For individuals who invest in real estate private equity funds, the sponsor promote is a key concept. In simple terms, the promote is the sponsor’s share of the profits. Here we’ll look at how the promote works in a fund, covering the basics and important considerations for investors:
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- What is the promote in a real estate fund?
- What is the purpose of a promote?
- How is the sponsor promote determined? An introduction to waterfalls
- Real estate sponsor promote: A simple calculation example
- How the economic cycle impacts the promote
- Avoiding the double promote
What is the promote in a real estate fund?
Every real estate fund has a capital stack, which represents a pecking order for how debt investors, equity investors, and sponsors will take on risk, be repaid, and share in the profits.
Lenders, such as debt investors or banks, are paid first at a predetermined interest rate. Equity investors are entitled to a proportionate (pro rata) slice of the profits after debt investors are paid.
Sponsors are also typically equity investors in their own funds, putting up capital as co-investors with skin in the game. Sponsors generally earn the same returns as other equity investors until a certain threshold is reached. Above this point, sponsors will earn a “promote.” In other alternative investments, this is known as carried interest.
What is the purpose of a promote?
As a performance-based fee, the promote creates motivation and incentive for sponsors to do their best to ensure a successful, profitable fund.
The promote enables the sponsor to earn a share of the upside for doing the heavy lifting in the fund, such as finding and managing the deals, renovating the assets, managing property operations, and overseeing resident relationships. In this sense, the promote aligns the interests of the sponsor with the investors—everyone benefits when the fund generates outsized returns.
How is the sponsor promote determined? An introduction to waterfalls
Cash flows from a real estate fund can be split in any number of ways. A fund’s “waterfall” describes how cash flows will be distributed and spells out the details of the promote.
We can think of cash flows as a stream of water pouring into a bucket, which fills up then spills down into another bucket, creating a waterfall. There are many ways to construct waterfalls. Let’s look at a few common components then consider a simple example.
Return of contributed capital
In general, the first bucket to fill is return of contributed capital. 100% of a fund’s proceeds are distributed to investors until they have received an amount equal to their investment.
Preferred returns
After contributed capital is returned, a preferred return bucket often comes into play.
The preferred return—often just called the pref—refers to a method of distributing profits created from the operations, sale, or refinancing of a real estate investment to the equity stakeholders involved, i.e., the sponsor and the investors.
In a pref distribution scenario, the profits are distributed first to certain equity investors until a specified rate of return on the initial investment is reached. Importantly, the sponsor doesn’t earn a promote until the preferred return is has been paid.
Prefs can be stated as a percentage of the cumulative return on the initial investment or as a multiple of the equity contribution.
Investors generally like prefs because they limit the sponsor’s profit participation (the promote) up to a certain point and allow investors to enjoy returns earlier in the life cycle of the investment.
Breakpoints against IRR hurdles
In many real estate fund waterfalls, the promote has “breakpoints” against IRR hurdles, for example:
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- After an 8% preferred return, the investors may receive the first 80% of profits, with the sponsor’s promote at 20%
- Then, after a 14% IRR, investors will get 70%, and the sponsor’s promote becomes 30%
Breakpoints against the amount invested
Seasoned fund sponsors will often provide for different breakpoints of promote to reward increased investment by individual investors and may offer increased preferred returns to incentivize investors.
For example, in Trion’s Fund II, equity investors receive differing pro rata shares of the upside, depending on how much they have individually put into the fund, with Trion retaining the remainder as the promote. Specifically:
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- If somebody invests more than $1 million, they receive 78% of the cash flow
- If somebody invests $250,000 to $1 million, they receive 76%
- If somebody invests $50,000 to $250,000, they receive 74%
By creating different investment hurdles, partners making larger investments are provided a greater share of the profits.
Some funds have significantly different breakpoints with much wider variances—or none at all. It is not uncommon to see breakpoints with 5 percentage point variations, for example: 70%, 75%, and 80%.
Real estate sponsor promote: A simple calculation example
Let’s consider a simple example.[1] Say we have a sponsor and a group of equity investors who contribute a combined total of $10,000,000 into a real estate fund. The sponsor invests 10%, or $1,000,000 and the other investors contribute the remaining 90%, or $9,000,000.
The fund’s waterfall has three buckets:
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- 10% preferred return
- 20% sponsor promote after reaching 15% IRR
- 30% sponsor promote for anything above a 15% IRR
The first bucket is straightforward: As equity investors, the sponsor and other investors receive their pro rata share of cash flow until a 10% return is achieved.
In the second bucket, the sponsor will first receive a 20% promote from the partnership, then the sponsor will receive its pro rata share of what’s left over after the promote is paid, which is 10% of the remaining 80%. As such, the sponsor’s total share is equal to 28%, calculated as 20% (the promote) + 8% (10% of the 80% remaining after the promote is paid). The other equity investors receive their pro rata shares of the balance, which is 100% – 28%, or 72%.
The third bucket is calculated the same way. The sponsor will first receive a 30% promote, then its pro rata share of what’s left over after the promote is paid. The calculation is 30% + (10% * 70%), or 37%. The other equity investors receive their pro rata shares of the balance, which is now 100% – 37%, or 63%.
How the economic cycle impacts the promote
Do cash flow splits ever reach the level of 50% sponsor/50% common equity investors? Experienced sponsors will typically only suggest this level of promote when investors have achieved 16% IRR or more.
That said, for common equity holders, it won’t often get to this point. When a project has the potential for such high returns, it makes more sense to offer investors lower risk, lower return participation where they still do very well.
For example, if a deal or fund has the possibility to of hitting a 30% IRR—more common during early periods of the economic cycle—sponsors will be more inclined to load the capital stack with preferred equity offering 12% to 13% percent interest rates with no share of profits. This structure provides strong returns to investors while rewarding sponsors for taking on higher risk.
In later cycle periods where deals are more likely to pencil to about 17% project-level returns—which translates to approximately 14% IRR investor-level returns—structuring a deal or fund with 12% preferred equity doesn’t make sense.
Avoiding the double promote
Investors should remain alert to the possibility of a double promote scenario—a situation where cash flows are essentially subject to two waterfalls.
This can happen when a sponsor runs a fund while simultaneously investing outside of the fund. In this case, investors in the fund would be paying the sponsor a promote at the fund level and also paying a promote at the deal level.
A fund, for example, could invest in a local operator’s deal. If the deal performs well and returns exceed the specified IRR hurdle, then the local operator will take a promote, which lowers the net cash flow to the fund. If the fund exceeds its own IRR hurdle, then the fund manager will take a promote. When all is said and done, this double promote will have meaningfully lowered returns for fund investors. Profits were split twice before fund investors receive anything.
It’s something that fund sponsors do—and is oftentimes overlooked by investors—but it’s not something that Trion Properties does. While our funds do invest alongside investors in individual deals, we rebate Trion’s upside at the deal level back to the fund, and we don’t take our promote on that deal on the fund’s investment. The result: Trion only gets an upside when the fund metrics are achieved; our upside is not based on any specific deal in which the fund is invested.
Additional resources
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- The Role of Catchups in Aligning Interests – Find out how catch-up clauses can impact distribution waterfalls.
- How Preferred Return Can Affect Your Real Estate Investment – Read about different perf structures.
- The Cross-Promote in a Fund Structure – Learn how a fund manager’s promote is “crossed over” the pool of properties, which can mitigate risk for individual investors.
[1] Adapted from https://propertymetrics.com/blog/what-you-should-know-about-equity-waterfall-models-in-commercial-real-estate/#waterfall-example