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Private Equity Capital for Commercial Real Estate: Understanding and Navigating the Options
Primer on Private Equity
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Objectives
• 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
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Real Estate Private Equity Investors
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Real Estate Private Equity Investor Universe
• 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
Traditional Sources Institutional Sources
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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
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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%
• 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%
• 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, 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%
Core Core - Plus
Value-AddedOpportunistic
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Investment StructureSingle 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:
Acquire a specific property, a portfolio of properties,
Make entity Level Investment
Recapitalize an existing partnership
Develop or redevelop a property
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
Creates alignment of interest; typically aids in raising additional JV capital
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
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A Closer Look at Joint Ventures
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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)
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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
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Structuring Joint Ventures• Example:
– 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
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Entity / GP Investments
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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
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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
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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
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Commingled Funds: Investment Structure
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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
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Real Estate Commingled Fund: How It Works
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Three Types of Fund G.P.s
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
Investment Banks
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
Investment Houses Dedicated Real Estate Players
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• Most private equity is invested via partnership of a limited duration
Follow-on fund Marketing
Commitments by investors in multiple ‘closings’
Cash Flows from investors
Cash Flows to investors
1 Year10 Years 3 Years
Marketing Divestments Extension Draw down/Investments
Fund Timeline
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Investment Strategy
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• 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.• Closed-ended Funds
– Raise a fixed amount of capital – Have a specified duration– Exits from the fund are limited– Exit prices can be predetermined
Open Ended v. Closed-Ended Funds
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Fundraising Statistics
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Fund Size
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Accessing Private Equity CapitalConsiderations, Process and Timeline
Accessing Private Equity CapitalConsiderations, Process and Timeline
ULI – January 11th, 2011
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Joint Venture Indicative Process
Investor Timeline
Outline Objectives
Outline objectives Identify major
transaction issues Due diligence and
underwriting Develop returns
analysis Explore
structural / financing alternatives
Formulate key investment terms
Prepare Marketing Materials
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
Pre-Marketing
Contact / screen potential investors
Complete and distribute Teaser
Incorporate feedback and refine marketing materials / presentation (and potentially term sheet) as necessary
Evaluate cultural “fit”
Formal Marketing Effort
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
Investor Due Diligence
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)
Final Proposals / Negotiations
Finalize due diligence
Negotiate proposals
Negotiate and sign Definitive Agreement
Closing / funds transfer
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Diligence Request ListCompany and Management Information
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
Market Analysis
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-Level Information
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 Copies of appraisals, environmental and engineering studies completed within last 2 years Land surveys and site plans for all properties Copies of title reports
Financing Information
Debt schedule, including amount, rate, terms, etc. Supporting debt documentation
Other Documents
Copy of standard tenant lease Significant tax information that may adversely impact the company or third parties Disclosure of any prior or pending litigation related to business dealings generally and portfolio specifically
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Explore Structural Alternatives
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, ROFO’s,
ROFR’s, 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
GP - WHOLE CO. PREPARATIONS 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
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3rd Party Management
Merchant Development Model - Illustrative
Sale of Property
Construction period: 22 Months
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
Management Fee: $9,000 (in 2011)
Lease-Up Period
Construction Period
Distribute Fees (as a % of Total Project Cost)A = 3.00% B = 3.65%
Stabilized Management Fee3% of Gross Effective Rent
Return of Equity
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Stabilization Period
0 22
12 23
24 35
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1
Equity Investment
Equity Investment
(Timeline in Months)
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Crafting the Investment Thesis Business Strategy
Define investment focus (asset type) Acquisition v. development Determine investment strategy (core, core-plus, etc.) Narrow the focus of the transaction, as needed Consider industry trends & fundamentals
Portfolio / Pipeline Quality Footprint (major MSAs?) Mix of (re) development / stabilized assets Size and age of portfolio
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
Management Team Experience Quality sponsor Depth of bench Ability to navigate current market environment Strong relationships
Well Established Scalable Platform Vertically integrated Platform to support larger scale business
Intensive Asset Management “Right-sized” organization Cost controls Revenue enhancement
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Investment Highlights
Positioning
Simplified management
structure
Simplified management
structure
Proven investment track record
Proven investment track record
Strong industry fundamentals
Strong industry fundamentals
Significant internal growth driven
through intensive asset management
Significant internal growth driven
through intensive asset management
Premium quality asset portfolio
Premium quality asset portfolio
Experienced management team
Experienced management team
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Two Scenarios – Diligence & Underwriting
- Small Developer – MF merchant builder run
by family for 75 years
- Large Owner – MF developer, owner,
operator
Comments
Size Team / Employees
20 people 200 people Market concerned about depth of bench and possible conflicts
Assets 5 stabilized multifamily
developments Own 100 assets
(½ multifamily, ½ office) Small size limits ability to contribute asset. Positive cash
flowing
Pipeline 3 “shovel ready” $500mm MF dev / acq, $500mm office dev / acq.
