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Real Estate Joint Ventures:

Waterfall Structures, Developer Promote,

IRR Lookback, Clawback and Catchup Calculating and Structuring Promote, Planning for Phantom Income, and Taxation of Carried Interest

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, AUGUST 6, 2015

Presenting a live 90-minute webinar with interactive Q&A

Nathaniel M. Marrs, Partner, Latham & Watkins, Chicago

Alan Van Dyke, Partner, Latham & Watkins, Chicago

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Latham & Watkins Investment Funds, Real Estate and Transactional Tax Practice Groups

February 9, 2015 | Number 1799

3 Developments Real Estate Fund Sponsors Should Know for 2015

Changes in fee terms as well as new guidance regarding GAAP consolidation and potential future tax developments can impact how fund sponsors structure and negotiate their investment vehicles.

Despite a slight downturn in capital-raising activity during 2014,1 US real estate fund sponsors can expect 2015 to support overall fundraising success as a result of a variety of economic factors. In doing so, however, sponsors should be cognizant of the latest trends in fee terms, new accounting guidance and potential developments in future tax rules. This Client Alert highlights these trends and potential developments.

1. Trends in Fee Terms Recently, the Pension Real Estate Association (PREA) released its 2014 study of fee terms — including both management fees and incentive fees (aka “carried interest” or “promote”) — associated with 164 private real estate investment vehicles targeting institutional investors and investing in all types of US and non-US real estate. Among other things, the study revealed the following:

• The most typical basis for management fees for closed-ended funds was limited partner commitments during the investment period, and invested equity thereafter. Open-ended funds, separate accounts and joint ventures were much more likely to utilize a different basis and typically did not apply different bases over time. The most common management fee basis for open-ended funds was net asset value.

• The median rate applied to closed-ended funds using invested equity as a management fee basis was 1.5 percent, with a fairly sizable standard deviation of .41 percent (i.e., just over 2/3rd of such fee rates fell between 1.91 percent and 1.09 percent.) For open-ended funds using net asset value as their management fee basis, the median rate was .99 percent, with a standard deviation of .11 percent.

• Almost all closed-ended funds (the vast majority of which pursued a value-added or opportunistic strategy) charged some type of incentive fee, but more than a third of open-ended funds (the vast majority of which pursued a core strategy) did not.

• Incentive fees charged to closed-ended funds most often (69 percent of the time) took into account a 100 percent return of capital as part of the determination of when such fees are distributed. But there

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was a significant difference based on fund vintage, with 64 percent of pre-2011 funds and 88 percent of post-2010 funds using such test.

• A majority (almost 60 percent) of closed-ended funds used a catch-up in calculating incentive fees, but catch-ups were almost never used for open-ended funds. The catch-ups which closed-ended funds used were most often (66 percent of the time) a 50-50 general partner-limited partner (GP-LP) split or a 60-40 GP-LP split.

• Closed-ended funds not using a catch-up (the vast majority of which pursued a value-added strategy) set their first “hurdle” at which incentive fees begin to be distributed (most commonly expressed as an internal rate of return or IRR) at 9.21 percent on average. The average incentive fee rate for such vehicles was 18.54 percent. The 2014 study did not separately report first hurdle rates and incentive fee rates for closed-ended funds using catch-ups or for open-ended funds (in isolation), nor the use of additional hurdle rates and incentive fee rates for all closed-end funds not using a catch-up.2

• Only a minority of closed-ended funds or open-ended funds charged other types of fees for managing the funds, such as acquisition fees (25 percent for closed-ended and 24 percent for open-ended), debt arrangement fees (4 percent for closed-ended and 19 percent for open-ended) or disposal fees (1 percent for closed-ended and 5 percent for open-ended).

• Study participants noted a trend of real estate investment vehicles aligning fees to achieve more transparent fee structures, although participants also believed that existing funds had implemented only a few changes in fee structures over the past two years.

Although many of these trends are not particularly surprising, this study is a very helpful confirmation of our anecdotal experiences. Indeed, a number of investors have recently cited the study in negotiations with our real estate sponsor clients, particularly when the investors view the information as revealing “off market” fee terms. Sponsors ignore this information at their negotiating peril.

