One of the main things someone wants to know when investing in commercial real estate is how much of a profit they can earn. You’ll quickly find that developers partnering with third-party equity sources typically secure profits greater than the percentage of equity they invest into their projects. So what gives? It all comes down to how the ‘equity waterfall’ is structured and the extent to which the developer is earning a ‘promote’ vs. taking a more straightforward profit ‘split.’
These considerable profits, often called a promoted interest, grant sponsors (the developer or operator) to secure more considerable earnings than they would ordinarily if based singularly on their tangible ownership or stake in the project. Investors figure in these situations around the performance of the project to incentivize the sponsor. For example, a sponsor may only invest 15% of the required equity, a disproportionate buy-in, but get 45% of the profits if the project does well.
These promoted interests are structured on a term sheet through a so-called “waterfall,” which is mathematical architecture/formula for divvying up distributions to the partnership in private equity or real estate finance. Waterfall tiers boost the incentive or share of the profits to the sponsor as the project meets specific profitability milestones.
Respectively, each tier usually triggers an IRR calculation, an equity multiple, or the greater of each. This space can get complicated swiftly when considering senior positions, catch-up provisions, look-back provisions, etcetera. We will do a cursory overview. We aim to clear up common mistakes around misused industry lingo that refers to these promoted interests as either a “promote” or a “profit split.”
The Profit Split
Let’s begin with a sample of “split” or “profit split.” We have a partnership agreement linking an equity investor and sponsor to develop a 100-unit multifamily community. The investment and waterfall structure is as follows:
Split Example:
90/10 co-invest
10% preferred return
70/30 split to a 12% IRR
60/40 split to an 18% IRR
50/50 split after that
The context on the 3rd bullet above sounds like “seventy, thirty to a twelve,” with 70% of this tier’s profit goes to the investor & 30% belongs to the sponsor. Partners divvy up each level according to the breakdown in the waterfall without regard to how much each party invested into the project. While the joint venture should payout preferred returns based on pro-rata ownership, profit splits are not dolled out that way.
The Promote
This second model of a promote tier structure looks almost identical with a cursory look, but it’s a bonus, a premium that is structured quite differently:
Promote Example:
90/10 co-invest
10% preferred return
30% promote to a 12% IRR
40% promote to an 18% IRR
50% promote after that
The situation on the 3rd bullet here reads like “thirty percent promote to a twelve.” One way to look at this is to see three parties in your mind’s eye when discussing promotes, the investor, the sponsor (both have each invested capital and are shareholders). The last party is the developer, who has advanced nothing but is a highly incentivized party. The caveat is that the developer and the sponsor can be on in the same. It’s easier to see why envisioning three separate parties makes this concept easier to understand. The developer funds the promotion based on co-investment, and the remaining percentage is split between the investor and the sponsor.
Let’s look at the first tier closely. Say that there was $1M for distribution of this tier before crossing the 12% threshold. Thus, 30% would go to the developer ($300k). The balance of $700k is divvied up 90/10, so the investor would get $630k, and the sponsor would get $70k. Since the sponsor and the developer are one-in-the-same, their gross share comes to $370k. If this were viewed as splits instead, the split or division at this level would be $700k to the investor and $300k to the sponsor.
Translation
It is beneficial to convert promotes into splits. Often there were multiple term sheets on a project, some using promotes and some are using splits; if everything is viewed as splits, then the concept is easier to understand. Our promote example above translates to:
Promote Example as Splits:
90/10 co-invest
10% preferred return
63/37 split to a 12% IRR
54/46 split to an 18% IRR
45/55 split after that
As you can see, the formula is very different using promotes instead of splits; now, the sponsor’s concluding tier frees up to 55% of the profit. This would grow significantly if the sponsor raised their co-invest too. For example, raising the co-invest to 20% here would boost the split to 60% since we are expecting a 50% promote.
Why does this Matter?
At this point, you may be believing that this concept sounds simple enough. The intention is that this material is mixed up time and time again by seasoned experts. Pay keen attention to each of these two expressions.
“70% to the Investor and 30% to the Sponsor” “70% to the Joint Venture and 30% to the Sponsor”
What has been substituted is that the word “Investor” is swapped out with the term “Joint Venture.” Sometimes, term sheets are clear on intention, but a quick and cursory review might often point to the wrong conclusion. It’s a complex area, and inadvertently, sometimes folks say “promotes” and mean “splits,” or vice versa. While this is less commonly confused in context, it is misrendered sometimes during deal talk. In essence, “promotes” and profit “splits” are not the same thing!
The exercise here is to be accurate, explicit, and precise with syntax. If you reply “promote,” make sure you mean “promote” and not profit “split” because they are, in fact, very distinct. Also, when examining equity proposals, be conscious that even advanced equity groups are sometimes guilty of maltreating terms. Managing proper real estate terminology, especially in drafting term sheets or negotiating joint venture structures, is crucial to professionalism and successful deal-making.