Can development pipeline be completed with existing financing? Guarantees? Are targets available at sensible pricing?
Motivation Financial Stress
Limited construction financing Recap existing Not all assets have same financial stress. Refinancing? CMBS / crossed?
Control 3 generations Discretion within a box Family unlikely to cede control
Tax 1031. Recycle capital (not REIT
eligible) Need simplified structure.
Low basis assets Different tax issues for each investor (individuals vs.
institutions)
Growth Need capital for construction
or continue to layoff Immediate acquisition
pipeline in current markets Willing to split business lines?
Markets Footprint Local “sharpshooter” National, coastal focus Positive fundamentals in markets?
Sector “A” quality MF “A” / “B” MF in Southeast
“A” MF CBD in Northeast MF demand is strong
Investment Investors Friends & family Friends & family and 7
institutions Existing institutional investors lend credibility but conflicts may
exist
Returns 50%+ asset level returns Hi teen / low 20% returns to
investors Stability of returns and at what leverage?
Offering Structure Development JV Acquisition JV including
possible GP investment Different investors choose different entry points
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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
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Process Alternatives
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Targeted BroadNarrow
Process
Number of Buyers
Structure / Process
Timing
Accelerated Limited information preparation
Investor returns model Teaser
Site visits Management meeting Due diligence
Key abstracts / documents
Somewhat accelerated Concise marketing materials
Investor returns model Teaser Management
presentation 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
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
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
Confidentiality High High / Moderate Moderate (risk of “leak”)
< 5 investors 5 to 20 investors > 20 investors
Several months to a year or more Fast Months
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Sample Investor Universe
Fund ManagersFund Managers
Pension Fund AdvisorsPension Fund Advisors
OtherOther
Unlisted REITsUnlisted REITs
InternationalInternational
Family Office / Private Wealth
Family Office / Private Wealth
Investor
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Description of Typical Fees
Description
of Services
Investment banking services: Screen and qualify potential investors Create and distribute marketing materials Contacting investors and solicit proposals Analyze investor proposal(s) Negotiate the transaction
Fees
Retainer fee Success fee based on sliding scale Reimbursement of out-of-pocket expenses
Other Engagement
Terms
Termination Tail Lock-up Indemnification
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Accessing Private Equity CapitalConsiderations, Process and Timeline
Understanding The Investor’s Financial Drivers/ Investment Framework
ULI – January 11th, 2011
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Type of Fund Typical CharacteristicsPREA Unlevered IRRs
Core 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
7.5 – 8.5%
Core-Plus 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)
8.5 – 10%
Value-Add 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
9.5 – 13%
Return Requirements by Investment Strategy
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Type of Fund Typical CharacteristicsPREA Unlevered IRRs
Opportunistic 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)
10 – 13%
Mezzanine/ Debt
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.
