Structuring JV Waterfalls: Hurdles, Subordination, and Fees

Structuring JV Waterfalls: Hurdles, Subordination, and Fees

Hurdles in JV Waterfalls

Hurdles define the point at which the operating partner begins to receive an incentive fee, also known as a promote. They are designed to align the interests of the investor❓ and the operating partner by ensuring The Investor❓ achieves a minimum return before the operating partner participates in a larger share of the profits.

Investor-Centric vs. Investment-Centric Hurdles

The hurdle can be applied from two perspectives:

• Investor-Centric: The hurdle is based on the Total cash flow to investor after accounting for JV expenses like management fees and any incentive fees paid to the operating partner. This approach directly focuses on the investor’s achieved return.

• Investment-Centric: The hurdle is based on the IRR that the asset achieves, potentially without consideration of JV expenses, or only subtracting the management fee. There are two variations:

  • Applying the hurdle to the Asset cash flow without accounting for JV management fees or incentive fees.
  • Applying the hurdle to Net cash flow before incentive fee, after subtracting the management fee but before accounting for the incentive fee payment.

It is easier to reach an IRR hurdle when measured at the asset cash flow level compared to the net cash flow before incentive fee level, and easier to reach at the net cash flow before incentive fee level than at the total cash flow to investor level.

Mathematical Impact of Hurdle Placement

Let’s consider an example. Suppose we have the following scenarios:

• Asset Cash Flow IRR Target (Hurdle): 10%
• Management Fee: 2% of Gross Asset Value (GAV)
• Incentive Fee (Promote): 20% after hurdle
• Initial Investment: $10,000,000

The Net Cash Flow Before Incentive Fee will be impacted by the management fee. If the GAV is $11,000,000,themanagementfeewillbe$220,000. The cash available for distribution and IRR calculation will be lower, requiring a larger overall asset return to meet the same IRR target from the investor’s perspective.

Example

If the hurdle is applied to Asset Cash Flow, achieving a 10% IRR is easier. If the hurdle is applied after subtracting the management fee (Net Cash Flow Before Incentive Fee), a higher Asset Cash Flow will be needed to achieve the same 10% IRR for the investor after paying the management fee.

Subordination in JV Waterfalls

Subordination dictates the order in which capital is returned to the investor and the operating partner. Typically, the operating partner’s capital is subordinated to the investor’s capital. This means the investor receives their capital back before the operating partner receives theirs.

Preferred Return vs. IRR-Hurdle Formulations with Subordination

When subordination is involved, waterfalls are often expressed in terms of preferred returns rather than IRRs.

• Preferred-Return Formulation (No Subordination):

  1. Investors get their capital returned.
  2. Investors get a preferred return (e.g., 10%).
  3. Remaining proceeds are split (e.g., 70% to investors, 30% to operating partner).

• IRR-Hurdle Formulation (No Subordination):

  1. Investors get a specified IRR (e.g., 10%).
  2. Remaining proceeds are split (e.g., 70% to investors, 30% to operating partner).

• Preferred-Return Formulation with Subordination:

  1. The investor gets its capital returned.
  2. The operating partner gets its capital returned.
  3. The investor receives their preferred return on its capital.
  4. The operating partner receives their preferred return on its capital.
  5. The remaining profits are split (e.g., 70% to the investor, 30% to the operating partner).

Mathematical Impact of Subordination

In scenarios with sufficient cash flow, the end result might be similar with or without subordination. However, when the project performs poorly, subordination significantly impacts the returns to each party.

Let:

• I = Investor’s Capital
• O = Operating Partner’s Capital
• P = Total Profit
• r = Preferred Return Rate

Scenario 1: Capital Treated Pari Passu (Equally)

Both investor and operating partner receive their capital and the preferred return proportionally.

Scenario 2: Operating Partner’s Capital is Subordinated

The investor gets their capital (I) back first, then the operating partner gets their capital (O) back. The preferred return is also paid in that order. If P is less than I, the operating partner receives nothing.

Practical Example

Consider a project with the following:

• Investor Capital: $9,000,000
• Operating Partner Capital: $1,000,000
• Total Capital: $10,000,000
• Net Sales Proceeds: $9,450,000

Pari Passu Treatment: Both parties lose proportionally.

Subordinated Equity: The investor receives $9,000,000back,andtheoperatingpartnerreceivesonly$450,000. The investor’s IRR will be significantly higher (less negative) than the operating partner’s IRR.