2. New US GAAP Consolidation Guidance In July 2014, the Financial Accounting Supervisory Board (FASB) voted to issue a new consolidation standard affecting the methodology for determining when companies should consolidate limited partnerships or similar entities, including limited liability companies. Under the new guidance:

• FASB will consider all limited partnerships or similar entities as “Variable Interest Entities” (VIEs) unless substantive kick-out rights or participating rights are exercisable by a single limited partner or a simple majority or less (by interests in the applicable entity) of all limited partners (or non-managing members, in the case of limited liability companies). FASB will hold entities determined to be VIEs to certain disclosure requirements and will analyse such entities for potential consolidation with their parent entity(ies) under the revised VIE guidance.

• In determining whether VIEs should be consolidated under such guidance, FASB will consider the size of a general partner’s (or managing member’s) investment in, and the amount and type of fees paid by, the VIE.3

• Fees a VIE paid will not represent a “variable interest” (triggering consolidation) if all of the following requirements are satisfied: (i) the decision maker’s compensation is commensurate with the services provided; (ii) the compensation agreement is on terms and conditions that are customary for similar services negotiated on an arm’s-length basis; and (iii) the decision maker does not hold other interests in the entity that, individually or in the aggregate, absorb more than an insignificant amount

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of the entity’s expected losses or receive more than an insignificant amount of the entity’s expected residual returns.

These consolidation rules are most immediately of interest for real estate fund sponsors with a publicly traded parent concerned with reporting consolidated information on the parent’s balance sheet that may be inconsistent with the amount of such parent’s true financial investment in, or exposure to, a subsidiary fund or similar vehicle. Conversely, real estate fund sponsors without a public parent may not be particularly concerned with such GAAP-driven consolidation, as sponsors may feel that they can adequately explain the resulting balance sheet to their private investors without a public reporting overlay. In any setting, however, this new guidance represents a significant departure from prior rules, and sponsors therefore should consider the guidance when structuring (or restructuring) real estate funds.

3. Recent Tax Proposals and Potential Tax Guidance In 2014, the US House Committee on Ways & Means considered two carried interest reform proposals, introduced by Congressman Sander Levin and Congressman Dave Camp, respectively.

• The Levin proposal was very similar to legislation that had been introduced on several other occasions regarding the treatment of carried interest. It would provide that all income allocable to designated service partners be taxed at ordinary income rates except to the extent the income is attributable to certain qualified capital interests

• The Camp proposal was more interesting, because it adopted a new approach to the issue. That proposal would calculate a deemed interest amount on the amount of capital that is treated as supporting a partnership’s carried interest, determined by applying the same percentage used to calculate such carried interest to the partnership’s total capital (e.g., 20 percent of total capital if carried interest is 20 percent). The resulting deemed interest amount would be ordinary income until it exceeded the amount determined by applying the long-term applicable federal rate (AFR) plus 10 percentage points to that amount of capital. Thus, the compensatory element would be that amount of carried interest income equal to interest at the long-term AFR plus 10 percentage points on a loan equal to the investment underlying the carried interest (or the totally carried interest amount, if less). The Camp proposal applies to interests in partnerships received in connection with the performance of services by a taxpayer in an “applicable trade or business.” Based on the statutory definition, whether this provision would apply to partnerships owning real estate remains unclear.

Also, on August 26, 2014, the IRS released its 2014-2015 priority guidance plan, which highlights areas of guidance that the IRS intends to develop between the last half of 2014 and the first half of 2015. Among other things, the plan addresses:

Guidance on management fee waivers. The IRS is studying management fee waiver structures to provide guidance on permissible fee waivers. Although specifics are still unclear, the IRS has informally raised two specific issues in connection with those arrangements — whether the interest in a partnership attributable to certain permitted waived management fees is treated as a profits interest in the partnership, and whether the waiving manager should treat waived fees as constructively received.

Simplifying regulations for fractions rule compliance. The IRS is also studying changes to simplify compliance with the fractions rule. This rule is complex and difficult to work with. The following issues are either problematic or a source of uncertainty in attempting to comply with the fractions rule:

• Charging different levels of management fees for different fund investors

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• Complying with the fractions rule by subsidiary entities, including joint ventures

• Determining whether a loss is an “unlikely loss” that can be ignored

• Carried interest clawbacks

Although these proposals and guidance have not yet been adopted, real estate fund sponsors should monitor them closely as these possible changes could significantly affect the sponsors’ businesses if they become effective and are not appropriately addressed.

