Real Estate JV Promote Calculations:
Catching Up With Soft Hurdles
Stevens A. Carey
This article supplements two previous articles published in the Spring 2003 and
Summer 2006 issues of The Real Estate Finance Journal entiUed "Real Estate
JV Promote Calculations: Basic Concepts and Issues" and "Real Estate JV
Promote Calculations: Recycling Profits," respectively. Those articles discussed
various issues that arise in a real estate joint venture between a capital partner
and a service partner where the service partner receives a promote in the form of
a greater share of profit distributions if an IRR hurdle is achieved. This article
discusses a special type of IRR hurdle known as a "soft" hurdle.
Consider the following scenario: a local operator
("Operator") has tied up a real estate project at a
below-market price and approaches an investor ("Investor") to form a partnership to acquire, refurbish
and sell the project. (This article refers to "partnerships" for ease of reference but it applies equally to
joint ventures conducted through limited liability
companies.) Operator wants investor to put up all the
money and Operator wants to receive 50 percent of the
profit distributions (in other words, a promote equal to
50 percent of the distributions remaining after investor
recoups its investment). Investor is generally willing to
agree to this arrangement, but it is unwilling to let
Operator keep any profit distributions to the extent Investor needs them to achieve a 20 percent lRR.
The 20 percent IRR requirement is often called a
"soft" hurdle. This article discusses alternative ways
to structure a soft hurdle and identifies certain dangers
and common mistakes one may encounter in the
process.
Stevens A. Carey is a transactional partner with Pircher, Nichols &
Meeks, a real estate law firm w~th offices in los Angeles and Chicago.
He can be reached at scarey@plrcher.com.
8
Hard vs. Soft Hurdles
The difference between a hard hurdle and a soft hurdle
is like the difference between a deductible and a
threshold.
Hard Hurdle
In the scenario described above, if the 20 percent IRR
hurdle were changed to a hard hurdle, it would function like a deductible: Operator would not receive any
promote (which, under the facts of the scenario described above, means it would not receive any profit
distributions) unless and until Investor were to receive
a 20 percent IRR and then Operator would receive only
50 percent of the balance remaining. In effect, the profit
distributions required to achieve a 20 percent IRR
would be deducted from all profit distributions in
detcmlining the portion that is shared by Operator.
Soft Hurdle
As a soft hurdle however, the 20 percent IRR functions
only as a threshold that must be reached as a condition
to Operator's retention of any promote:
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
• if 50 percent of the profit distributions were suf-
.
ficient (when added to the return of Investor's
capital) for Investor to achieve a 20 percent IRR,
then the threshold would be reached and Operator would get 50 percent of all profit distributions
just as it would ifthere were no soft hurdle at all,
and in that sense, the soft hurdle would go away;
and
• if 50 percent of the profit distributions were not
sufficient (when added to the return of Investor's
capital) for Investor to achieve a 20 percent IRR,
then the threshold would not be met and Operator
would not get 50 percent of all profit distributions; instead, the 50 percent share of profit
distributions that would otherwise go to Operator
would go to Investor to the extent necessary to
meet the threshold.
Uncertainty of Soft Hurdle
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 sofi hurdle
is contingent and may not result in any reduction at all.
Tn the scenario described above, we know that 50
percent of the profit distributions will go to Investor.
However, the fate of the other 50 percent of profit
distributions is uncertain: all or some portion could
end up going to Investor and all or some portion could
end up going to Operator depending on the extent to
which Investor's 50 percent of profit distributions were
sufficient to achieve Investor's 20 percent IRR. A
fundamental question is what should be done with this
money in the meantime? Should it go to Investor or to
Operator?
Look-back vs. Catch-up
The "soft" 20 percent IRR hurdle would typically be
structured in one of two ways:
• Look-back for Investor: one approach is to give
Operator 50 percent 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 hasn't achieved a 20 percent
IRR, Operator must turn over to Investor its
promote distributions (in this case, all of Operator's distributions ).1
• Catch-up for Operator: another approach is to
give Investor 100 percent of the profit distributions until Investor achieves a 20 percent TRR,
and then give Operator its share with a so-called
"Catch-up": after Investor achieves a 20 percent
IRR, Operator gets 100 percent2 of all subsequenf profit distributions until profit distributions
are in a 50/50 ratio.
Operator may favor the Look-back because a Catch-up
could defer Operator's receipt and use of funds (especially if Operator believes there will be nothing to give
back under the Look-back). However, the Look-back
is not likely to be favored by Investor for two reasons:
first, if the soft hurdle comes into play, then Investor
must chase Operator for Investor's deficiency (at a time
when the money may be long gone and Operator may
not have the credit to back up its obligation to refund
the money); and
second, even if Investor is successful in getting a
refund from Operator, Investor does not get the use of
the refund money until the Look-back, and consequently Investor's IRR may be reduced. 4
Many investors feel they should get 100 percent of the
first profit distributions necessary to achieve the soft
hurdle, because Investor will always be entitled to
retain this amount whereas if these profit distributions
arc initially split 50/50, Operator may ultimately be
required to turn over to Investor all or a portion of its
share. If someone must get the money first, then given
the issues associated with a potential Operator refund,
Investor may insist that it be first in line.
