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Private Equity Capital for Commercial Real Estate: Understanding and Navigating the Options

Primer on Private Equity

Understand the real estate private equity universe Discuss investment strategies and vehicles used by private equity Become familiar with the capital raising process and timeline Understand the workings of a joint venture, including fees, waterfalls and major terms Learn how to define your value proposition for investors Gain insight into current investor appetite from active capital providers

Real Estate Private Equity Investors

Real Estate Private Equity Investor Universe

Traditional Sources Institutional Sources

Owner / developer personal resources Friends & family HNW investors

Family offices Commingled dedicated real estate equity funds Hedge Funds Pension funds, endowments, foundations Sovereign wealth funds Life insurance companies, banks, corporate investors Listed and unlisted REITs

Investment Criteria
Real estate private equity investors will consider the following in making investment decisions:
Returns Structure Strategy (Acquisition, Development, Land Banking, Debt, Capital Allocation) Property Type Geography Hold Period

One size does not fit all

Certain investors constrained by very specific investment mandates dictated by their investor base Investor cost of capital will determine strategy

Investment Return Characteristics

Class A assets or premier multi-tenant buildings Primary markets High occupancy/credit tenants/long-term leases Stable cash flow investment Modest leverage <50% when used Unleveraged IRRs ~ 7.5% - 8.5%

Core - Plus
Variation on core investing Primary markets Fewer credit tenants Some vacancy or releasing risk Cash flow with some potential for growth through increased cash flow Slightly higher leverage 50-60% Unleveraged IRRs ~ 8.5% 10%

Class A and B assets Recovering Primary markets or Secondary / tertiary markets Mid-high vacancy / releasing risk / obsolescence / rents below market/repositioning Balanced mix of cash flow and appreciation Moderate leverage 60-70% Unleveraged IRRs ~ 9.5% - 13%

Class A, B, or C Assets Secondary/tertiary markets or new developing markets Land/Development/Redevelopment/Repositioning/ Turnaround potential New or innovative product types Dramatic increase in cash flow Growth-oriented investment Higher levels of leverage 70-80% Unleveraged IRRs ~ 10% - 13%

Investment Structure
Single Asset Joint Ventures

Strategic / Programmatic Joint Ventures

Entity/GP Investment

Commingled Funds

Joint ventures are individually negotiated and tailored transactions A joint venture may be formed to:

Widely used vehicle for sponsors who have a good reputation and track record Establishes terms on which a series of investments may be made with a single investor or small number of investors Terms vary widely and are individually tailored (e.g., discretion within a box vs. deal by deal approval) Can offer a more certain funding source for projects within specified parameters

Investments by one or more investors at the operating company (entity) or sponsor equity (GP) level Involves sale of a portion of all income streams generated by the entity or the GP Investments can take form of common or preferred equity and can vary with respect to governance Can provide permanent capital and a longer term/global solution for the sponsor

Group of investors pool their resources to create a larger investment Money is gathered from various sources that is managed together in one account Includes a wide variety of entities including insurance companies, group trusts, limited partnerships, LLCs and private or untraded REITs

Acquire a specific property, a portfolio of properties, Make entity Level Investment Recapitalize an existing partnership Develop or redevelop a property

Creates alignment of interest; typically aids in raising additional JV capital

A Closer Look at Joint Ventures

Structuring Joint Ventures

Joint Venture: Partnership between a private equity investor and real estate sponsor to invest directly in real estate Involves formation of new, special-purpose entity to own the properties of the joint venture
Acquisition JV Disposition JV Development JV

In a disposition JV, sponsor contributes assets at agreed upon value while institutional investor contributes cash Profit sharing based on value of equity contributed by the parties to the joint venture Increasingly popular alternative source of equity capital for public and private real estate operating companies (REOCs)


Structuring Joint Ventures

Single asset or programmatic joint venture
Ability to attract programmatic capital largely determined by investor appetite, sponsor track record, investment parameters and visibility of pipeline