If you have questions about this Client Alert, please contact one of the authors listed below or the Latham lawyer with whom you normally consult:

Nathaniel M. Marrs nathaniel.marrs@lw.com +1.312.777.7052 Chicago Alan Van Dyke alan.vandyke@lw.com +1.312.876.6539 Chicago

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Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the lawyer with whom you normally consult. The invitation to contact is not a solicitation for legal work under the laws of any jurisdiction in which Latham lawyers are not authorized to practice. A complete list of Latham’s Client Alerts can be found at www.lw.com. If you wish to update your contact details or customize the information you receive from Latham & Watkins, visit http://events.lw.com/reaction/subscriptionpage.html to subscribe to the firm’s global client mailings program.

Latham & Watkins February 9, 2015 | Number 1799 | Page 5

Endnotes

1 See Pension Real Estate Association report “PREA-ANREV-INREV Management Fees & Terms 2014 - A Comparison Study”

as described in Law360 article Real Estate Fund Closings Dropped In 2014, Study Says. 2 Note: Without such additional information, the average first hurdle and incentive fee rates for the relatively small number of

closed-ended funds not using a catch-up appears to be of limited utility. In addition, in our experience hurdle rates tend to be highly variable depending on vehicle type and investment strategy, making averages of such figures (without information on standard deviation or similar measures) potentially misleading.

3 Interests held by and fees paid to parties related to the general partner (or managing member) also need to be evaluated in such analysis.

De�ciencies of IRRs and TWRs asMeasures of Real Estate Investmentand Manager PerformanceCopyright © 2005 Thomson/West. Originally appeared in the Winter 2006 issue of Real Estate Finance Journal.For more information on that publication, please visit http://west.thomson.com. Reprinted with permission.

Nathaniel M. Marrs and Stephen G. Tomlinson

Internal rates of return are a useful measure of investment performance in manyrespects, particularly when analyzing the performance of private real estateinvestments and the managers of such investments, and particularly whencompared and contrasted against an alternative measure of investmentperformance such as the time-weighted return. As the authors explain, however,IRRs should never be used, whether in evaluating the performance of aninvestment or an investment's manager, without an appropriate understanding ofan investor's cost of capital and net present value goals.

Perhaps the most commonly used measure of invest-ment performance in the real estate marketplace todayis the internal rate of return (‘‘IRR’’). Despite thisprevalence, IRRs can be misleading to investors whodo not consider limitations inherent in IRR calcula-tions that are best mitigated by carefully consideringan investor's required cost of capital and net presentvalue (‘‘NPV’’) investment goals.

A common alternative to the IRR as a measure ofinvestment performance is the time-weighted return

(‘‘TWR’’), a metric that does not weight investmentreturns by amount or by the timing of those amounts.1

While useful, TWRs su�er from their own de�cien-cies, and are particularly problematic when applied tothe performance of private real estate investments andthe managers of such investments. As a result, IRRsare often appropriately preferred to TWRs in evaluat-ing the performance of private real estate managers,including managers of private real estate joint venturesand pooled discretionary investment vehicles (or‘‘funds’’). That is not the end of the story, however, asthe lessons learned when analyzing the limitations ofIRRs and TWRs as measures of investment perfor-mance illuminate potentially con�icting investor-manager incentives resulting from the unsophisticateduse of IRRs in awarding manager compensation andsuggest means for mitigating these con�icts.

IRRs As A Measure Of Investment ReturnsThe IRR of an investment is formally de�ned as therate of discount which makes the net present value of a

Nathaniel M. Marrs, a partner in the Chicago o�ce of Kirkland & EllisLLP, focuses his practice on complex corporate and commercial realestate transactions of all types, with a speci�c focus on private realestate fund formations and investments and complex joint venturearrangements. As the senior partner in Kirkland & Ellis' Real EstatePractice Group, Stephen G. Tomlinson's practice focuses on complexbusiness transactions for real estate investment trusts, real estateprivate equity sponsors, institutional investors and real estate operat-ing companies engaged in acquisitions and dispositions, operatingcompany investments and formations, and multi-investor fund forma-tions and investments. The authors can be reached atnmarrs@kirkland.com and stomlinson@kirkland.com, respectively.The authors would like to acknowledge the contributions of two otherKirkland & Ellis partners, Gary E. Axelrod and Roberto S. Miceli.

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series of investment cash �ows equal 0. It is expressedby the following equation:0=sCFi/((1+IRR)i), where CFi is the cash �ow in pe-riod i and i is the number of each period.

