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Variations In Structuring ‘‘Whole Fund’’ And ‘‘Deal By ...

Variations In Structuring WholeFund And deal By deal CarriedInterest Or Promote In Real EstateFunds And Joint VenturesNathaniel M. Marrs, Louis D. Hellebusch and Krishnakshi DasA number of Variations in distribution waterfall terms enable managers andinvestors to tailor the timing of distributions of pro ts to the particularcharacteristics of their fund or joint venture, including the fund s or joint venture sinvestment strategy and expected nancial performance. In this article, theauthors analyze these Variations and explore some of the considerationsunderpinning their pro t-sharing for managers of realestate funds and joint ventures,1called carried inter-est or promote, 2is typically thought of as calcu-lated on either a deal by deal or a whole fund basis.

Variations In Structuring ‘‘Whole Fund’’ And ‘‘Deal By Deal’’ Carried Interest Or Promote In Real Estate Funds And Joint Ventures

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Transcription of Variations In Structuring ‘‘Whole Fund’’ And ‘‘Deal By ...

1 Variations In Structuring WholeFund And deal By deal CarriedInterest Or Promote In Real EstateFunds And Joint VenturesNathaniel M. Marrs, Louis D. Hellebusch and Krishnakshi DasA number of Variations in distribution waterfall terms enable managers andinvestors to tailor the timing of distributions of pro ts to the particularcharacteristics of their fund or joint venture, including the fund s or joint venture sinvestment strategy and expected nancial performance. In this article, theauthors analyze these Variations and explore some of the considerationsunderpinning their pro t-sharing for managers of realestate funds and joint ventures,1called carried inter-est or promote, 2is typically thought of as calcu-lated on either a deal by deal or a whole fund basis.

2 This simple dichotomy, however, conceals anumber of Variations which enable fund managers andinvestors to tailor the timing of distribution of pro tsto the particular characteristics of their fund , includingthe fund s investment strategy and expected nancialperformance. This article analyzes these Variations andexplores some of the considerations underpinning theiruse. Perhaps most critically, an appropriately con-structed fund distribution waterfall can assist in align-ing the incentives of managers and investors andproperly motivate and compensate the individualscharged with executing a fund s investment Basics: Manager Carried Interest andThe fund Distribution WaterfallA manager s carried interest is one of the most impor-tant nancial terms negotiated in the formation of afund.

3 Quite often, it is the most signi cant componentof a manager s expected incentive , a manager will not be entitled to carriedinterest until each investor in the fund recoups its ap-plicable capital contributions (whether for a speci cdeal or for the whole fund ) and achieves a preferredreturn thereon. Thereafter, a manager will begin toreceive carried interest distributions equal to a percent-age (or percentages) of remaining fund pro ts. Al-though the speci c investor preferred return andmanager carried interest percentages vary, a commonNathaniel M. Marrs, a partner in the Chicago o ce of Kirkland & EllisLLP, focuses his practice on corporate and commercial real estatetransactions of all types, with a speci c focus on and internationalprivate real estate fund formations and investments and complex jointventure arrangements.

4 Louis D. Hellebusch and Krishnakshi Das areassociates in the rm s Chicago o ce. The authors can be reached REAL ESTATE FINANCE JOURNAL/SPRING 20095preferred return for real estate funds (at least success-ful, opportunistic real estate funds) is eight percent(8%) per annum, compounded annually, and a com-mon overall carried interest percentage is twentypercent (20%).4 After achieving the preferred returnand return of capital for investors, the next questionthat arises is precisely how much of the next dollar ofpro ts is given to the manager versus the investors. Amanager may be entitled to up to one hundred percent(100%) of the next dollar of pro ts until such time asthe manager has received twenty percent (20%) of thefund s total pro ts (known as a catch-up ).

5 We willassume for all discussion purposes and examplesthroughout the remainder of this article that, afterinvestors receive a return of their applicable investedcapital (again, whether for a speci c deal or for thewhole fund ), plus a preferred return of eight percentper annum (compounded annually) thereon, 100 per-cent of all pro ts of the fund will be distributed to themanager until the manager has received 20 percent ofthe total pro ts of the fund (a so-called 100 percentcatch-up ) and, thereafter, all additional pro ts will bedistributed 20 percent to the manager and 80 percent tothe of whole fund versus deal By DealWaterfall ModelsAfter determining the basic features discussed above,the parties must decide whether carried interest will bedistributed on a deal by deal or on a whole fund the deal by deal model, returns are generallycalculated foreachinvestment, and the managerreceives its carried interest as pro ts are realized onthe particular investment.