Each joint venture is idiosyncratic; there are no pre-set terms and conditions Terms to be negotiated include:
Contributions Preferred returns and Claw-backs Promotes Governance, guarantees (if any), fees, and transaction costs and expenses Hold period Winding-up, Buy/Sell


Structuring Joint Ventures

Capital contribution: 95% investor / 5% sponsor Sponsor returns subordinated to investor receipt of preferred returns

Sponsor handles day-to-day operations; paid market rate fees (which increase return on investment)
E.g., asset management, property management, leasing, development, construction, acquisition, disposition or financing fees

Exit may include buy/sell provisions where properties are liquidated through acquisition by one JV partner or sale to a third party


Entity / GP Investments


Entity Level Investment Considerations

Equity infusion at the operating company level is akin to selling a portion of the firm Sale of majority or minority stake in the company entitles investor to share in corporate level cash flow
May include net property income, fees, and carried interest Investor would pay its pro rata share of expenses Investor would expect control / governance rights commensurate with its ownership stake in the company

May provide sponsor with global solution

Capital raised typically used to recapitalize existing assets, provide corporate working capital or fund future growth


Entity Level Investment Considerations

Enterprise valuation will take into consideration
Value of existing portfolio (legacy assets) Value of existing and future fee streams Underwriting of corporate assets and liabilities Future value creation

Company benefits from long term strategic alignment of interest Requires a close relationship with the investor, with fit crucial
Important to vet strategy, governance, mechanisms for conflict resolution and potential exit


GP Level Investment Considerations

Equity infusion at the GP level is focused on future opportunities only
No valuation issues with respect to legacy assets

GP level returns are enhanced

Sharing of GP level carried interest enhances underlying deal IRRs by 250 500 basis points for the investor.

Need to address key man provisions and management time commitments to legacy assets Investor will need to be comfortable with limited governance inherent within GP structure


Commingled Funds: Investment Structure


Commingled Fund Structure

Pooled investment vehicle with defined strategy used for making investments in various debt and equity positions Funds are typically limited partnerships (or LLCs) with a fixed term of 7-10 years Typically raised and managed by investment professionals of a specific private equity firm (the general partner/sponsor/investment advisor)
Sponsor has greater discretion over deployment of capital

Increasing institutional appetite for funds sponsored by established operators


Real Estate Commingled Fund: How It Works


Three Types of Fund G.P.s

Investment Banks

Investment Houses

Dedicated Real Estate Players

Long standing relationships with high net worth clients who can help capitalize these funds These banks, serving as frequent intermediaries, have access to proprietary deal flow Skillful at corporate finance and complex structuring Examples: Morgan Stanley, Goldman Sachs, Credit Suisse, and UBS Volcker rule will limit participation by banks in the future

Funds are generally stand-alone funds which are a part of a family of funds The advantage of having multiple funds under the same umbrella is in fundraising and underwriting Brand recognition is a huge factor in the investing business Examples: Blackstone, Carlyle, Cerberus, Apollo, Angelo Gordon, and Oaktree

People who head these funds have worked in real estate most of their lives Skilled at raising money Comparative advantage is typically at the property level Examples: Starwood, Lonestar, Westbrook, AEW, Lubert Adler, Walton Street, Colony Capital


Fund Timeline Most private equity is invested via partnership of a limited duration
Commitments by investors in multiple closings Cash Flows from investors Cash Flows to investors

1 Year Marketing

10 Years
Draw down/Investments Divestments

3 Years

Follow-on fund



Investment Strategy


Open Ended v. Closed-Ended Funds

Open-ended Funds
No limits on the number of properties in which the fund can invest No limit on the number of investors No limit on the duration of the investment Unit certificates in the fund may be redeemed at any time at a set price, usually at Net Asset Value. Raise a fixed amount of capital Have a specified duration Exits from the fund are limited Exit prices can be predetermined

Closed-ended Funds


Fundraising Statistics


Fund Size


Accessing Private Equity Capital Accessing Private Equity Capital Considerations, Process and Timeline
Considerations, Process and Timeline