IRRs are calculated in Table 1 relative to two invest-ments and resulting cash �ows.

Table 1

Year-end cash �ows Investment 1 Investment 2Cash �ow year 1 (100) (125)Cash �ow year 2 20 10Cash �ow year 3 40 15Cash �ow year 4 30 10Cash �ow year 5 150 125IRR 32.25 percent 7.24 percent

Table 2

Year-end cash �ows Investment 1 Investment 2Cash �ow year 1 (100) (200)Cash �ow year 2 175 300IRR 75 percent 50 percentNPV, using 10 percent discount rate 53.72 66.12

In addition to certain obscure mathematical limita-tions,2 however, IRR calculations can be misleadingwhen applied to investments of di�erent sizes and toinvestments with di�erent cash �ow patterns over time.These limitations are best demonstrated by carefullycomparing IRR results to NPV calculations of invest-ment performance.

Investments Of Di�erent SizesThe misleading nature of IRR calculations when ap-plied to two very simple investments of di�erent sizesis illustrated by Table 2.3

As illustrated by the example in Table 2, a simpleIRR investment rule (i.e., invest in whichever invest-

ment generates a higher IRR) will lead to a less thandesirable result from an NPV perspective as the inves-tor investing in Investment 1 will be substantially lesswell o� than an investor investing in Investment 2. Aslightly di�erent IRR investment rule mandating anyinvestment which generates an IRR equal to or higherthan a speci�ed target (e.g., 20 percent), however, canbe salvaged by decomposing Investment 2 into twodistinct investments (comprised of Investment 1 andthe ‘‘incremental’’ investment of the additional 100required for Investment 2), and then examining the IRRon the incremental cash �ow generated by Investment2 relative to Investment 1. This is illustrated by Table3.

Table 3

Incremental year-end cash�ows Investment 2-�rst part Investment 2-second partCash �ow year 1 (100) (100)Cash �ow year 2 175 125IRR 75 percent 25 percent

As shown in Table 3, the cash �ow on the incremen-tal investment made in Investment 2 still exceeds theinvestor's desired IRR goal, and, since Investment 2generates a cash �ow not generated by Investment 1,Investment 2 is the superior investment under thisanalysis. It is important to note that this type of analy-sis does not take into account any consideration of theprojected ‘‘reinvestment rate’’ of cash�ows resultingfrom either investment.4

Investments With Di�erent Cash Flow Pat-terns Over TimeIRR calculations can also be misleading when appliedto investments which generate materially di�erent cash�ow patterns over time. These results are demonstratedin Table 4.

De�ciencies of IRRs and TWRs as Measures of Real Estate Investment and Manager Performance

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Table 4

Year-end cash �ows Investment 1 Investment 2

Cash �ow year 1 (100) (100)

Cash �ow year 2 100 25

Cash �ow year 3 50 25

Cash �ow year 4 0 25

Cash �ow year 5 0 25

Cash �ow year 6 0 25

Cash �ow year 7 0 25

Cash �ow year 8 0 25

Cash �ow year 9 0 25

Cash �ow year 10 0 25

Cash �ow year 11 0 25

IRR 36.6 percent 21.41 percent

NPV, using 10 percent discount rate 29.3 48.74

Once again, a simple IRR investment rule mandat-ing whichever investment generates a higher IRR willproduce discouraging results for investors concernedwith maximizing NPV. The primary reason for these

misleading results is best illustrated by analyzing theNPVs of the di�erent investments at di�erent assumeddiscount rates. These results are depicted in Chart 1.

As these results show, the attractiveness of eachinvestment from an NPV perspective varies dependingupon the discount rate that is utilized (which, in turn,will be driven by each investor's required cost ofcapital). For an investor facing a required cost ofcapital greater than 20 percent, Investment 1 will bemore attractive from an NPV perspective. This inves-tor sees Investment 2 as generating an insu�cientreturn to justify investing, given the investor's capitalconstraints. For an investor facing a required cost ofcapital less than 15 percent, however, Investment 2will be more attractive from an NPV perspective. Thisinvestor sees Investment 1 as generating high returnstoo quickly in sacri�ce for the lower, more stablereturns generated over a much longer period by Invest-ment 2.

