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When you have a two-player equity joint venture partnership in a commercial real estate deal and there is a promote structure in place, you will likely end up with three different IRRs. Read more to learn why.
(For a very basic foundation on joint ventures, you can watch this free video)
Let’s say there is real estate developer, who we will refer to as the sponsor, developing an office building along with a third party investor. The sponsor invests 10% of the cash investment and the investor puts in the remaining 90%. The profit-sharing deal between the sponsor and the investor is summarized below:
- Tier 1: both sponsor and investor will receive a Preferred Return pari passu (pro-rata, simultaneously) through an 8.00% IRR
- Tier 2: above an 8.00% IRR to the investor, through a 15.00% IRR to the investor, the sponsor will receive a 20% promote
- Tier 3: above a 15.00% IRR to the investor, through a 20.00% IRR to the investor, the sponsor will receive a 30% promote
- Tier 4: above a 20.00% IRR to the investor, the sponsor will receive a 40% promote.
What is a promote?
“Promote” is short for “promoted interest”, which is just a fancy way of saying a share of profit cash flows. In some cases, promote is defined and interpreted as the overall share of cash flows at a specific cash flow tier, and in other cases, it’s defined and interpreted as the share of cash flows at a specific tier in excess of the promote recipient’s pro-rata share of invested dollars in the transaction.
Using Tier 2 as an example, in the first interpretation, the sponsor would receive a total of 20% of cash flows related to Tier 2, inclusive of their 10% share of cash flows for which they invested 10% of the cash into the deal. In the second interpretation, the sponsor would receive 20% of cash flows related to Tier 2 above and beyond their 10% share of cash flows, for a total of 30% of cash flows in Tier 2.
Neither interpretation is right or wrong, it’s just a matter of how things are set up legally in the joint venture operating agreement, so be sure you comprehend this for each specific deal for which you are modeling an investment cash flow waterfall.
What base factors impact the deal-level IRR?
When IRR (internal rate of return) is measured at the “deal level” aka “property level” (100% of the equity) as of the end of an investment timeline, IRR is the reporting of the average annual return on equity over the entire hold period. The factors that impact the deal-level IRR are:
- the size of the negative and positive equity cash flows related to acquisition, operation, re-financing (if any) and sale
- the timing of these cash flows.
How the promote impacts IRRs
The deal-level IRR, as stated above, reflects how 100% of the equity does in aggregate. In the case of a two-party JV, we have three IRRs:
- deal-level IRR (100% of the equity)
- investor IRR (90% of the equity)
- sponsor IRR (10% of the equity)
Naturally, each of the sponsor and investor parties of a two-party joint venture regards their own IRR as the most important measurement for them.
What happens in a JV that involves a promote is that the larger of the two cash contributors (investor, in this case) is willingly forfeiting some portion of what would otherwise rightfully be their cash flow on a strictly pro-rata basis.
For instance, if we use the second interpretation of the definition of promote given above, the investor is agreeing to forfeit the following:
- Tier 2: investor forfeits 20% of their ownership share’s 90% share of Tier 2 cash flows
- Tier 3: investor forfeits 30% of their ownership share’s 90% share of Tier 3 cash flows
- Tier 4: investor forfeits 40% of their ownership share’s 90% share of Tier 4 cash flows.
Assuming that one or more of the IRR hurdles is being exceeded — thus triggering one or more of the promote distributions — what is happening in the course of this forfeiture is that the investor underperforms the deal IRR, and the sponsor, as recipient of these promote cash flows without having to invest more cash to receive them, outperforms the deal IRR.
Assuming that one or more of the IRR hurdles is being exceeded, an example of these disparate IRRs is here:
- deal-level IRR: 20%
- investor IRR: 17%
- sponsor IRR: 25%.
More on why promotes make the IRRs different
If it’s not yet clear why this makes sense, ask yourself the following: What would the investor IRR be if they were the only equity player in the deal?
It would be 20%, same as the deal, because if there is no other equity player, the investor IS the deal.
Now, let’s reintroduce the sponsor to the mix, and assume that the JV deal between the sponsor and investor is that they simply receive profits pro-rata to how investment was made (10% to sponsor and 90% to investor). Assuming all dollars invested were done so pari passu (pro-rata, simultaneously), what would the three IRRs be? All would be equal, at 20%, because the two parties are simply shares of the deal with no special treatment related to their ownership stakes.
Now, let’s revert back to the original JV profit sharing scenario wherein the investor is willingly giving up some portion of what, in the absence of a promote, would rightfully be their cash flows, and the sponsor is the beneficiary of those cash flows without having to buy them dollar for dollar with cash investment in the deal.
Consequently, the investor IRR will decline incrementally with every additional dollar with which they promote the sponsor, and the sponsor IRR will rise incrementally with every promote dollar received.
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