The look-back IRR waterfall can be tough to grasp conceptually if it’s not explained intuitively (buy this Self Study tutorial if you have not mastered the concepts already). One of the potential confusions relates to the correct proportion of distributions made to the equity players during the operation of the property due to the fact that one will not know the final IRR until after exit from the deal. We’ll attempt to address and resolve this clearly below.
Let’s assume the following:
- the investor put in 90% of the capital and the sponsor put in 10%
- the first tier is the Preferred Return tier, and it’s an 8% annual look-back IRR based return, measured off of the transaction-level IRR
- this “Pref” is paid to both sponsor and investor pari passu (proportional to how cash investment was made).
If we don’t know the final deal IRR until after exit, how do we know we should be making distributions at all during operation?
The answer lies in the fact that a positive IRR requires that all capital has been returned first. At the point of all capital being returned, the IRR will become 0%, and the first dollar of profit made on the invested capital will push the IRR to be slightly greater than 0%.
An easy way to relate to the behavior of the IRR is to think about the IRR % as a measure of achievement on the investment, where the higher the number, the higher the achievement (i.e, the larger the aggregate returns). Now think about constructing a building, where the goal is to build the tallest building possible, and thus each additional story you build is another level of achievement.
The act of funding the investment is analogous to the act of digging the foundation of the building. At this point you have a hole in the ground and your IRR is very negative. Once the foundation has been poured and the construction is now back to grade (ground-level), it is akin to you having recouped your capital in full (with your IRR now being 0%). Each floor built above the foundation represents a higher level of achievement of the height of the building, and the IRR rises similarly.
The point of this comparison is that the levered cash flows distributed during the asset’s operating period (i.e., everything before sale/exit) are in part or in whole the cash flows that are equal to the act of pouring of the concrete that brings the building back to grade, i.e., that brings the IRR from something very negative up to 0%.
In other words, through the lens of the IRR computation, the initial distributed cash from operations is really just the return of capital, even if the JV operating agreement specifies that the Preferred Return is paid first and then capital is returned. Keep in mind that the IRR calculation is just math. It does not discriminate as to the classification of the dollars that are coming out of the operation of the property. It sees positive dollars and pits them against the previously logged negative investment dollars and returns the result.
So in the early years of operation, distributions from operations will not cause the transaction to achieve or pierce the Preferred Return hurdle because the early year distributions are simply contributing towards returning the invested capital. In later years, however, if all capital has been returned, distributions from operations will allow the IRR to rise up to and possibly through the Preferred Return hurdle rate.
As an example, let’s say you have a property with an 8% going-in cap rate, and with leverage, it is achieving a 13% cash-on-cash return in year 1. If this 13% cash-on-cash return remains constant in the subsequent years (let’s assume no subsequent year capital contributions or a refinancing), all capital will be returned by the end of the 8th year (13% x 7.69 years = 100% of capital returned), and as of the end of the 9th year the return would not only achieve the 8% Preferred Return, but also exceed it by 5%. Those dollars associated with the 5% cash-on-cash return in excess of an 8% return would need to be split according to the next tier’s mechanics.
The good news is that all of this can be monitored each month of the investment by tracking the current Unreturned Capital Balance of the investment. Once the unreturned capital hits $0 (meaning all capital has been returned), the IRR function can be run (and will return a positive % value) at the end of each month. If the IRR in the current month remains below the Preferred Return hurdle rate, then you pay out pari passu, and if it exceeds it, then you pay out in the negotiated proportions for dollars in Tier 2.
Our Valuate web-based software can remove the headache from these types of modeling exercises.
Please post questions below.