Again, a slightly modi�ed IRR investment rule can

be salvaged by examining the incremental cash�owsgenerated by Investment 2 relative to Investment 1. Itshould now be clear, however, that such a modi�edIRR rule works for the same reason illustrated abovewith respect to our more detailed NPV analysis of theseinvestments—the investor utilizing such a modi�edIRR rule has adopted a desired investment return goalbased on the investor's anticipated capital constraints.

This point—that IRRs should only be employed byan investor in combination with a clear understandingof such investor's required cost of capital and NPVinvestment goals—is a critical investor lesson. In theabsence of this understanding, investors may makecertain unjusti�ed assumptions about IRR results. Forexample, investors reviewing the IRR results gener-ated by the investments in Table 4 may believe theyprefer Investment 1 based on the unjusti�ed assump-

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tion that capital is highly constrained for them. Perhapseven more importantly, investors may fail to grasp theeconomic incentives of managers who receive incen-tive compensation based on IRR calculations.

TWRs As Alternative Measure Of InvestmentReturnsAs a result of these de�ciencies, investors may betempted to use an investment return metric, like theTWR, which does not accord any ‘‘weight’’ to invest-ment returns by amount or by the timing of thoseamounts. While useful to certain types of investors,however, TWRs su�er from their own de�ciencies andoften do not make sense when analyzing the perfor-mance of private real estate investments or the perfor-mance of the managers of such investments.

In technical terms, a TWR is a method of comput-ing a rate of return for an investment based on theinvestment's period-by-period performance over aseries of periods. Unlike an IRR, a TWR will usuallyrequire the calculation of ‘‘interim’’ valuations, eventhough the investment in question may not have actu-ally generated any cash, because the performance ofthe investment (based on both cash �ows and unreal-ized appreciation) must always be measured for eachperiod.

A basic TWR calculation is illustrated in Table 5and contrasted against the IRR calculation generatedby the same investment cash �ows used in Table 1.Beginning and ending ‘‘interim’’ values have beenarbitrarily chosen.

Table 5

Year-end cash�ows

Investment 1 Investment 2 Period-by-period returns

Investment 1 Investment 2

Cash �ow year 1 (100) (125) Period 1-2 Beginningvalue: 100Ending value:112.5Cash �ow: 20Return: 32.5percent

Beginningvalue: 125Ending value:125Cash �ow: 10Return: 8percent

Cash �ow year 2 20 10 Period 2-3 Beginningvalue: 112.5Ending value:125Cash �ow: 40Return: 46.66percent

Beginningvalue: 125Ending value:125Cash �ow: 15Return: 12percent

Cash �ow year 3 40 15 Period 3-4 Beginningvalue: 125Ending value:137.5Cash �ow: 30Return: 34percent

Beginningvalue: 125Ending value:125Cash �ow: 10Return: 8percent

Cash �ow year 4 30 10 Period 4-5 Beginningvalue: 137.5Cash �ow: 150(all value real-ized)Return: 9.1percent

Beginningvalue: 125Cash �ow: 125(all value real-ized)Return: 0percent

Cash �ow year 5 150 125IRR 32.25 percent 7.24 percent TWR 30.57 percent 7 percent

The TWR calculation used in this example is thearithmetic average of the investment's returns overeach applicable period. A TWR could also be calcu-lated for this investment by taking the geometric aver-

age of the investment's returns over each applicableperiod. Such a geometric TWR for Investment 1 wouldequal 29.81 percent and for Investment 2 would equal6.91 percent.5 This type of geometric calculation takes

De�ciencies of IRRs and TWRs as Measures of Real Estate Investment and Manager Performance

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into account the principal of compounding and istherefore generally viewed as a better measure of aninvestment's past performance.6

The fundamental di�erence between an IRR calcu-lation and a TWR calculation is that the former, bysolving for a single rate that fully discounts a series ofcash �ows over future periods to 0, takes into accountthe timing and amount of such cash �ows where thelatter, by solving for an average period-by-periodreturn, does not. Because TWR calculations generateperiod-by-period returns una�ected by the timing ofinvestment cash in�ows or out�ows, they are oftenemployed to evaluate the period-by-period perfor-mance of investment managers who are unable tocontrol the timing or amount of cash in�ows or out-�ows of the investments they manage, such as pensionfund managers. The performance of many pensionfund managers, in fact, is evaluated against an index—the ‘‘NCREIF Index’’—which is itself calculated on aTWR basis.