Risk to Operator with a Look-back
With the Look-back approach, Operator is betting that
Investor's share of profit distributions before the Lookback (in this case, 50 percent) will be sufficient to
achieve Investor's JRR. This wager is not without risk.
In effect, Investor is loaning money to Operator (that
would otherwise go to Investor to achieve its IRR). If
Operator wins its bet, the loan is forgiven. However, if
Operator loses, it may be obligated to repay all (or
some portion) of this loan, together with interest at the
IRR hurdle rate (in this case, 20 percent per annum). In
fact, under certain circumstances, Operator may end
up with less whole dollar profits using a Look-back
than it would with a hard hurdle, as illustrated by the
following example: EXAMPLE. Assume the following
facts: (i) Investor contributes $100 million as of the
beginning of Year 1, (ii) there are no other contributions, (iii) there is a refinancing distribution of $120
million as ofthe beginning of Year 2, and a final distribution of $2 million at the beginning of Year 3, and
(iv) there are no other distributions.
Compare the results (I) using a Look-back, (2) changing thc soft hurdle to a hard hurdle, and (3) using a
Catch-up:
(1) Look-back. With a Look-back, the first $100 million of the refinancing distribution would be used to
repay Investor's capital contribution. The remaining $20 million of the refinancing distribution and
final $2 million would be split equally (before the
Look-back). Consequently, Investor's share of the
refinancing distribution would be $110 million. Immediately before the refinancing distribution, Inves~
tor's $100 million investment would have grown
(for IRR purposes) to $120 million (based on a 20
percent annual return, assuming annual compounding) and therefore immediately after the refinancing
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
9
Real Estate JV Promote Calculations: Catching Up With Soft Hurdles
distribution, Investor would be $10 million shy of
achieving a 20 percent IRR. One year later, immediately before the final $2 million distribution,
this $10 million deficiency would have grown to
$12 million; and immediately after the final distribution to Investor of $1 million, Investor would be
$11 million shy of a 20 percent IRK Thus, the
Look-back would work as follows:
(2) liard Hurdle. With a hard hurdle, the entire $120
million refinancing distribution would be used to
achieve Investor's 20 percent IRR. The final distribution would be split equally:
(3) Catch-up. With a Catch-up, the entire $120 million refinancing distribution would be used to
achieve Investor's 20 percent IRR. The final $2 mil-
lion distribution would be paid entirely to Operator
under the Catch-up:
To summarize: with a Catch-up, Operator ends up with
$2 million of "whole dollar profits" (i.e., the amount
by which its distributions exceed its contributions);
with a hard hurdle, Operator ends up with $1 million
of whole dollar profits; and with a Look-back, Operator ends up with no whole dollar profits at all! Under
the Look-back approach, Operator takes $10 million
out of the refinancing distribution that might otherwise
have gone to Investor to achieve its 20 percent IRR.
This leaves Investor with a $10 million deficiency in
its 20 percent IRR. This deficiency grows to $12 million at the time of the final distribution and the $2 million retum component ends up wiping out the $2 million whole dollar profits Operator would have received
under the Catch-up approach. It is as though Operator
borrowed the $10 million from Operator at a 20 percent
interest rate.
Admittedly, with the Look-back, Operator would get
the use of the funds that it must ultimately return and
this is not reflected in the above charts. Uut Operator
would need to earn 10 percent per annum (on the
$10,000,000 portion of the Look-back payment that it
held for one year) to get the same total dollars it gets
with the hard hurdle, and 20 percent per annum to get
the same total dollars it gets under the Catch-up.
To make the results more dramatic, we eould assume
that the final distribution were made after Investor's
IRR deficiency had more time to grow. For example,
assume that the final distribution were made at a time
when Investor's 20 percent IRR deficiency (which was
$10 million immediately after the refinancing distribution) had grown to $20 million (which would occur in
less than four years after the refinancing, assuming a
20 percent annual rate, compounded annually), and that
10
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
the amount of the final distribution were $10 million.
Under these modified facts, Operator would still end
up with no whole dollar profits using a Look-back, but
would end up with $10 million ofwholc dollar profits
using a Catch-up, and $5 million of whole dollar profits
using a hard hurdle.
Operator may prefer a Catch-up to either a Look-back
or an escrow because it wants Investor to hit its IRR
hurdle as fast as possible and maximizc Operator's
share of whole dollar profits. For the balance of this
article, it is assumed that the Catch-up approach has
been adopted.
What about an Escrow?
