity amount invested. As a mentor of mine liked to say, “You don’t eat IRR. You eat chunk dollars.” (A simple, extreme example of this is: you give me a dollar and then one minute later I give you $1.50 back. The IRR on your return would essentially be infinitely positive, but you have only earned 50 cents on the investment. You still can’t even get a Starbucks with the $1.50 you got back.)
Tier 1 line items explained. The line items for Tier 1 of the Equity Multiple analysis of the Investor’s levered cash flows would be (ordered as shown from top to bottom):
Beginning of Period Balance – Last period’s end of period balance
Investor Injections – amounts invested, if any, in the current period
Investor Accruals – amount earned on the current period’s injection based on the equity multiple being used (e.g., 1.20x), calculated as periodic investment times (the equity multiple less 1) e.g., $5,000 * (0.20)
Maximum Potential Payment – the largest potential amount that could be paid out in the current period (this sets a ceiling on the distribution so as to not overpay at Tier 1), calculated as: cumulative investment amount to date times the Tier 1 Equity Multiple, less all Distributions made through the prior period
Actual Distribution – the amount paid out to the Investor associated with Tier 1, where the amount is constrained to the lesser of: a) the Investor’s pro-rata share of equity investment multiplied by total available cash flow for distribution, b) beginning of period balance, and c) Maximum Potential Payment in the current period
End of Period Balance – This period’s beginning of period balance less any Actual Distributions made in this period
Subsequent Tier line items explained.
Subsequent Tier line items explained.
Beginning of Period Balance – Last period’s end of period balance
Investor Injections – amounts invested, if any, in the current period
Investor Accruals – amount earned on the current period’s investment based on the equity multiple being used that is higher than the previous Tier’s equity multiple (e.g., 1.50x vs. 1.20x in the previous Tier)
Sum of Distributions of all Previous Tiers – exactly what it says
Current Tier Distribution – exactly what it says, calculated as the lesser of : a) beginning of period balance for the current tier plus accruals at the current Tier’s multiple less sum of distributions of all previous tiers, and b) Investor negotiated share of cash flow at the current Tier times cash remaining to distribute from the prior Tier.
End of Period Balance – sum of all lines above.
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