As mentioned, TWR calculations also require hy-pothetical interim valuations in order to determine theperiod-by-period returns necessary to generate them inthe �rst instance, whereas such interim valuations arenot required for IRR calculations. For this reason,TWRs are also appropriately used to evaluate the per-formance of relatively liquid investments (e.g., pub-licly traded REIT shares) where investment in�owsand out�ows can be realized fairly rapidly and e�ort-lessly, and where accurate interim valuations are easyto calculate.

Like IRRs, TWR calculations must be carefullyevaluated relative to an investor's required cost ofcapital and NPV goals.7 TWR calculations are particu-larly problematic when applied to the performance ofprivate real estate investments and to the performanceof the managers of such investments, where the timingand amounts of investment in�ows and out�ows aresome of the most critical elements of managerial skill,and where liquidity is usually the exception rather thanthe rule. The spread between a private real estateinvestment's TWR and IRR performance, in fact, canrightly be viewed as an important measure of the per-formance of the manager of that investment as itdemonstrates the relative success of that manager ininvesting and realizing cash �ows at ‘‘the right time.’’Other speci�c problems with the use of TWRs inevaluating the performance of private real estateinvestments include the following:

E The beginning and ending period valuationsrequired by TWR calculations are often specula-tive and di�cult to calculate in relation to privatereal estate investments;

E During the early phases of most real estate invest-ments, cash �ow performance is often very unin-spiring relative to the level of invested capital (oreven negative in the event managers are entitledto fees or expense reimbursements which must

be satis�ed out of additional capital contributionsinstead of investment cash�ows). On the otherhand, the cash �ow performance of these invest-ments during later phases is often phenomenalrelative to the level of invested capital. TWRs, byweighting the performance of such investmentsequally over all periods, essentially overweightearlier periods when a relatively small amount ofcapital has been invested and a relatively smallnumber of investments have been realized andunderweight later periods when a larger amountof capital has been invested and larger numbersof investments have been realized. In contrast,IRRs, by according less weight to smalleramounts of invested capital and investment re-turns, appropriately take into account these sys-tematic return characteristics of most real estateinvestments; and

E Similarly, during both early and later phases ofmost multi-asset real estate portfolio investments,portfolios are more concentrated by property-type and/or geographic location because, duringthe early phases, capital has not been fully in-vested (and many assets have yet to be pur-chased), and, during the later phases, many assetshave already been liquidated. The performanceof such investments during such phases may ac-cordingly be biased in a manner that is not re�ec-tive of the performance of the entire portfolioover the life of investment. Again, by weightingthe performance of such portfolio investmentsequally over all periods, TWRs are more likely toproduce return results that are unduly in�uencedby such unrepresentative periods. And again,since these periods are less likely to involve thesame levels of invested capital or investmentreturns as other periods, IRR calculations will, ingeneral, appropriately discount them.

Use Of IRRs In Incentive CompensationCalculations For Real Estate Joint VentureAnd Fund ManagersAs a result of the relative quality of IRRs as measuresof private real estate investment performance, IRRsare frequently used in some form by investors in realestate joint ventures and funds to evaluate the perfor-mance of the managers of such vehicles. However, forthe same reasons IRRs are potentially misleading as ameasure of investment performance, IRRs are alsopotentially misleading when evaluating managerperformance. Investors should accordingly think care-fully about implementing certain methods to mitigatethe technical de�ciencies of such calculations whendocumenting manager compensation driven by them.

Let's revisit the two investments addressed in Table4. As discussed in more detail below, a manager whois entitled to incentive compensation based on a speci-

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�ed IRR target may view Investment 1 as more attrac-tive than Investment 2 (depending on the exact amountand timing of such compensation), even if the managerwould otherwise prefer Investment 2 based on astraight equity investment (i.e., if the manager wererequired to invest its own money without the bene�t ofany IRR-driven incentive compensation). For example,let's assume that a real estate fund manager is entitledto a 20 percent ‘‘carried interest’’ in all investmentpro�ts, commencing after an investment has returnedcash �ows to investors su�cient to achieve a 25percent IRR. In this situation, the manager has an un-equivocal incentive to make Investment 1 over Invest-ment 2 as the manager earns $3.758 if it makes Invest-ment 1 and nothing if it makes Investment 2! On theother hand, most investors (including the manager if itmade a straight equity investment) will prefer Invest-ment 2 unless facing an anticipated cost of capital inexcess of 20 percent. These potential con�icts betweenmanager and investor goals are only exacerbated to theextent IRR-driven compensation is earned over a seriesof investments.9

