The Pros and Cons of Catchup
One of the key characteristics of any real estate opportunity that investors should consider is the alignment of their own interests with those of the principals they are investing with.
There are two aspects to this: there should be both a profit motive for the sponsor to encourage them to perform well and a loss-driven disincentive for them if things go badly.
This classic ‘carrot and stick approach’ to evaluating an investment is often misunderstood, because people tend to focus solely on the disincentive—through emphasizing that a meaningful sponsor co-investment need be in place—and miss the nuances of the profit motive through a mechanism known as the ‘catchup’ provision, which must also come into play to bring true alignment of interest to projects.
When a project is financed, there are two types of capital that form the basic structure of the capital stack: the debt and the equity. The debt comes from banks or other financial institutions, typically, and the equity comes from investors.
In transactions where sponsors ask their investors to contribute all the equity required, they eliminate downside risk by putting none of their own capital into the deal. They have no ‘skin in the game,’ and so interests are not aligned—because if something goes poorly, there is little to prevent the sponsor from walking away from the deal.
Furthermore, investors looking at transactions where the principals have none of their own capital in a project may find that it is the fees that are driving sponsor asset acquisition decisions. This can result in transactions with higher risk profiles, because the sponsor is motivated by deal volume and not deal quality.
When sponsors have their own capital in a project, investors can be sure that the threat of loss is equally balanced between them and the sponsor, and this aligns interest more equitably between the parties.
That said, a lack of profit motive should not stifle a sponsor’s incentive to outperform. Investors want to maximize their returns, so properly motivating sponsors to exceed expectations is as important as ensuring they co-invest.
This is where the catchup comes into play, because it aligns the profit motive to a true split, and this is how it works:
There are two types of preferred interest: the hard pref and the soft pref.
A hard pref would be an 8 percent pref with, for example, a 70/30 split after the 8 percent. In this scenario, the sponsor does not participate in any of the cash flow—or upside—until the investor has received their 8 percent preferred return and all of their capital back.
In this structure, the sponsor can be inadvertently motivated to sell a property before its optimal value is achieved in order to participate in any of the cash flow, or upside, of that transaction.
A good example of how this might occur in practice is to consider an investment where the sponsor has renovated a property, increased its value by a couple million dollars, and is achieving projected rents. Without a catchup, the sponsor may see that the project has hit a 20 percent IRR and—in order to capture their own profit—be inclined to sell.
However, the area may be continuing to improve—there is a strong job market, there are tailwinds of additional employers moving to the area, and the location is presenting an even higher quality-of-life than originally expected. In this case, investors’ best interests are served by holding the property another five years or so, collecting the cash flow, and then selling the asset.
To reduce the risk of an premature exit, and to align interests more precisely, deals can be structured with a soft pref which includes a catchup—meaning once the investors have received their preferred return, the sponsor will receive the next tranche of cash available for distribution proportional to their percentage of the profit splits.
Some transactions will see the soft pref implemented from dollar one. This is more common in family office transactions, where every dollar available for distribution is split according to the promote structure, and waterfall breaks change the splits once certain returns are received by investors. More typically, however, are soft prefs after investors first receive a return on their investment, coupled with a catchup.
For instance, in a transaction requiring a $10 million equity investment that offers an 8 percent preferred return, the first capital paid out after debt service would be $800,000 to investors for the preferred return. If the profit split is set at 70/30, then the next $240,000 is paid to the sponsor—30 percent of the total preferred return paid to investors—and thereafter, the next hurdle in the waterfall kicks in.
By instituting a catchup, sponsors can participate in profits along the way, even if it means accepting a lesser percent of the upside overall. To be clear, this is not to keep the lights on—fees do that—but serves to eliminate the risk that a sponsor would be motivated to sell properties prematurely in order to get into the promote and participate in the profit.
Where there is a hard pref and no catchup, a lot of sponsors may be motivated to sell the property so they can pay the preferred return, return the capital, and then get into their promote, and receive their upside for doing that deal.
With the catchup in place, the sponsor is allowed to participate in cash flow during the hold period, enhancing returns for all parties by better aligning the interests of the sponsor to the investors.
Further, to alleviate investor concerns that the sponsor receives incentive payments before capital has been returned, typical catchup structures are paired with what is known as a ‘clawback.’ This is if, for whatever reason, capital is not returned in full at the end of a project’s life, the sponsor is obligated to pay back all catchup capital received.
While some investors may balk at the idea of the sponsor receiving anything but fees before they receive back their principal investment, the catchup makes any transaction more of a true partnership through balancing both the loss motive through co-investment, and the profit motive in a more harmonious alignment of interest.
Related: What is Good Cash on Return for Real Estate Investing?