ULI January 11th, 2011


Joint Venture Indicative Process

Investor Timeline
Outline Objectives

Prepare Marketing Materials


Formal Marketing Effort

Investor Due Diligence

Final Proposals / Negotiations

Outline objectives Identify major transaction issues Due diligence and underwriting Develop returns analysis Explore structural / financing alternatives Formulate key investment terms

Prepare Teaser Finalize investor list Continue due diligence and prepare other marketing materials/ presentations Begin assembling electronic data room and / or supporting information Develop financial model

Contact / screen potential investors Complete and distribute Teaser Incorporate feedback and refine marketing materials / presentation (and potentially term sheet) as necessary Evaluate cultural fit

Negotiate and execute CAs Finalize and distribute Marketing Materials, financial model and open data room Respond to investor requests/ questions Begin drafting Definitive Agreement Receive proposals

Tier potential investors based on transaction criteria Distribute draft Definitive Agreement Facilitate due diligence process / respond to investor questions Conduct management presentations / site visits (if applicable)

Finalize due diligence Negotiate proposals Negotiate and sign Definitive Agreement Closing / funds transfer


Diligence Request List

Management biographies Organizational chart of asset-level management or any employees necessary to manage properties Transaction sourcing strategy Investment committee policies and procedures, if available Industry information / forecasts completed internally or by third parties, including any sub-market studies for each asset Strategy for investing in primary markets / market selection criteria Arial submarket photos, with contributed properties and land for development identified Detail of replacement costs for each submarket (i.e., land, bldg., site, interest, commissions, TIs, design, etc.) Property detail for contributed assets, including address, size, age, physical details, etc. Current rent rolls Property level historical financial information for the past three years Abstracts of all leases Development pipeline and related contracts / documentation Property inspection / asset summary reports

Company and Management Information

Market Analysis

Property-Level Information

Copies of appraisals, environmental and engineering studies completed within last 2 years
Land surveys and site plans for all properties Copies of title reports Debt schedule, including amount, rate, terms, etc. Supporting debt documentation Copy of standard tenant lease Significant tax information that may adversely impact the company or third parties

Financing Information

Other Documents

Disclosure of any prior or pending litigation related to business dealings generally and portfolio specifically


Explore Structural Alternatives

GP - WHOLE CO. PREPARATIONS Corporate and Legal Due Diligence Articles of incorporation, board minutes, ownership structure, legal entity list, etc. Business Due Diligence Financial model(s) and detailed rollup Financing debt abstracts / loan documentation Estimate of defeasance and yield maintenance costs for in place debt 2011E and run-rate G&A detail All executive employment agreements Change of control analysis - tenant rights summary, ROFOs, ROFRs, etc. Lease abstracts Vacancy guidance Other Tax returns Employee benefit plans Third party reports Ultimate Deliverables Confidentiality agreements and process documents Dataroom Purchase and sale agreement(s) Updated Management Presentation LP - JOINT VENTURE PREPARATIONS Diligence Items Loan documents

Third party lease abstracts, documents and tenant data Review previously provided portfolio financial model Any third party reports on properties Appraisals, environmental, structural, etc. Supporting material used in current offering memorandum provided Any document(s) previously gathered for data room Property photos All property-level Argus data

Summary of property management operations Ultimate Deliverables Dataroom

Teaser Offering memorandum Confidentiality agreements and process documents Contribution agreement LLC agreement


Merchant Development Model - Illustrative

(Timeline in Months) Equity Investment
0 22

Equity Investment

Sale of Property


Construction Period
Distribute Fees (as a % of Total Project Cost) A = 3.00% B = 3.65%
12 23

Return of Equity

Lease-Up Period
Management Fee: $9,000 (in 2011)
24 35

Construction period: 22 Months

Stabilization Period
Stabilized Management Fee 3% of Gross Effective Rent

Equity investment: Month 1 or 22

Lease-up management fee: Months 12 - 23 Stabilized management fee: Months 24 - 35 Sale of property: Month 36 Return of equity: Month 36 3rd Party Management: Month 37