Such investor-manager con�icts resulting from theuse of IRR-driven compensation can be mitigated byrequiring a ‘‘total dollar’’ return (calculated on thebasis of the investor's desired NPV goal for this typeof investment) before the manager is entitled to receiveany such compensation.10 Speci�cally, an investorcould calculate its required cost of capital, utilize adiscount rate in the same percentage, and calculate anNPV goal for a ‘‘hypothetical’’ investment based on aseries of cash �ows that the investor believes such aninvestment should generate. This investor could thencarefully analyze the time horizon over which the in-vestor believes such cash �ows should be generatedand calculate a total return amount which, if earnedover that period, would permit the investor to achieveits desired NPV goal. If an investor were to require a$200 total return in the example from Table 4 ad-dressed immediately above, for example, the manag-er's incentive to choose Investment 1 over Investment2 would be completely eliminated.11 This method, ifimplemented properly, would also eliminate the man-ager's IRR-driven incentive to choose smaller overlarger investments, as the total dollar threshold wouldalways need to be satis�ed in any event.

ConclusionIRRs are a useful measure of investment performancein many respects, particularly when analyzing the per-formance of private real estate investments and themanagers of such investments, and particularly whencompared and contrasted against an alternative mea-sure of investment performance such as the TWR. ButIRRs should never be used, whether in evaluating theperformance of an investment or an investment'smanager, without an appropriate understanding of aninvestor's cost of capital and NPV goals. Only by

understanding such goals and setting appropriateinvestment or manager performance targets will an in-vestor be in a position to truly evaluate, and utilize,IRRs.

1 The term ‘‘time-weighted return’’ is a bit of a misnomeras it implies other investment return measurements do nottake time-weighting into account when calculating returns.This is clearly not the case relative to IRRs (or other measuresof investment returns). As this article illustrates, a bettername might therefore be ‘‘non-dollar weighted return.’’

2 The �rst obscure mathematical limitation results from aproblem with any general solution to a polynomial equation,discovered by the famous French philosopher and mathema-tician Renes Descartes—Descartes' so called ‘‘Rule ofSigns.’’ Speci�cally, this rule entails that multiple rates ofreturn will be generated by the standard IRR formula to theextent there is more than one change in cash �ows from neg-ative to positive (or vice-versa). Such cash �ow patterns,however, are fairly unusual, and sophisticated solutions (farbeyond the scope of this article) are available to salvage IRRcalculations in these circumstances.

The second obscure mathematical limitation is generatedif an investor desires to utilize an IRR calculation as a simpleinvestment rule (i.e., invest if the IRR of investment xexceeds y percent) but faces di�erent costs of capital overthe relevant investment period (perhaps as a result of antici-pated �uctuations in the term structure of interest rates). Inthis situation, since the standard IRR calculation generatesonly 1 discrete result (barring the issue noted above), an IRRcalculation will not adequately address the investor's desiredinvestment goals as and when the investor's anticipated costof capital changes. As will be seen, however, IRR calcula-tions should almost never be used in such a simple-mindedway. In addition, other (more straight-forward) examples areavailable to illustrate some conceptually similar de�ciencieswith IRR calculations.

For a more detailed discussion of these issues, as well asmany of the other problems with IRR calculations discussedin this article, see Brealy and Myers, Principles of CorporateFinance, Chapter 5 (McGraw-Hill 2003).

3 All NPV results throughout this article are calculatedbased on the following standard NPV equation:

NPV=sCFi/((1+DR)i), where CFi is the cash �ow in pe-riod i, i is the number of each period and DR is the applicablediscount rate.

4 Perhaps the most common objection to IRR calculationsin these situations—that such calculations fail to take intoaccount the ‘‘reinvestment rate’’ of resulting investment cash�ows (or, stated slightly di�erently, that such calculationsimproperly only assume reinvestment at the IRR rate)—ismisplaced. Although it is true that IRRs, as the name implies,are measures of an investment's internal return and do nottake into account how an investment's cash �ows might bereinvested after the investment's liquidation, the inclusion ofpotential ‘‘reinvestment rates’’ in any calculation of aninvestment's return automatically combines the prospectivereturn resulting from another independent investment withthe return resulting from the investment in question. Invest-ment return calculations incorporating any notion of a‘‘reinvestment rate’’ thus permit the return characteristics ofother investments to in�uence decisions which should be

De�ciencies of IRRs and TWRs as Measures of Real Estate Investment and Manager Performance

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based upon the return characteristics of the investment inquestion, considered in isolation.