6 In contrast, under a wholefund model, the manager does not receive carried inter-est distributions until the investors receive distribu-tions equal to their total capital contributions to theentire fund and a preferred return on all suchcontributions. Assuming that a fund incorporates a so-called claw-back feature,6both the deal by dealmodel and the whole fund model should result in thesame aggregate sharing of pro ts over the life of thefund, with the only variable being the timing of receiptof such pro ts by the manager earlier for a deal bydeal model and later for a whole fund model. Ofcourse, timing is everything as they say, and a numberof interesting Variations of the whole fund and deal bydeal waterfall models can be employed in di erent cir-cumstances to address di erent Source Variations on WaterfallsOne potential variation in carried interest arrangementsis based on the source of income generated by a most common income source variation utilized inreal estate funds is based on a distinction between current income ( , rents, hotel room revenue, andother forms of operating pro t) and dispositionproceeds ( , income resulting from the sale or otherdisposition of a fund s underlying investments).

7 Undermost real estate fund distribution waterfalls (whetherstructured to provide carried interest on a whole fundor on a deal by deal basis), current income simply owsthrough the same distribution waterfall as any othertype of income. In contrast, those funds that distinguishbetween these di erent sources of income usually doso by creating separate distribution waterfalls, onegoverning the distribution of current income and theother governing the distribution of dispositionproceeds. As we will explore in more detail, this typeof distinction can be used in various circumstances toencourage a manager to execute the fund s mandatemore e ciently, particularly for current income fo-cused the remainder of this article, we will review vari-ous possible forms (and combinations of forms)

8 Ofthese di erent models in detail and consider how theiruse a ects the timing of distributions of pro ts to fundmanagers and whole fund Model and VariationsBasic whole fund ModelIn the basic whole fund model distribution waterfall,each investor must recoup its total capital contribu-tions to the fund and receive a speci ed preferredreturn on those total contributions before the manageris entitled to receive any carried interest. In the simpleillustration in Figure 1, we assume a fund with one in-vestor made Investment A in Year 1 for $5 million,continued to make investments over the interveningyears, such that the investor had contributed a total of$100 million as of the last day of Year 4, and thatInvestment A was sold in Year 4 for $12 million, withthe resulting proceeds distributed at that In Structuring whole fund And deal By deal 6 THE REAL ESTATE FINANCE JOURNAL/SPRING 2009 Because the distribution waterfall re ected inFigure 1 is based on a whole fund model, the entire$12 million is distributed to the investor as return ofcapital.

9 The manager will not receive a share of pro tsuntil the investor has received its entire capital contri-bution of $100 million plus the eight percent preferredreturn thereon, presumably following subsequent whole fund model is generally the most favorableto investors from a time value of money perspectivesince it defers distributions of carried interest tomanagers, and investors therefore receive more distri-butions of fund pro ts fund , Income Source VariationAs noted above, the most common income sourcebased variation utilized in real estate funds distin-guishes current income and disposition cally, a manager applying this variation to awhole fund model waterfall is permitted to receive car-ried interest from distributions of current income (butnot distributions of disposition proceeds) as soon asinvestors receive the preferred return on all investedcapital, even if investors have not recouped any of theircapital contributions.

10 Figure 2 is a basic illustration ofthis variation on the whole fund model. For purposesof this example we assume a fund with one investorwho made total contributions to the fund of $100 mil-lion, that the fund distributes $12 million of currentincome received by the fund from the operation of itsinvestments on the last day of Year 1. We also assumethat Investment A was purchased on the rst day ofYear 1 for $5 million and sold on the last day of Year 1for $12 million. For simplicity, we assume that theentire $100 million was contributed on the rst day ofYear 1 and that there have been no distributions priorto the last day of Year REAL ESTATE FINANCE JOURNAL/SPRING 20097In the case of Figure 2, the manager immediatelyreceives some portion of its carried interest on the cur-rent income generated by the fund ($ million), whilethe capital invested in each deal is returned pursuant toa separate disposition proceeds waterfall (in this case,$12 million).


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