Must the distributions in question (i.e., 50 percent of
the first profit distributions that are necessary to achieve
the 20 percent IRR, which would be distributed to
Operator under the Look-back approach, but would be
distributed to Investor under the Catch-up approach)
go to Investor or Operator? One might ask whether it
makes sense to deposit these distributions in cscrow
until their ultimate disposition is certain (i.e., when the
20 percent IRR is achieved without these distributions
or at the end of the deal). Howcver, if the money were
going to an cscrow, then it would not be a distribution
to Investor that would be applied towards the 20
percent IRR, and Operator would get the worst of both
worlds: as with a Catch-up, Operator's reccipt of funds
would be deferred, and as with a Look-back, Investor's
IRR deficiency would be allowed to grow larger and
reduce Operator's share of whole dollar profits.
In each of the alternative distribution waterfalls below,
Investor receives a first level distribution to recoup its
capital,6 Investor also receives its 20 percent IRR
befi)re Operator receives any distributions and there is
some form of Catch-up which, if there are sufficient
distributions, is (was) intended to result in a 50/50 split
of profit distributions.
The Catch-up
How docs the Catch-up work? This article next considers a number of distribution waterfalls with Catch-ups
actually encountcred by the author with facts modified
to fit the following example. 5 EXAMPLE. Assume the
following facts: (i) Investor contributes $100 million
as of the beginning of Year I, (ii) there are no other
contributions, (iii) there is a distribution of $200 million as of the beginning of Year 2, and (iv) there are no
other distributions.
With a soft 20 percent IRR hurdle, the intended result
would be that $100 million would go to Investor to
recoup its contributions and the remaining $100 million would be split equally because Investor would
achieve its 20 percent JRR without the soft hurdle:
A Dangerous Waterfall (that Never Catches
Up)
In one partnership agreement, the drafter provided for
a first level of distributions to Investor to recoup capital
followed by a second level to Investor to achieve a 20
percent IRR. The drafter created a third level of
distributions to Operator intended to recoup the second
level distributions that were diverted from Operator
due to the soft hurdle (i.e., 50 percent of the second
level distributions). The distribution waterfall looked
something like this:
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
11
Real Estate JV Promote Calculations: Catching Up With Soft Hurdles
,'.
:~
Distribution Waterfall No. 1 (Defective)
(Catch-up level equal to 50 percent o/Investor's pre/erefltialpr(ifii(li$trib~tions):
irst L~vcl (Investor's Preferential Ca ital Distributions): 100 percent to Investor pntH Investor has recouped al
f its capital;
..
" •..•...•..... , •
Second Level Jnvestor's Preferential Profit Distributions : 100 percent to'InVe~tor;,pntillnvestor has received
nvestor's then "20 percent]RR Deficiency" (i.e., the amount then necessary.;fOr1nvestdr.to achieve a 2
.
. ......• '. .'
ercent IRR)"
hirdLevel 'Operator's Catchwu }: 100 percent to Operator until it hasreceived'S()·percent of the distribution,
nderthe second level above; and
.
.ourlh Level: 50 percent to Investor and 50 percent to Operator.
Under this provision, the distribution splits would be
as follows:
Somchow Operator got shorted out of $5 million. How
did this happen? Investor effectively received $JO million of what would otherwise (absent the soft hurdle)
have been Operator's distributions in the second level.
To put the parties back in balance, Operator should
have received $10 million back from Investur (by getting the next $10 million of Investor's distributions).
Instead, it got $10 million back from the partnership
(by getting the next $10 million of distributiuns); but
50 percent of these distributions would have gone to
Operator anyway so (under the provisions above)
Operator picked up only an extra $5 million (i.e., 50
percent of$10 million). That is why the $10 million
distribution Icft Operator $5 million short.
Confusing the Source of Payment
The error made in Distribution Waterfall No.
IS
a
surprisingly common mistake in distribution calculations, namely, confusing the partnership and a partner
as the appropriate source of payment. Specifically,
when one partner is entitled to a payment from the
other partner, whether as a Catch-up or otherwise, a
distribution level in the amount of the payment may
not work, because it makes the partnership the source
of the payment: it may reduce the distributions that the
recipient partner would othcrwise receive and thereby
effectively have such partner pay itself for a portion of
the payment.
Investor as the Source of Payment
A correct way to draft the distribution splits in Distribution Waterfall No. I would be to have the same
Catch-up amount paid solely out ofInvestor's distributions as follows:
Distribution Waterfall No. 2
(Catch-up paid out o(Jnvestor distrihutions equal to 50 percentolInvestor's preferential profit distributions):
First Level (Investor's Preferential Capita] Distributions): 100 percent to Investor uutil Investor has recouped al
of its c a p I t a l ; ,
Second Level (Investor's Prcferential Profit Distributions): 100 percent to Investor in an amount equal to the then
20 perccnt IRR defiCIency; and
fhird Level: 50 percent to Operator and 50 percent to Investor; provided, however, that all distributions under this
hird level that would otherwise be paid to Investor shall be paid instead to Operat()r until Operator has received
from the distributions that would otherwise have been made to Investor under this third level an amount equal to
50 percent of the total distributions under the second level.