Return Requirements by Investment Strategy
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Returns and Leverage
• Leverage Ratio (LR):– at the time of purchase
• = Acquisition Price/Equity
– thereafter • = Value/Equity
re – required return on levered equity
rp – required return on property without leverage
rd – return on debt (cost of
mortgage debt)
(rp – rd) – risk premium without leverage
LR – leverage ratio
re = rd + LR*(rp – rd)
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Levered Returns Table
0% 25% 50% 60% 75% 80%7.5% 7.5% 8.3% 10.0% 11.3% 15.0% 17.5%8.0% 8.0% 9.0% 11.0% 12.5% 17.0% 20.0%8.5% 8.5% 9.7% 12.0% 13.8% 19.0% 22.5%9.0% 9.0% 10.3% 13.0% 15.0% 21.0% 25.0%9.5% 9.5% 11.0% 14.0% 16.3% 23.0% 27.5%
10.0% 10.0% 11.7% 15.0% 17.5% 25.0% 30.0%10.5% 10.5% 12.3% 16.0% 18.8% 27.0% 32.5%11.0% 11.0% 13.0% 17.0% 20.0% 29.0% 35.0%11.5% 11.5% 13.7% 18.0% 21.3% 31.0% 37.5%12.0% 12.0% 14.3% 19.0% 22.5% 33.0% 40.0%12.5% 12.5% 15.0% 20.0% 23.8% 35.0% 42.5%13.0% 13.0% 15.7% 21.0% 25.0% 37.0% 45.0%
LTV
Requ
ired
Retu
rn U
nlev
ered
Assumes 5% cost of debt
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Median IRRs
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Venture Cash Flow Sharing Arrangements
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Joint Ventures
• Two types of partners that combine expertise with capital
• Cash flow sharing arrangement made between these two partners
Developer/ Operator/Sponsor Investor
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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
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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
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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
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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
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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
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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
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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 hasn’t
achieved a 9% IRR, Operator must turn over to Investor its promote distributions (in this case, all of Operator’s 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
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Return Multiples
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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
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Net Multiple (cont.)
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Investment Horizon in Years
Assumes capital contribution made at time zero and also assumes 8% cash distributions per year
IRR Multiple Table
3 5 7 108.0% 1.24x 1.40x 1.56x 1.80x
10.0% 1.31x 1.52x 1.75x 2.12x12.0% 1.37x 1.65x 1.96x 2.50x15.0% 1.48x 1.87x 2.33x 3.22x17.5% 1.58x 2.07x 2.70x 3.98x20.0% 1.68x 2.29x 3.11x 4.92x25.0% 1.89x 2.80x 4.12x 7.45x30.0% 2.12x 3.39x 5.43x 11.18x35.0% 2.37x 4.09x 7.09x 16.54x40.0% 2.64x 4.90x 9.19x 24.14x
IRR
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2. Sponsor receives a 30% promote until a 15% IRR hurdle
3. Sponsor receives a 40% promote until a 20% IRR hurdle
1. Cash flow split pari passu until an IRR of 10% is generated
4. Sponsor receives a 50% promote thereafter
Cash Flow Waterfall
Period Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Annual Net Cash Flow (15,000,000) 600,000 700,000 800,000 900,000 40,750,000
1. All cash flow split pari passu until each Member has reached a 10.0% IRRJV Investor (13,500,000) 540,000 630,000 720,000 810,000 18,197,242 90.0% of cash flowJV Sponsor (1,500,000) 60,000 70,000 80,000 90,000 2,021,916 10.0% of cash flow
2. JV Sponsor receives a 30.0% promoted interest until the JV Investor receives a 15.0% IRRJV Investor - - - - - 4,922,157 63.0% of cash flowJV Sponsor - - - - - 546,906 JV Sponsor 1st Promote- 30.0% - - - - - 2,343,884
3. JV Sponsor receives a 40.0% promoted interest until the JV Investor receives a 20.0% IRRJV Investor - - - - - 5,900,233 54.0% of cash flowJV Sponsor - - - - - 655,582 JV Sponsor 2nd Promote- 40.0% - - - - - 4,370,543
4. JV Sponsor receives a 50.0% promoted interest on all remaining cash flowJV Investor - - - - - 806,192 45.0% of cash flowJV Sponsor - - - - - 89,576 JV Sponsor 3rd Promote- 50.0% - - - - - 895,769
Total DistributionsJV Investor (13,500,000) 540,000 630,000 720,000 810,000 29,825,824
IRR: 20.6%
JV Sponsor (1,500,000) 60,000 70,000 80,000 90,000 10,924,176
IRR: 51.5%
37.0% of cash flow
46.0% of cash flow
55.0% of cash flow
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
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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