3rd Party Management


Crafting the Investment Thesis

Business Strategy

Management Team Experience

Define investment focus (asset type)

Quality sponsor

Acquisition v. development
Determine investment strategy (core, core-plus, etc.) Narrow the focus of the transaction, as needed Consider industry trends & fundamentals

Depth of bench
Ability to navigate current market environment Strong relationships

Well Established Scalable Platform

Portfolio / Pipeline Quality

Vertically integrated Platform to support larger scale business

Footprint (major MSAs?) Mix of (re) development / stabilized assets Size and age of portfolio

Intensive Asset Management

Right-sized organization Cost controls Revenue enhancement

Track Record and Performance

Historical returns Cycle adjusted returns

Deal activity and operating performance in past year

Internal and External Growth Story

Upside from new projects brought online? Access to off-marketed deals? Anticipated returns


Investment Highlights
Premium quality asset portfolio Strong industry fundamentals

Experienced management team

Simplified management structure

Significant internal growth driven through intensive asset management

Proven investment track record


Two Scenarios Diligence & Underwriting

- Small Developer MF merchant builder run by family for 75 years Size Team / Employees Assets Pipeline 20 people 5 stabilized multifamily developments 3 shovel ready - Large Owner MF developer, owner, operator 200 people Own 100 assets ( multifamily, office) $500mm MF dev / acq, $500mm office dev / acq. Recap existing Discretion within a box Need simplified structure. Low basis assets Immediate acquisition pipeline in current markets National, coastal focus A / B MF in Southeast A MF CBD in Northeast Friends & family and 7 institutions Hi teen / low 20% returns to investors Acquisition JV including possible GP investment Comments Market concerned about depth of bench and possible conflicts Small size limits ability to contribute asset. Positive cash flowing Can development pipeline be completed with existing financing? Guarantees? Are targets available at sensible pricing? Not all assets have same financial stress. Refinancing? CMBS / crossed? Family unlikely to cede control Different tax issues for each investor (individuals vs. institutions) Willing to split business lines? Positive fundamentals in markets? MF demand is strong Existing institutional investors lend credibility but conflicts may exist Stability of returns and at what leverage? Different investors choose different entry points


Financial Stress Control Tax Growth

Limited construction financing 3 generations 1031. Recycle capital (not REIT eligible) Need capital for construction or continue to layoff Local sharpshooter A quality MF Friends & family 50%+ asset level returns Development JV


Footprint Sector Investors Returns Structure




Teaser Outline
Teaser Overview
3-5 page summary of joint venture investment Provided to interested, potential joint venture partners along with Confidentiality Agreement Enables potential joint venture partners to quickly determine preliminary interest

Teaser Outline
Transaction Overview Corporate Overview
Company History Track Record The Opportunity

Selected Investment Highlights Market Highlights Portfolio Overview Process & Timing Contacts


Process Alternatives
Process Number of Buyers Confidentiality

< 5 investors

5 to 20 investors

> 20 investors

High Accelerated Limited information preparation

High / Moderate Somewhat accelerated Concise marketing materials

Moderate (risk of leak) Formal and elongated process Complete set of marketing materials prepared and distributed to potential buyers Preliminary term sheets with general transaction terms submitted in a first step

Investor returns model Teaser

Investor returns model Teaser Management presentation

Site visits Management meeting Due diligence

Structure / Process

Key abstracts / documents

Straight from Confidentiality Agreement to data room Small group of investors selected to proceed to a close Provides competitive tension to enhance value and optimize JV terms Months

No access to management or properties in first step

Selected group of investors conduct detailed due diligence in second step Final term sheets submitted Maximum value



Several months to a year or more

3 4


Sample Investor Universe

Pension Fund Advisors

Unlisted REITs

Fund Managers



Family Office / Private Wealth



Description of Typical Fees

Investment banking services:

Screen and qualify potential investors

Description of Services

Create and distribute marketing materials

Contacting investors and solicit proposals Analyze investor proposal(s) Negotiate the transaction