.
12
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
Under this provision, the distributions would be allocated as follows (where the Catch-up, which is the
proviso in the third level, is indicated below on a separate line):
Partnership as Source of Payment
to Investor, but also the corresponding $ J 0 million of
distributions that would have gone to Operator
anyway). In other words, this alternative solution
increases the Catch-up level so that it covers not only
50 percent of the distributions under the second level
but also 50 percent of the Catch-up distributions
themselves (i.e., 50 percent of the total distributions
under the second and third levels). In this way, the goal
of the Catch-up level is clearly achieved, namely, to
increase Operator's share of all profit distributions (i.e.,
all distributions above $100 million) to 50 percent.
To repeat, Distribution Waterfall No. I had a $10 million Catch-up payment by the partnership, which
resulted in a $5 million net gain to Operator (because
Operator effectively bore 50 percent of the payment).
Distribution Waterfall No.2 fixed this problem by
changing the source ofthe payment. This problem can
also be fixed, without changing the source of payment,
by increasing the Catch-up level (under the facts in our
example) to $20 million (so that it covers not only $10
million of distributions that would otherwise have gone
Distribution WaterfalJ No.3
(Catch-up level equal to 50 percent of all profit distribution until caught up):
First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped all
of its capital;
Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20
percent IRR deficiency;
Third Level (Operator's Catch-up): 100 percent to Operator until the total distributions it has received under this
hird level equal 50 percent of the total distributions under the second level above and this third level; and
Fourth Level: 50 percent to Investor and 50 percent to Operator.
Under this provision, the distributions would be allocated as follows:
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
13
· ..
,~,,-
Real Estate JV Promote Calculations: Catching Up With Soft Hurdles
<\
Distribution Waterfall No.3 can be simplified or
complicated (depending on your perspective) by using
some simple algebra to identify the amount of the
Catch-up as a percentage of the second level
distributions. If we let x equal the Catch-up amount,
and let S equal the total amount of the distributions
under the second level, then (using the formulation in
Distribution Waterfall No.3):
x = 50 percent (x + S)
One can easily solve this equation to sec that x equals
S, so that the third Catch-up level to Operator should
equal the second level to Investor. The numbers in our
example are simple enough that it is obvious without
any calculation that the second level and the third level
should be equal,7
Distribution Waterfall No.4
(Catch-up level equal to the appropriate percentage 4 investor's preferential profit distributions):
First Level(lnvestor's Preferential Capital Djstribution~: 100 percent to Investor until Investor has recouped all
of its capital;
Second Level(lnvestor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20
percent IRR deficiency;
Third Level (Operator's Catch-up): 100 percent to Operator until the total distributions it has received under this
hird level equal 100 percentS of the total distributions under the second lcvel above; and
r.'ourth Level: 50 percent to Investor and 50 percent to Operator.
..
Under this prOVISIOn, the dlstnbutlOns would be allocated as follows:
The problem with this approach is that when the
numbers are more complicated, it may be difficult to
see how the percentage (of second level distributions)
was derived. Distribution Waterfall No.3 may be
preferable for this reason.
Getting Lost in the Words
Some .IV documents do not specify distribution levels
to establish the soIl hurdle, and instead simply use the
proviso approach as follows:
Distrjbution Waterfall No.5 (Ambiguous"!)
(Catch-up level equal to amount Operator failed to receive due to soft hurdle):
!First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped al
pf its capital; and
.
Second Level: 50 percent to Operator and 50 percent to Investor.
!Notwithstanding the foregoing, in no event shall Operator be entitled to any distributions until Investor has
eccived Investor's then 20 percent IRR Deficiency, and when there is no 20 percent lRR Deficiency, all distribuions will be made to Operator. until it has received the amount by which (A) the aggregate amount which would
Ihave been distributed to Operator but for the operation of this sentence, is greater than (B) the aggregate distribuions received by Operator.
14
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
This provision could have been written with distribution levels (without a proviso) as follows:
First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped
all of its capital;
Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20
percent lRR deficiency;
Third Level (Operator's Catch-up): 100 percent to
Operator until it has received the amount by which (A)
the aggregate amount which would have been distributed
to Operator (under the Fourth Level below) but for the
operation of the second level above and this third level, is
greater than (B) the aggregate distributions received by
Operator; and
Fourth Level: 50 percent to Investor and 50 percent to
OperatoL
The problem with Distribution Waterfall No, 5 is that
it is not clear, It is not dissimilar to having a Catch-up
in the amount necessary to put Operator in the same
position it would have been in without a soft hurdle. In
theory, this is fine, but the provision doesn't tell you
how to do it.