5 1+X=(1.325*1.466*1.34*1.091)1/4, X=29.81 percent;and 1+X=(1.08*1.12*1.08*1)1/4, X=6.91 percent.

6 TWR arithmetic calculations, however, continue to havetheir uses. In fact, for complicated statistical reasons, TWRarithmetic calculations are better unbiased predictors of aninvestment's future performance than TWR geometriccalculations.

7 In fact, ignoring practical di�erences (such as the needto use ‘‘interim’’ valuations), the only mathematical di�er-ence between a TWR calculation and an IRR calculation isthat the former represents the unweighted average of aninvestment's performance over a series of subperiods,whereas an IRR always re�ects the dollar/time-weightedaverage of an investment's performance over the samesubperiods. See, e.g., NCREIF White Paper: Recommenda-tion to Amend the AIMR Performance Presentation Stan-dards to include the Internal Rate of Return for Real EstateDiscretionary Closed-End Funds and Discretionary SeparateAccounts (October 1998). Given these similarities, TWRcalculations su�er most (if not all) of the mathematical limi-tations addressed earlier in this article relative to NPVcalculations.

8 20 percent of 18.75, which represents the excess cash�ow over the cash �ow required to achieve a 25 percent IRR(131.25).

9 Such con�icts are exacerbated to the extent a fundmanager has the right to utilize bank �nancing instead of in-vestor capital contributions to make investments. As partiallydemonstrated by the examples in this article, there is aninverse relationship between the magnitude of IRR returnsand the size of an investor's capital contributions. To theextent managers are able to obtain bank �nancing at e�ectiveinterest rates lower than the IRR targets utilized to calculatetheir incentive compensation (which is almost always thecase), such managers are incentivized to fund investmentswith such �nancing in lieu of investor capital contributionsfor as long as permitted.

10 Note: One seemingly plausible alternative to mitigat-ing these con�icts—requiring a minimum hold period for aninvestment (without more)—fails in that the manager earn-ing incentive compensation in excess of the referenced IRRtarget would still be incentivized to make Investment 1 andhold it until permitted to dispose of it (unless the manager is

required to hold Investment 1 beyond the point that the 25percent IRR target is no longer achieved, in which case themanager is indi�erent between Investment 1 and 2—also notan ideal result). In this sense, a minimum holding periodrequirement is neither necessary nor su�cient for purposesof encouraging appropriate manager decision-making as italways requires an analysis of manager-investor NPV resultsin any event.

Likewise, a so-called ‘‘claw-back’’ requirement imple-mented in a fund or other multi-asset investment situation—whereby a manager is required to pay back incentive compen-sation paid as a result of earlier successful assets (or on thebasis of less than fully-drawn capital commitments) if laterassets are su�ciently less successful to drive the overall per-formance of all assets below the manager's IRR target (or ifthe IRR target calculated on the basis of the later fully-drawncapital commitments mandates the same result)—also doesnot mitigate these con�icts as the manager could simplychoose multiple investments akin to Investment 1 overInvestment 2 and never be required to pay back any of itscompensation.

However, the countervailing incentive e�ects of any non-IRR-driven manager compensation must also be taken intoaccount before utilizing any particular return target. Forexample, if a signi�cant component of a manager's compen-sation takes the form of management fees calculated on thebasis of committed or invested capital (as is often the case),the manager will already be incentivized (unless such incen-tive is outweighed by other incentives) to hold on to theinvestment for as long as possible (even beyond the pointthat makes sense from an NPV perspective). The use of atotal dollar return threshold in such a situation could exacer-bate these potentially negative incentives (whereas the use ofpure IRR-driven compensation could alleviate them). Ac-cordingly, each manager compensation program should becarefully evaluated to determine the overall e�ect of imple-menting a total dollar return threshold.

11 The ultimate amount of any total dollar threshold, ofcourse, will only be agreed after negotiation between themanager and investors involved with the underlying invest-ment, and a manager can rightfully object that any total dol-lar threshold requiring the full payback of an investor'santicipated NPV is overreaching. The important point is that,whatever amount is agreed, some speci�c total return will berequired which will re�ect the investor's anticipated NPVgoals (at least in part), thereby mitigating the IRR-drivenincentive con�icts referenced in this article.

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