Catch-Ups in JV Waterfalls

A catch-up is a mechanism that allows the operating partner to receive a larger share of the profits after the investor has reached a specific hurdle, until the operating partner has received their full intended promote share. Catch-ups are generally considered more “operating partner-friendly”.

Catch-Up vs. No Catch-Up

• No Catch-Up: The operating partner receives a specified percentage of cash flow after the investor has reached a hurdle.
• With Catch-Up: After the investor has received a hurdle, the operating partner receives 100% of the cash flow until the operating partner has received their total intended promote share. Thereafter, the operating partner and investor split the cash flow according to the agreed-upon percentages.

Mathematical Formulation of a Catch-Up

1. Calculate the amount needed for the investor to achieve the hurdle (H).
2. Calculate the total profit (P).
3. Calculate the operating partner’s target share of the total profit (TargetShare = P * OperatingPartnerPercentage).
4. Distribute 100% of excess cash flow after the hurdle to the operating partner until the operating partner reaches the TargetShare.
5. After the operating partner has reached the TargetShare, distribute the remaining cash flow according to the standard profit split (e.g., 70% to investor, 30% to operating partner).

Example

• Asset Cash Flow: See Table 11.1 ($19,031,250 in Year 3).
• Investor Hurdle (10% IRR): $12,980,000 Total Cashflow to the investor.
• Operating Partner Percentage: 30%
• Total Profit: $18,931,250 (Net cash flow before incentive fee)

1. Investor Needs: $12,980,000 to hit the 10% hurdle.
2. Total Profit: $18,931,250
3. Operating Partner Target Share: $18,931,250\ast 30$5,679,375

In this example, the Operating partner will receive 100% of the excess cash flow after the investor hurdle (before the split) until the operating partner has received a total amount of $5,679,375.

Periodicity and Compounding❓❓

Understanding the periodicity of cash flows is critical for calculating incentive fees.

• Periodicity: Cash flows can be analyzed annually, quarterly, or even monthly. More frequent calculations allow for more precise tracking of IRR and preferred returns.
• Compounding: If using a preferred-return formulation, it’s important to specify whether any unpaid accrued return itself earns a preferred return and how it is compounded (e.g., annually, quarterly, or monthly). The IRR-hurdle formulation addresses compounding by its very nature.

Items More Likely to Arise in Multi-Property or Programmatic JVs

Portfolio True-Ups and Clawbacks

In multi-property JVs, portfolio true-ups and clawbacks are mechanisms used to ensure overall portfolio performance aligns with the incentive fee structure.

• Portfolio True-Up: The incentive fee is calculated on an asset-by-asset basis, but the JV agreement includes a mechanism that allows for a return of some of that incentive fee to the investor should the overall portfolio not meet or exceed a pre-specified, portfolio-based test.

• Clawback: The mechanism for returning to the investor some of the incentive fee previously distributed to the operating partner. The specifics of the clawback are determined by the JV’s operating agreement and are frequently heavily negotiated.

Phantom Income and Tax Distributions

• Phantom Income: Arises when the operating partner (and potentially taxable investors) has a tax liability based upon profits from an asset sale, even though no cash was distributed.
• Tax Distribution: Many JVs have a provision that allows for payment to the operating partner of a ‘tax distribution’ sufficient to pay the tax liability associated with the phantom income.

The calculation of tax distributions can be complex, involving multiple taxing jurisdictions and taxable investors. A simplifying assumption is often to use the highest marginal tax rate of any taxable investor as the relevant rate for calculating the tax distribution for all investors.

Non-Incentive Fees

Various fees can be included in JV agreements beyond the incentive fee, compensating the operating partner for their services. These fees are limited only by the imagination of the operating partner and the investor’s willingness to pay them.

• Management/Asset Management Fee: A percentage of gross asset value, equity value, capital invested, unreturned capital, revenue, or net operating income (NOI).
• Development Fee: A percentage of project costs (sometimes excluding land value and construction interest).
• Construction Management Fee: A percentage of project hard costs and sometimes some or all soft costs.
• Property Management Fee: A percentage of revenue or NOI (fixed percentage or sliding scale).
• Acquisition Fee: A percentage of gross asset value or equity invested.
• Financing/Refinancing Fee: A percentage of the amount of financing secured.
• Leasing Fee: Market rate for brokerage services.
• Disposition Fee: A percentage of the sales price.