Gregg Hanks, a very careful and thoughtful attorney in
Arizona, once encountered this provision, and was
concerned with a potential ambiguity in determining
(in clause (A» what "would have been distributed to
Operator." Distributed from what? If the quoted
language were read to refer to what "would have been
distributed to Operator" from all the profit distributions prior to the Catch-up9 (i.e., the 2nd level distributions in the restated provision above or equivalently
the first $20 million of profit distributions in our
,
example), then the language would be the equivalent
of Distribution Waterfall No.1: Operator would receive a Catch-up equal to $10 million of profit
distributions. But Investor would have already received
$20 million of profit distributions. Thus, although
Operator would receive what it would have received
from the first $20 million of profit distributions, Investor would have received more. Gregg wanted to make
sure both Investor and Operator received the profit
distributions they would have received in the absence
of the soft hurdle (namely, equal amounts alter Investor recoups its capital).
While the accountants arc likely to do a better job than
the lawyers in reaching the correct result, it is generally preferable to avoid any doubt as to the ultimate
outcome. Faced with this issue, Gregg might have
substituted Distribution Waterfall No.2, 3 or 4, but he
was also faced with the common elient mandate of
working with (and doing as little damage as possible
to) the language before him. He therefore did what is
generally advisable in such situations: eliminate perceived ambiguities and do an example.
To assure the correct result, Gregg wanted the amount
that "would have been distributed to Operator" to be
based on grossed-up profit distributions that would
yield what Investor actually received (when received)
and an equal amount of profit distributions for Operator, as indicated in the next Distribution Waterfall.
Thus, Distribution Waterfall No.5 may be fixed by
revising the Catch-up so that it gives Operator what it
would have received from hypothetical distributions
(without the soft hurdle) that would have given Investor what it actually received, when received:
,
Distribution Waterfall No.6
(Catch-up level equal to amount Operator would have receivedfrom profit distributions, without soft hurdle, tha
would have generated the aC,ttlal amolmts received by Investor when received):
First Level (Investor's Preferential Capital Distributions); 100 percent to Investor until Investor has recouped al
pf its capital; and
"
Second Level: 50 percent to Operator and so percent to Investor.
!Notwithstanding the foregoing, inno evel1t shall Operator be entitled to any distributions until Investor has
eceived the then 20 percent JRR Defici¢J1cy;un4wheIlJhere is t10 20, percent IRR Deficiency, all distributions will
be made to Operator until it has received the ,ariIotintby which (A) the aggregatcamount which would have been
distributed to Operator if (x) this sentence did not existand(y) the, amounts distributed resulted in lnvestor receiv
.ng the same amounts that Investor did in: fact receive (when received), is greater than (B) the aggregate distribuions previously received by Operator. "
Under Distribution Waterfall No.6, the first $120 million would be distributed 100 percent to Investor to
satisfy the soft 20 percent IRR hurdle. How should the
Catch-up distribution be calculated? In order for Investor to have received $120 million without the soft
20 percent IRR hurdle, there would have been distributed an aggregate amount equal to $140 million (so
that Investor would have received the first $100 mil-
lion and 50 percent of the next $40 million, which
would add up to the $120 million total actually received
by Investor). The Catch-up would therefore be the $20
million Operator would have received from this hypothetical $140 million distribution.
Thus, the distributions would be allocated as follows:
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
15
Real Estate JV Promote Calculations: Catching Up With Soft Hurdles
This or course is the correct result, because we have
grossed up the distributions (in clause (A) above) to
make sure the amount Operator receives is consistent
with the ultimate 50/50 split we are trying to achieve.
However, the wording may be confusing and one of
Distribution Waterfall No.2, 3 or 4 may be easier to
understand.
Distribution Waterfall No.5 could also be fixed by using the Catch-up amount interpretation Gregg wanted
to avoid, but making Investor the source of payment,
as was done in Distribution Waterfall No.2:
Distribution Waterfall No.7
(Catch-up fiwn Investor equal to amount Operator would have received from second level distributions, withou
soft hurdle):
!r,-irst Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped al
101' its capital; and
Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor in an amount equal to the ther
120 percent IRR deficiency; and
trhird Level: 50 percent to Operator and 50 percent to Investor.
Notwithstanding the foregoing, all distributions that would otherwise be made to Investor under the third level
\Shall be made instead to Operator until Operator has received from the distributions that would otherwise have
Ibeen made to Investor under the third level an amount equal to the distributions Operator would have received, i
here had been no second level above, from the amounts actually distributed under the second level above.
Distribution Waterfall No.7 may still be confusing and
one of Distribution Waterfall Nos. 2, 3 and 4 would be
preferable. If forced to use a Distribution Waterfall
such as No.6 or 7, an example is highly recommended.