1. Cash flow split pari passu until an IRR of 10% is generated
4. Sponsor receives a 50% promote thereafter
Cash Flow Waterfall
Period Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Annual Net Cash Flow (15,000,000) 600,000 700,000 800,000 900,000 40,750,000
1. All cash flow split pari passu until each Member has reached a 10.0% IRRJV Investor (13,500,000) 540,000 630,000 720,000 810,000 18,197,242 90.0% of cash flowJV Sponsor (1,500,000) 60,000 70,000 80,000 90,000 2,021,916 10.0% of cash flow
2. JV Sponsor receives a 30.0% promoted interest until the JV Investor receives a 15.0% IRRJV Investor - - - - - 4,922,157 63.0% of cash flowJV Sponsor - - - - - 546,906 JV Sponsor 1st Promote- 30.0% - - - - - 2,343,884
3. JV Sponsor receives a 40.0% promoted interest until the JV Investor receives a 20.0% IRR and a minimum 2.50x equity multipleJV Investor - - - - - 6,867,663 54.0% of cash flowJV 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 flowJV Investor - - - - - - 45.0% of cash flowJV Sponsor - - - - - - JV Sponsor 3rd Promote- 50.0% - - - - - -
Total DistributionsJV Investor (13,500,000) 540,000 630,000 720,000 810,000 29,987,062
IRR: 20.7%
JV Sponsor (1,500,000) 60,000 70,000 80,000 90,000 10,762,938
IRR: 51.0%
37.0% of cash flow
46.0% 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
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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 a 12% preferred return
Cash Flow Waterfall
Period Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Annual Net Cash Flow (15,000,000) 600,000 700,000 800,000 900,000 40,750,000
1. JV Investor receives all cash flow until a 12.0% IRRJV Investor (13,500,000) 600,000 700,000 800,000 900,000 19,792,141 100.0% of cash flowJV Sponsor (1,500,000) - - - - - 0.0% of cash flow
2. JV Sponsor receives all cash flow until a 12.0% IRRJV Investor - - - - - - 0.0% of cash flowJV Sponsor - - - - - 2,642,214 100.0% of cash flow
3. All remaining cash flow is split 50.0% / 50.0%JV Investor - - - - - 9,157,822 100.0% of cash flowJV Sponsor - - - - - 9,157,822 0.0% of cash flow
Total DistributionsJV Investor (13,500,000) 600,000 700,000 800,000 900,000 28,949,963
IRR: 20.0%
JV Sponsor (1,500,000) - - - - 11,800,037
IRR: 51.1%
JV Waterfall Examples• Preferred Return: In the scenario below, the Sponsor’s return is subordinated to the LP’s (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
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2. All remaining cash flow is split 65%/35% in favor of the Sponsor
1. Cash flow split pari passu until all invested capital is returned
Cash Flow Waterfall
Period Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Annual Net Cash Flow (15,000,000) 600,000 700,000 800,000 900,000 40,750,000
1. All cash flow split pari passu until invested capital is returnedJV Investor (13,500,000) 540,000 630,000 720,000 810,000 10,800,000 90.0% of cash flowJV Sponsor (1,500,000) 60,000 70,000 80,000 90,000 1,200,000 10.0% of cash flow
2. All remaining cash flow is split 65.0%/35.0% in favor of the JV SponsorJV Investor - - - - - 18,687,500 65.0% of cash flowJV Sponsor - - - - - 10,062,500 35.0% of cash flow
Total DistributionsJV Investor (13,500,000) 540,000 630,000 720,000 810,000 29,487,500
IRR: 20.4%
JV Sponsor (1,500,000) 60,000 70,000 80,000 90,000 11,262,500
IRR: 52.4%
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 pre-determined split
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Return Summary
JV Promote StructureJV Promote Structure with
min. Equity MultiplePreferred Return with Catch
up to SponsorProfit Split After Return of
Capital
JV Investor ReturnsNet Profit 19,025,824 19,187,062 18,449,963 18,687,500 Levered IRR 20.62% 20.74% 20.03% 20.37%Equity Multiple 2.41x 2.42x 2.37x 2.38xProfit % Split 66.18% 66.74% 64.17% 65.00%
JV Sponsor ReturnsNet Profit 9,724,176 9,562,938 10,300,037 10,062,500 Levered IRR 51.48% 51.05% 51.06% 52.41%Equity Multiple 7.48x 7.38x 7.87x 7.71xProfit % Split 33.82% 33.26% 35.83% 35.00%
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
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More on Commingled Funds
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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 fund’s 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
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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
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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 fund’s 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
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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 fund’s 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