If a private equity’s fund’s financial performance turns out the way the fund managers predicted, they face a second layer of issues to deal with: compensation for the LP (investors) versus compensation for the GP (the fund managers).
Real estate private equity funds either share profits on a “deal-by-deal” basis or a “whole fund” basis. Within these two options, fund managers can use a variety of techniques to precisely time the distribution of profits to each party. This includes the fund’s performance, expected performance, and investment strategy.
GP (fund management) compensation
How does a fund’s owners and managers make money? Mainly through carried interest, which istheir incentive compensation to ensure the underlying assets perform up to par. Here’s how it works:
· Each investor in the fund recoups his or her capital contributions and a preferred return. Preferred returns are usually around 8% for value-add real estate funds, in the low teens for opportunistic funds, and in the 20’s+ for ground-up development.
· Once investors are paid up, fund managers can receive a percentage of the remaining profits in the form of carried interest. This is commonly 20% in real estate value-add funds. However, some funds may entitle the fund manager up to 100% of profits until they have reached 20% of the fund’s total profits. This is known as a manager catch-up.
1. Investment amount is paid back to investors
RETURN OF CAPITAL
1. Current income and disposition profts are calculated separately; each flows through the waterfall separately.
2. Investors are paid a preferred return
3. Manager receives 100% of remaining proceeds until they have earned 20% of overall fund profit
4. Remaining profit: 20% to manager and 80% to investor
CARRIED INTEREST & PROMOTE
Differentiating factors: Whole Fund vs. Deal by Deal compensation
When fund managers receive compensation on a deal-by-deal basis, returns are calculated for each investment. Carried interest, as a percentage of profits, is based on this calculation. In this compensation scheme, the P&L of each deal is isolated from the profits and losses of all of the other investments in the fund. When deals are completely isolated this way, it tends to encourage investors to make riskier investments: they can profit off of successful deals and consequences are low for financial failures.
One solution to this problem is in the “realized loss” deal-by-deal scheme, where any losses on assets must be made up from distributions from future realized (sold) deals. This must happen before reaching any other tier of the waterfall (ie, before the fund manager can receive catch-up or carry).
Note: the deal-by-deal payment scheme usually applies current income directly to carried interest and skips over the “return of capital” and “preferred return” tiers of the waterfall.
When fund manager receive compensation on a whole-fund basis, managers receive carried interest after investor funds are paid back for ALL investments in the fund, and a preferred return has been paid for ALL investments in the fund.
Over the life of a fund, the deal-by-deal and whole fund calculations offer the same profit share amount. So, what’s the difference? Timing. Fund managers receive compensation more quickly in the deal-by-deal model. Therefore, fund models are more favorable to investors because they get the benefit of time value of money. The carried interest to fund managers gets deferred.
One common variation of the whole fund model is where investors receive cua preferred return on ALL of the capital invested, but not necessarily any of their capital contributions recouped. Here, the fund manager receives carried interest on current income concurrently with the LP’s pref. This requires a clawback provision. This variation is midway between the “standard” whole fund setup and the deal-by-deal setup.
How Refinancing Proceeds are Treated
Investors prefer for any proceeds from refinancing to be treated as return of capital; fund managers prefer to consider it current income, and therefore receive the 80/20 split.
One technique for giving the fund manager incentive compensation for the value it has created is to look at the ratio:
total capital funded by an investor: new property valuation based on refi proceeds
Calculating this ratio allows an investor to receive his or her pro rata share of the proceeds.