Summary of Catch-up Alternatives
1n sum, the amount of the Catch-up should take into
account the source of payment and the language should
be clear for future readers of the partnership agreement; if confusing language cannot be avoided, there
should be an example. Distribution Waterfall No. I
contains a faulty Catch-up: it uses the partnership as a
source of payment for a Catch-up amount that would
be correct only if the source of payment were Investor.
16
This problem is solved in each of Distribution Waterfall Nos, 2, 3 and 4. Distribution Waterfall No.5
contains potentially ambiguous language which, without an example, might lead to the wrong result. Distribution Waterfall Nos. 6 and 7 are an improvement over
Distribution Waterfall No.5, but still may need an
example to avoid confusion. The author's preference is
Distribution Waterfall No.3 because it explains the
methodology without obscuring the intent of the
parties.
For the scenario described in this article,W some of the
possible Catch-up formulations can be outlined as follows:
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
Conclusion
Generalized Assumptions
Soft hurdles and Catch-ups frequently find their way
into real estate joint venture documentation. Whi Ie
they involve simple concepts, they are sometimes
complicated and obfuscated in their wording and
application. With a little patience and thought, they
can and should bc crafted in a manner that is easy to
understand and implement.
Assume the following facts: (1) there is a partnership
between two partners, an investor ("Investor") and an
operator (' 'Operator' '), which contribute all the capital
("C") to the partnership in accordance with their
partnership percentages, (2) distributions are to be
made first to the partners "pro rata" (i.e., in accordance with their partnership percentages) unti I they get
all their capital recoup, and Operator is entitled to a
promote equal to "p" (this is a percentage) of all profit
distributions (with the balance of the profit distributions distributed pro rata), subject to a single promote
hurdle (after all capital is retumed) which is soft, and
(3) (unless otherwise indicated) there arc sufficient
distributions to complete the Catch-up.
APPENDIX
Generalized Scenario for a Single Promote
Hurdle
This Appendix considers a generalized scenario assuming a single promote hurdle (after all capital is
recouped) that is soft, and in this generalized contcxt:
• describes alternative Catch-up fommlations; and
• compares Investor's IRR and whole dollar returns
under the Catch-up approach and Look-back
approach.
Generalized Distribution Waterfall
If a Catch-up approach is used, the distributions
described above could be written as follows (using provisions similar to Distribution Waterfall No.3):
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
17
Real Estate JV Promote Calculations: Catching Up With Soft Hurdles
'''~~n~nilizedOistrib..tion Waterfall Usingeateh~~p
,
, irst LeveE
the pa~ersprorat\untilall ,capital is recouped;
econclLeycl:. To the partners pro
until they receive the soft hurdle; . ."
"'·i
. . . . . . ..
hird Level.: tOO. perc"ent t6((? OP<::t;atot as promote until the to~af.distribut~ons "it has.reyeivedunder this thir
eveP equal pof the total disttibutionsurider.the second level above arid this thirdlevel~ aiid
ourth.Level: .(l~p ) to the partners pro bta imd p to Operator asptoffiote: . . . '
. .
To
rata
As was done in Distribution Waterfall No.4, we can
reword the Catch-up amount in the third level above as
a percentage of the second level distributions. Ifwe let
x equal the Catch-up amount, and let S equal the total
amount of the distributions under the second level, then
Comparison of Catch-up and Look-back
""I~~~;
To help illustrate the differences between the Catch-up
approach and the Look-back approach, the following
x = p(S + x). Solving for x, we see that x = (p/[l - p))
S.
In sum, some of the possible Catch-up fonnulations
under the more generalized facts above can be outlined
as follows:
chart shows how each level under the Catch-up approach would be distributed under the Look-back approach:
" ~'
'''~,
..'
·'f'}~
:~~~:~\'
¥~;
'~~~~
~i1(
18
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
p
s.
B
L
=
-.
~
-
~: This·
the case. ... .
The Transposition under the Catch-up Approach
to each Member as though there had been no soft
hurdle.