Retainer fee Success fee based on sliding scale Reimbursement of out-of-pocket expenses


Termination Tail Lock-up Indemnification

Other Engagement Terms


Understanding The Investors Financial Drivers/ Accessing Private Equity Capital Investment Framework Considerations, Process and Timeline

ULI January 11th, 2011


Return Requirements by Investment Strategy

Type of Fund

Typical Characteristics

PREA Unlevered IRRs

7.5 8.5%

Well-diversified, low risk/return strategy Traditional asset classes (i.e. office, retail, industrial, multi-family) in established locations Well occupied and well maintained assets with stable cash flows Generally little or no debt is employed (i.e. up to 30% levered) Income stream represents significant part of expected total return
Moderate risk/return strategy Core-type assets, some of which may require some form of value-add enhancement Assets located in either primary or secondary locations Moderate amount of leverage employed (i.e. up to 55% levered) Moderate to high risk/return strategy Opportunity to add value through operating, re-leasing, and/or redevelopment Leverage employed is higher (i.e. up to 70% levered) Value appreciation comprises significant part of expected total return


8.5 10%


9.5 13%


Return Requirements by Investment Strategy

Type of Fund

Typical Characteristics

PREA Unlevered IRRs

10 13%

High risk/return strategy Re-positioning of poorly managed, obsolete, and/or vacant assets Acquisitions of entire companies with portfolios of assets and operating platforms in-place New-build development or conversion projects International focus pursing opportunities in established and emerging markets Leverage employed is higher (i.e. over 70% levered) Originate loans at terms which are more aggressive than traditional lenders May contain profit-sharing in addition to higher interest rates and fees charged Acquire distressed loans from lenders at discount prices (i.e. below par value) Participate in higher-yielding tranches of mortgages (i.e. non-rated CMBS; first-loss positions) Generally not adverse to owning the assets in the event such loans default.

Mezzanine/ Debt


Returns and Leverage

re = rd + LR*(rp rd)
re required return on levered equity rd return on debt (cost of mortgage debt)
LR leverage ratio rp required return on property without leverage

(rp rd) risk premium without leverage

Leverage Ratio (LR):

at the time of purchase
= Acquisition Price/Equity

= Value/Equity


Levered Returns Table

7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0% 12.5% 13.0% 0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0% 12.5% 13.0% 25% 8.3% 9.0% 9.7% 10.3% 11.0% 11.7% 12.3% 13.0% 13.7% 14.3% 15.0% 15.7% 50% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% 21.0% 60% 11.3% 12.5% 13.8% 15.0% 16.3% 17.5% 18.8% 20.0% 21.3% 22.5% 23.8% 25.0% 75% 15.0% 17.0% 19.0% 21.0% 23.0% 25.0% 27.0% 29.0% 31.0% 33.0% 35.0% 37.0% 80% 17.5% 20.0% 22.5% 25.0% 27.5% 30.0% 32.5% 35.0% 37.5% 40.0% 42.5% 45.0%

Assumes 5% cost of debt

Required Return Unlevered


Median IRRs


Venture Cash Flow Sharing Arrangements


Joint Ventures
Two types of partners that combine expertise with capital
Developer/ Operator/Sponsor


Cash flow sharing arrangement made between these two partners


Joint Ventures: Cash Flow Sharing

Sharing Cash Flow Operating Cash Flows
Typically pari passu or at predetermined percentages

Sharing Cash Flow Property Sale/Refinance

Repay any debt Return of initial investment (return of invested capital remaining) Remainder Distributed (return on capital)
Split of Cash Flow (often a waterfall arrangement) Predetermined portions/percentages Preferred returns and return hurdles Hard Hurdle Soft Hurdle IRR lookback (clawback) or catch-up with soft hurdle


Example JV Waterfall Distribution

First, to repay capital contributions made by each partner (typically 90%/10%) pari passu Second, to pay each partner a 9% cumulative annual return on capital Remaining proceeds split 50% to Institutional Investor and 50% to Developer/Sponsor Target IRR 18% to Capital Investor


Hard vs. Soft Hurdles

The difference between a hard hurdle and a soft hurdle is like the difference between a deductible and a threshold.

Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey


Hard Hurdles
A hard hurdle functions like a deductible:
Operator would not receive any promote unless and until capital investor were to receive IRR hurdle and then operator would received a predetermined percentage of the incremental cash flow. In effect the profit distributions required to achieve the hurdle would be deducted from all profit distributions in determining the portion that is shared by Operator.

Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey


Soft Hurdles
The soft hurdle is a threshold that must be reached as a condition to operators retention of any promote:
If the profit distribution is sufficient to achieve the IRR hurdle, then
The threshold would be reached Operator would get a predetermined percentage of all profit distributions Catch up if preferred returns are met first In that sense, the soft hurdle would go away

If the profit distributions are not sufficient to achieve the IRR hurdle, then
The threshold would not be met Operator would not get a predetermined percentage of all profit distributions Operator must forfeit distributions (lookback or clawback if preferred returns are not met first) to the extent necessary to meet the threshold

Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey


Uncertainty of Soft Hurdles

A hard hurdle always reduces the amount of profit distributions that may be shared by Operator (if there are profit distributions to share), whereas a soft hurdle is contingent and may not result in any reduction at all.

Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey


Look back vs. Catch-up

Look-back for Investor: one approach is to give Operator 50% of the profit
distributions from the outset with a so-called Look-back:
The parties look back at the end of the deal and to the extent Investor hasnt achieved a 9% IRR, Operator must turn over to Investor its promote distributions (in this case, all of Operators distributions)

Catch-up for Operator: another approach is to give Investor 100% of the profit distributions until Investor achieve IRR hurdle, and then give Operator its share with a so-called Catch-up:
After Investor achieves a 9% IRR, Operator gets 100% of all subsequent profit distributions until profit distributions are in 50/50 ratio

Source: Real Estate JV Promote Calculations: Catching up with Soft Hurdles, by Stevens Carey


Return Multiples


Net Multiple
The net multiple return is used by investors to determine how much they have received in cash relative to how much they paid in
It does not take into consideration the timing of capital call-ups and distributions It does provide a good indication of fund performance

Calculated as a Ratio: Total Cash Inflows/Total Cash Outflows

Source: 2010 Preqin Private Equity Real Estate Review


Net Multiple (cont.)


IRR Multiple Table

Investment Horizon in Years

8.0% 10.0% 12.0% 15.0% 17.5% 20.0% 25.0% 30.0% 35.0% 40.0%

3 1.24x 1.31x 1.37x 1.48x 1.58x 1.68x 1.89x 2.12x 2.37x 2.64x

5 1.40x 1.52x 1.65x 1.87x 2.07x 2.29x 2.80x 3.39x 4.09x 4.90x

7 1.56x 1.75x 1.96x 2.33x 2.70x 3.11x 4.12x 5.43x 7.09x 9.19x

10 1.80x 2.12x 2.50x 3.22x 3.98x 4.92x 7.45x 11.18x 16.54x 24.14x

Assumes capital contribution made at time zero and also assumes 8% cash distributions per year



JV Waterfall Examples
Typical JV Promote Structure: The Sponsor invests a small portion of the equity, with a Limited Partner (LP) providing the balance. The Sponsor is generally entitled to received performance incentives in the form of promotes (a greater portion of the cash flow) upon achieving certain return hurdles
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000

1. Cash flow split pari passu until an IRR of 10% is generated 2. Sponsor receives a 30% promote until a 15% IRR hurdle 3. Sponsor receives a 40% promote until a 20% IRR hurdle 4. Sponsor receives a 50% promote thereafter

1. All cash flow split pari passu until each Member has reached a 10.0% IRR JV Investor (13,500,000) 540,000 JV Sponsor (1,500,000) 60,000

