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Sponsor “Promote” Interests
October 15 | 2014

Earlier articles have discussed real estate equity structures generally, as well as some alternative structures that are sometimes used.  The usual arrangements have the sponsoring real estate company being given the right to earn an incentive through a so-called “promote” – an extra share of the upside from the transaction.  This article explains the concept of promote shares and some of the forms they can take.

The promote involved in the usual equity investment structure is similar to the “carried interest” concept used in the fund context, and is essentially a profits interest that is significantly greater than a sponsor’s capital (investment) interest.  The promote is generally given in exchange for the sponsor’s having created value through finding and managing the opportunity, and in some cases for bearing a disproportionate share of the downside risk.  The argument for this additional compensation is that the sponsor has or will, among other things:

  • Locate a profitable investment opportunity
  • Provide useful relationships, expertise, experience, and knowledge
  • Provide assets, construction, or development management services
  • Provide loan guaranties that may lead to cheaper debt, which other investors can also enjoy
  • Provide indemnities for performance and other bonds required by governmental agencies
  • Take responsibility for construction cost overruns

The forms that promote interests can take, however, may vary.  Generally the capital investors usually receive a “preferred return,” an annualized rate of return that distributions to them must attain before the sponsor participates in any promote compensation.  (Realty Mogul has performed extensive research on “market” rates of preferred and promote return rates; you can view a recent analysis here.) 

Thereafter, the “waterfall” (a tiered payment structure) usually moves to a second level, where the excess distributable cash flow is distributed with a certain amount going to the capital investors and another amount going to the sponsor, with the sponsor getting a disproportionate amount (usually in the 20-30% range; again see here our recent market analysis). 

The precise manner in which the preferred and the promote may be calculated, however, can vary by transaction.  A few key points to review when analyzing a deal’s structure can include:

Is the preferred return based on a compounded rate?

Sometimes it is, and sometimes it isn’t.  If it is, the frequency of the compounding can affect return rates considerably; 12% compounded quarterly, for example, can yield an effective annual rate of about 12.68%.  Generally, if no compounding is stated in the sponsor’s operating agreement, then there may (by law) be no compounding.

When does the promote get paid?

Sometimes the promote is paid on a quarterly basis, immediately after the payment of all accrued preferred distributions have been made.  In some cases, however, strong investors can negotiate that all of their capital contribution get repaid first before the sponsor begins to enjoy any promote.  How this is formulated can also affect how return rate formulations are calculated.

How many tiers to the waterfall?

Sometimes sponsors negotiate multiple “hurdles,” or investor rates of return, that may trigger changes in the promote rates.  For example, a sponsor might offer an 8% return and an 80/20 split (investor/sponsor) of excess distributions until the investors have enjoyed a cumulative rate of return of 12%, after which the sponsor’s promote participation might increase to 30%.  There might even be one ore more additional tiers, where the sponsor gains an increasing portion of profits once the investors have realized varying levels of return. 

Is there a “catch-up” provision?

The investors are almost always paid first, but at some point along the waterfall the sponsor may ask that it “catch up” to a fuller participation in the project’s profits.  For example, the sponsor may enjoy 20% of the project’s excess distributable cash flow after the investors’ preferred payments have been made, but it may ask also that, once a trigger threshold is reached, it be permitted to “catch up” to those earlier investor payments so that its overall profit share rises to 20% of all profits, not just those following the payment of the preferred return.  For example, after the investors have reached an annualized 12% return, the sponsor might ask that it get additional cash distributions so that it has 20% share of the project’s profits as a whole (i.e., it “catches up” on the preferred returns that were first paid to the investors).

When can the sponsor lose the promote?

Most agreements provide that the sponsor loses its right to any promote participation if the sponsor defaults on its obligations or otherwise engages in improper conduct.  In these situations, many partnership of LLC agreements give the investors the right to remove the sponsor, at which time it becomes just another investor (to the extent of its actual capital contributions) and the investors choose another managing partner or member, who would then be entitled to the promote going forward.

The incentive nature of the promote structure is intend to align the interests of the equity investors with those of the sponsor.  Each side needs to be careful that the structure does not misalign those interests, and in some cases investors may want to retain some control over certain key matters.  Considerations regarding the promote structure also need to be kept in perspective; the asset itself is still key.  A generous promote to a sponsor is nothing to be begrudged if the property purchased was a good one, was bought at a good price, and continues to perform well. 

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