The heavily shaded distributions in the above chart arc
equal in amount-·· but one goes to Operator as a
promote (second level shaded portion) and one goes to
the partners in accordance with partnership percentages (third level shadcd portion). Thc soft hurdle, when
using the Catch-up approach, simply reverses the order
(i.e., transposes the recipients in the second and third
level shaded portions): Operator's promote share of
the second level (i.e., the heavily shaded portion) is
diverted to the partners (in accordance with partnership perccntages) to pay the soft hurdle and then the
non-promote share of the third level (the heavily
shaded portion) is diverted to Operator (to effectuate
the Catch-up). It is a perfect match and therefore, as
long as the distributions are adequate, reversing the
heavi Iy shaded distributions accomplishes the same
total distrihutions (ignoring the time value of money)
IRR and Whole Dollar Comparisons
Thus, assuming that distributions are sufficient to
complete the third level, the same amount will be
distributed to Investor under each approach through
the first 4 levels and the only differences between the
two approaches will be timing (as to the second and
third levels) and the Look-back payment. (For simplicity we refer only to Investor for the balance of this Appendix, but the statements made apply to all capital on
a pro rata basis.) Moreover, based on the generalized
assumptions in this Appendix, and assuming there are
no contributions after distributions, it follows that the
IRR and whole dollar returns of Investor satisfy thc
following relationships (where "CU" means Catchup, "LH" means Look-back and "WDR" means
whole dollar return):
To see this, note the following:
Prior to the Look-back Payment. The side-by-side
chart above shows that the distribution amounts under
each approach will be equal if there is enough to distribute, but Investor gets its money at the same time or
sooner under the Catch-up approach. Therefore, before
any Look-back payment, Investor's whole dollar return
(i.e., the whole dollar amount of the distributions
ignoring the time value of money) and IRR under the
Catch-up approach cannot be less than what they are
under the Look-back approach. 19 Does the Look-back
payment change these relationships?
After the Look-back Payment - IRK Assuming no
contributions are made alter distributions, t.he IRR n:lationship should not change because the Look-back
payment can't make the Look-back I RR any greater
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
19
Real Estate JV Promote Calculations: Catching Up With Soft Hurdles
than the target IRR (assuming it is worded to cover no
more than the deficiency in the target IRR):
• If the Catch-up IRR were not achieved, then all
distributions would ultimately be pro rata under
both approaches, but the pro rata distributions
would he received at the same time or sooner
under the Catch-up approach (so for Investor, CU
IRR ~ LB IRR); and
• If the Catch-up IRR were achicved, then the
Look-back payment would at most result in the
same IRR (so for Investor, CU IRR ~ LB IRR).
Remember that we are assuming that no contributions
are madc after distributions. The results may be different otherwise: it is possible that Investor ends up with
a deficiency under the Catch-up approach (if there is
no clawback) and achieves or gets closer to its target
IRR under the Look-back approach. For example, using the facts in the scenario described at the beginning
of this article (i.e., a partnership between Investor and
Operator where Investor puts up all the capital and
distributions are made 100 percent to Investor until Investor recoups its capital and then profit distributions
are split SO/50 subject to a 20 percent per annum soft
hurdle preference to Investor), further assume a $100
contribution at the beginning of Year I followed by a
$140 distribution at the beginning of Year 2 and a $20
contribution at the beginning of Year 3 just at the time
of dissolution before the Look-back:
Under this example, there is a $20 IRR deficiency at
the end of the dcal (before the Look-back payment).
This IRR deficiency would be recoupcd under the
Look-back approach to achieve the target 20 percent
IRR hut Investor would be left with the deficiency
under the Catch-up approach (assuming thcre is no
clawback).20
After the Look-back Payment - WDR. What about the
whole dollar returns? Before the Look-back payment,
the distributions under the Look-back approach are less
than or equal to the distributions to Investor under the
Catch-up approach. After thc Look-back paymcnt, this
relationship is reversed, with the Look-back distributions to Invcstor (including the Look-back payment)
being greater than or cqual to the distributions to Investor under the Catch-up approach:
levcls and under thc final Look-back payment
level would be at least as much as the amount of
pro rata distributions under the first three levels
of the Catch-up approach, because the lattcr
amount was necessary to achieve the target IRR
under the Catch-up approach and would be received at the same time or later under the Lookback approach (so for Investor, Cll WDR ::::; LB
WDR).
• If the required Look-back payment were positive
and after the Look-back payment, the target IRR
were not achieved, then all profit distributions
would go pro rata under the Look-back approach
(i.e., all promote distributions are refunded) and
obviously, this amount can't be less than the pro
rata profit distributions under the Catch-up approach because it is the maximum possible
amount (so for Investor, CU WDR ::::; LB WDR).
As shown in the body ofthis article (under the heading
"Risk to Operator with a Look-Back"), it is possible
for Investor to get significantly more distributions
(ignoring the time value of money) under a Look-back
approach than under a Catch-up approach. Such a
result assumes, of course, that Investor is able to collect the Look-back payment. In the author's experience, most investors would prefer not to take that collection risk and instead receive their money sooncr and
boost their IRR. And this is generally fine with many,
• If the required Look-back payment were zero
(whiCh means the target IRR were achieved
without a Look-back payment or there were no
profit distributions), then it is obvious from the
side-by-side chart above that the pro rata distributions under either approach would be equal (so
for Investor, CU WDR ::::; LB WDR).
• If the required Look-back payment were positive
and after the Look-back paymcnt, the target IRR
were achieved, then the total pro rata distributions received under the first three Look-back
20
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
if not most, operators by reason of the same analysis:
as long as there are no contributions after distributions,
Operator may get its money sooner with a Look-back,
but it will never get less and may get more with a
Catch-up.