630,000 70,000

720,000 80,000

810,000 90,000

18,197,242 2,021,916

90.0% of cash flow 10.0% of cash flow

2. JV Sponsor receives a 30.0% promoted interest until the JV Investor receives a 15.0% IRR JV Investor JV Sponsor JV Sponsor 1st Promote- 30.0% 3. JV Sponsor receives a 40.0% promoted interest until the JV Investor receives a 20.0% IRR JV Investor JV Sponsor JV Sponsor 2nd Promote- 40.0% 4. JV Sponsor receives a 50.0% promoted interest on all remaining cash flow JV Investor JV Sponsor JV Sponsor 3rd Promote- 50.0% Total Distributions JV Investor IRR: 20.6% JV Sponsor IRR: 51.5% (1,500,000) 60,000 70,000

4,922,157 546,906 2,343,884

63.0% of cash flow 37.0% of cash flow

5,900,233 655,582 4,370,543

54.0% of cash flow 46.0% of cash flow

806,192 89,576 895,769

45.0% of cash flow 55.0% of cash flow











JV Waterfall Examples
JV Promote Structure with Minimum Equity Multiple Hurdle: The scenario below is similar to the previous structure, with an added return hurdle. The investment must generate a minimum equity multiple for the LP before the second promote can be paid out to the Sponsor
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000

1. Cash flow split pari passu until an IRR of 10% is generated 2. Sponsor receives a 30% promote until a 15% IRR hurdle 3. Sponsor receives a 40% promote until a 20% IRR and a 2.50x equity multiple 4. Sponsor receives a 50% promote thereafter

1. All cash flow split pari passu until each Member has reached a 10.0% IRR JV Investor (13,500,000) 540,000 JV Sponsor (1,500,000) 60,000

630,000 70,000

720,000 80,000

810,000 90,000

18,197,242 2,021,916

90.0% of cash flow 10.0% of cash flow

2. JV Sponsor receives a 30.0% promoted interest until the JV Investor receives a 15.0% IRR JV Investor JV Sponsor JV Sponsor 1st Promote- 30.0% -

4,922,157 546,906 2,343,884

63.0% of cash flow 37.0% of cash flow

3. JV Sponsor receives a 40.0% promoted interest until the JV Investor receives a 20.0% IRR and a minimum 2.50x equity multiple JV Investor 6,867,663 JV Sponsor 763,074 JV Sponsor 2nd Promote- 40.0% / 2.50x equity multiple 5,087,158 4. JV Sponsor receives a 50.0% promoted interest on all remaining cash flow JV Investor JV Sponsor JV Sponsor 3rd Promote- 50.0% Total Distributions JV Investor IRR: 20.7% JV Sponsor IRR: 51.0% (1,500,000) 60,000 70,000 80,000 90,000 10,762,938

54.0% of cash flow 46.0% of cash flow

45.0% of cash flow 55.0% of cash flow








JV Waterfall Examples
Preferred Return: In the scenario below, the Sponsors return is subordinated to the LPs (the Sponsor does not receive any cash flow until the investment generates a set return for the LP). After this hurdle is achieved, the Sponsor may be entitled to a catch up payment sufficient to generate the return already received by the LP. Afterwards there may be additional promotes or a set cash flow split
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000

1. JV Investor receives a 12% preferred return 2. Sponsor gets a catch up (receives all cash flow) until a 12% IRR is reached 3. All remaining cash flow is split 50%/50%

1. JV Investor receives all cash flow until a 12.0% IRR JV Investor (13,500,000) JV Sponsor (1,500,000) 2. JV Sponsor receives all cash flow until a 12.0% IRR JV Investor JV Sponsor 3. All remaining cash flow is split 50.0% / 50.0% JV Investor JV Sponsor Total Distributions JV Investor IRR: 20.0% JV Sponsor IRR: 51.1% (1,500,000)

