A key term to a real estate private equity deal is the sponsor “promote.” This term is really just industry jargon for the sponsor’s disproportionate share of profits in a real estate deal above a predetermined return threshold. In almost any other form of alternative investment, a sponsor promote is referred to as “carried interest”. In this article, we will define the sponsor promote, explore how promotes work, explain how they are justified as well as how they benefit both sponsors and investors and, finally, what they mean to investors under a direct-to-investor model, like the offerings on our Marketplace.
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Real estate sponsors usually invest their own capital into a deal alongside their equity co-investors. While it is possible for sponsors to subordinate their own capital to that of their investors, it is far more typical that they earn the exact same returns (this is known as being “pari passu”) as the other equity investors until they reach a certain return threshold (“known as the “preferred return”). Above the preferred return, sponsors will begin to divide excess profits disproportionately in their favor. The amount of money paid to the sponsor above the amount earned on his/her contributed capital to the deal is the promote.
Example: A sponsor contributes 10% of his own capital as part of the total equity required to acquire a property and raises the remaining 90% of total equity from other investors. The sponsor contributes his 10% of the equity in the same entity as the other 90% of co-investors. Therefore, “Members” is 100% of equity. Also, the sponsor is the General Partner, and the investors are Limited Partners.
Below is a detailed look at the priority of distributions and profit-sharing, known as the “waterfall” that includes the sponsor promote and an explanation of each tier:
DISTRIBUTION WATERFALL
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First, 100% pro-rata to the Members until each member has received an amount equal to a 10% IRR preferred return and its unrecovered capital contribution
Explanation: Since the sponsor has contributed 10% of total equity alongside his co-investors, this first tier of the waterfall splits revenues on a 90% (investors) / 10% (sponsor co-invest) basis until everyone has received a full return of capital plus a 10% annualized compounded rate of return. This first tier is the preferred return.
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Second, 75% to the Members until each member has received an amount equal to a 20% IRR, and 25% to the General Partner as Promoted Interest.
Explanation: This is the first tier of the promote. Above a 10% IRR, the sponsor now earns 25% of all excess profits over and above the sponsor’s pro-rata share of his own profits from his 10% equity contribution. This disproportionate profit split continues until the Members receive a 20% IRR. Another way to look at this second tier is on a pure investors vs. sponsor split basis. Since investors contributed 90% of total equity, then at the second tier, they receive 75% of 90% or 67.5% of excess profits above a 10% IRR up to a 20% IRR. The sponsor receives the balance or 32.5% of excess profits above a 10% IRR up to a 20% IRR, which is inclusive of his 10% equity contribution.
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Thereafter, any remaining net cash shall be distributed 60% to the Members and 40% to the General Partner as Promoted Interest.
Explanation: This is the second and final tier of the promote. Above a 20% IRR to all equity, the sponsor now earns 40% of all excess profits. When looking at it from the pure investor vs. sponsor split perspective, this would mean that investors receive 60% of 90% or 54% of profits above a 20% IRR and the sponsor receives 46% of excess profits above a 20% IRR, which is inclusive of his 10% equity contribution.
Why does the sponsor deserve to earn a promote?
An investor might look at the waterfall structure detailed above and think, “If the property performs exceptionally well, the sponsor stands to make a lot more money in this transaction than investors.” However, it is important to remember that investors are relying upon the sponsor, among other things, to do the following:
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Source and identify assets
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Underwrite and discover hidden value
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Pursue, negotiate and win deals
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Develop asset business plans
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Negotiate purchase and sale agreements
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Conduct thorough due diligence
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Close deals
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Manage assets
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Lease to new tenants
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Renew leases with existing tenants
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Perform and manage capital expenditure projects
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Execute asset business plans
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Dispose of assets; and
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Deliver investment returns
Considering that the sponsor does all of the heavy lifting in a deal while investors are paid a preferred return or are “unpromoted” up until a hurdle return, it is logical for the sponsor to expect to earn a greater share of profits than their pro-rata equity participation would otherwise suggest.
Win-win scenario
The sponsor promote incentivizes sponsors to exceed expectations and beat the original pro forma or business plan. If a sponsor beats expectations, their bonus is earned in the form of the promote. Equity investors also share in those additional profits but to a lesser degree. Because investors rely on the sponsor to execute upon the items listed above, they want to incent the sponsor to keep his/her eye on the prize, and the carrot of disproportionate profits participation is a strong incentive.
It also is important to note that a promote structure can vary depending on the sponsor and the type of property. Generally speaking, the more the sponsor has to work to generate the targeted returns and/or have the greater the complexity of the deal, the more favorable the splits of the promote will be for that deal.
Finally, keep in mind that a promote is separate and distinct from fees that a sponsor may earn in a deal, which can include acquisition fees, asset management fees and, potentially, disposition fees.
The direct to investor difference
One of the advantages of a direct-to-investor platform is that there is only one promote, which is paid to the sponsor. Platforms that use a special purpose vehicle (SPV) model to list offerings may also include a second promote. In this double-promoted structure, project profits are split twice- once between the platform and sponsor, and once between the platform and investor- before the investor receives anything. The CrowdStreet Marketplace, however, uses a direct to investor platform that does not charge a second promote.
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Prior to making an investment decision, it is important to understand the sponsor promote including tiers and splits and whether or not that is the only promote in the deal. CrowdStreet’s policy is that a sponsor must be fully transparent regarding offering information. Specifics on the sponsor promote may always be found on the detail page under the Summary of Terms tab.