I Other fonnulations of the Look-back arc possible, but
this is a common fonnulation encountered by the author. All
references to the Look-back in this article assume this
formulation.
2 Some investors require a percentage (greater than
Operator's normal promote share, which promote share is 50
percent under the scenario described in this article) that is
less than 100 percent. For simplicity (and given the assumptions in this article), it is assumed that thc Catch-up percentage is 100 percent.
3 All "subsequent" profit distributions may be
misleading. The Catch-up normally applies only when the
hurdle is satisfied. Thus, if there were a subsequent contribution by Investor, there might be a new hurdle deficiency and
the Catch-up would stop until the new hurdle deficiency were
satisfied.
4 This problem could be solved by imposing an interest
factor, but most operators would ratber use a Catcb-up approach than have an obligation to repay all of their promote
distributions plus interest (especially at 20 percent per
annum). Also, although Investor's IRR may be enhanced by
the Catch-up approach, its share of whole dollar prolits may
be reduced becausc it is not kecping its money working as
long at a 20 percent rate, as illustrated in the next section.
See Appendix for general discussion oftbe relative IRR and
whole dollar returns under the two approaches.
Ii This example is given in the context of thc scenario
described at the outset (in the first paragraph) of this article.
6 The recoupment of capital is a hard hurdle. The return
component of the 20 percent IRR requirement (i.e., the
amount of profit distributions necessary to achieve a 20
pcrccnt IRR) is in effect the actual soft hurdle.
7 Howcver, thc numbers will not always be so obvious.
For example, if Operator's promote were 20 percent instead
of 50 percent, then, Operator would be entitled to 20 percent
of the total distributions under the Second and Third Levels
so that x equals 20 percent (x + S), in which event x equals
(20 percent/SO percent) S, which equals 25 percent S. See
Appendix for a more general formulation.
S This percentage will vary depending on the deal. For
example, under the facts presented in endnote 7 above, the
appropriate percentage would be the percentage equivalent
of20/80, which is 25 percent.
D Another interpretation, which would lead to the correct
result, is that the quotcd language refers to what' 'would have
been distributed to Operator" from all profit distributions
until the Catch-up is completed.
10 See Appendix for more generalized scenario.
n This is similar to a word version of the Catch-up
formula in Distribution Waterfall No.2.
IZ This is similar to a word version of the Catch-up
formula in Distribution Waterfall No.3.
13 See Distribution Waterfall No.2.
See Distribution Waterfall No.3.
See Distribution Waterfall No.4.
16 See Endnote 2 above.
17 In the body of this article, Investor contributes 100
perccnt of the capital, so that all distributions to Operator are
promote distributions. In this Appendix, Operator contributes
a pro rata share of the capital, and is cntitled to both (I) a pro
rata share of the distributions (along side of Investor) on account of its capital contributions and (2) promote
distributions. Basically, all the capital is treated alike, but
Operator has two roles, as (I) an investor, and (2) a promoter,
and it is important to distinguish the two. In any case, the
soft hurdle relates only to thc promote and therefore the
amount received as the Catch-up includes only promote
distributions. This can be a source of confusion when the
Catch-up level is not 100 percent (see endnote 2) and Operator is receiving pro-rata (non-promote) distributions at the
samc timc it is receiving the Catch-up.
IS If Investor contributes 100 percent of the capital, the
source in this column is Investor's distributions aftcr it has
achieved thc soft hurdle. If Investor and Operator both contribute capital, then thc source in this column is Investor's
and Operator's prorata (non-promote) distributions after they
have achieved the soft hurdle.
19 It may seem intuitively obvious that if the same amount
of distributions is received sooner, then the IRR will increase.
But with positive and negative cash flows (where distributions arc positive cash flows and contributions are negative
cash flows), it is possible not only to have multiple IRRs, but
also in some cases, to reduce one of the IRRs (in some cases,
the lowest, and in some cases, the highest) by accelerating
distributions. To avoid these complications, this Appendix
assumes that contributions do not occur after distributions
(so there is no more than one change of sign among the cash
/lows). With this assumption, it is not difficult to show that
an acceleration of distributions increases the IRR, but the
proof is beyond the scope of this article. For more on multiple
IRRs, sec Carey, "Real Estate IV Promote Calculations:
Recycling Profits," Real Estate Finance Journal (Summer
2006) at Appendix.
20 The Look-back described in this article is a fonn of
clawback, but it may not elfectuate a complete adjustment.
See Example I in Carey, supra, for which such a clawback
would have no elrect.
14
15
THE REAL ESTATE FINANCE JOURNAL/SPRING 2008
21
Copyright © 2008 Thomson/West. Originally appeared in the Spring 2008 issue of Real Estate Finance
Journal. For more information on the publication, please visit http://west.thomson.com. Reprinted with
permission.