600,000 -

700,000 -

800,000 -

900,000 -

19,792,141 -

100.0% of cash flow 0.0% of cash flow


0.0% of cash flow 100.0% of cash flow

9,157,822 9,157,822

100.0% of cash flow 0.0% of cash flow









JV Waterfall Examples
Cash Flow Split after Return of Capital: In this scenario, once the total invested capital has been returned to the Sponsor and the LP (on a pari passu basis), all of the profits are distributed based on a predetermined split
Cash Flow Waterfall Period Annual Net Cash Flow Year 0 (15,000,000) Year 1 600,000 Year 2 700,000 Year 3 800,000 Year 4 900,000 Year 5 40,750,000

1. Cash flow split pari passu until all invested capital is returned 2. All remaining cash flow is split 65%/35% in favor of the Sponsor

1. All cash flow split pari passu until invested capital is returned JV Investor (13,500,000) 540,000 JV Sponsor (1,500,000) 60,000 2. All remaining cash flow is split 65.0%/35.0% in favor of the JV Sponsor JV Investor JV Sponsor Total Distributions JV Investor IRR: 20.4% JV Sponsor IRR: 52.4% (1,500,000) 60,000

630,000 70,000

720,000 80,000

810,000 90,000

10,800,000 1,200,000

90.0% of cash flow 10.0% of cash flow

18,687,500 10,062,500

65.0% of cash flow 35.0% of cash flow












JV Waterfall Examples
Each scenario produces similar returns
IRRs ranging from 20.03% to 20.74% for the Investor and 51.05% and 52.41% for the Sponsor Equity Multiples ranging from 2.37x and 2.42x for the Investor and 7.38x and 7.87x for the Sponsor Profit ranging from $18.45m to $19.19m for the Investor and $9.56m and $10.30m for the Sponsor

Return Summary JV Promote Structure JV Investor Returns Net Profit Levered IRR Equity Multiple Profit % Split JV Sponsor Returns Net Profit Levered IRR Equity Multiple Profit % Split JV Promote Structure with Preferred Return with Catch Profit Split After Return of min. Equity Multiple up to Sponsor Capital

19,025,824 20.62% 2.41x 66.18%

19,187,062 20.74% 2.42x 66.74%

18,449,963 20.03% 2.37x 64.17%

18,687,500 20.37% 2.38x 65.00%

9,724,176 51.48% 7.48x 33.82%

9,562,938 51.05% 7.38x 33.26%

10,300,037 51.06% 7.87x 35.83%

10,062,500 52.41% 7.71x 35.00%


More on Commingled Funds

Commingled Fund Customary Terms

Minimum investment commitment in these funds is at least $1 million A typical return target for these funds is a 20% IRR and a 2x equity multiple over the life of the investment However in light of the financial crisis, these returns have crept down significantly Fund sponsors hope to raise new funds seamlessly and are generally permitted to raise a new fund after 85% of the funds capital is invested The sponsor also invests its capital in the fund The amount invested by the sponsor can range from 1-3% for first time fund managers, to 25-50% of total equity commitments


Commingled Fund Customary Terms

A return waterfall details how cash is split between the investors and the sponsor These preferred returns range from 8 to 10% If the returns exceed the preferred return than these additional profits are split 80/20
With 80% of the profits going to the investor The 20% of the profits given to the sponsor is called a carried interest or promote


In addition to their promote, fund sponsors also receive an annual management fee

Commingled Fund Customary Terms

Management fees an annual payment made by the investors in the fund to the fund's manager to pay for the private equity firm's investment operations (typically .50% to 2% of the committed capital of the fund) Management Fees are fees paid to the funds manager based on a variety of measures which include:
Total equity commitment Total equity invested to date Gross or Net asset value Percentage of income Or combinations thereof



Carried Interest or Promote

Carried interest - a share of the profits of the fund's investments (typically up to 20%), paid to the private equity funds management company as a performance incentive (also called a promote). The remaining 80% of the profits are paid to the fund's investors Hurdle Rate or preferred return a minimum rate of return (e.g. 8 - 10%) which must be achieved before the fund manager can receive any carried interest payments Fees are calculated based on a set hurdle rate (IRR) and often include claw back provisions if funds hurdle rate is not achieved