Sponsor's promote based on Cash on Cash Return instead of IRR?

[Account Closed]

I know people frequently structure deals with disproportionate distributions to the sponsor to reward them for their performance. 

Every waterfall model I've ever done has used IRR targets as hurdle rates.

This is great and all, and obviously if the property does exceed these hurdle rates, the sponsors can get paid off in a big way...

But since so much of the IRR comes from the sales proceeds, the sponsor doesn't see any of that bonus until the end. And why should they, right? I mean, most of the return for the investor is coming from that last cash flow when you sell. 

The problem is, if you're a lowly sponsor without much money, you might have to live off of your crappy pro-rata cash flow for years before your partnership sells off properties and you're rewarded with a huge windfall. 

Are there cases where sponsors are rewarded if they meet certain cash on cash targets, rather than IRR?

So far example, rather than giving the sponsor a 20% promote for anything above a 12% IRR, they'd receive a 20% promote for every year they exceed a 12% return on equity, then receive 20% on the backend in excess of whatever return brings the cash flows above 12% IRR. 

As an investor, would you ever consider this type of arrangement?

One alternative might be to give your investors a preferred return, and a locked in profit split for when you sell... do you think promising a preferred return would create problems for lenders?

Anything thoughts would be appreciated. 
Thanks,
Patrick 

[Brian Burke]

Preferred return means that 100% of the cash flow goes to the investor until such time as the hurdle has been met.  So let's say that you have an 8% preferred return, and in year 1 the investment throws off 4% in distributable cash.  In year 2 it throws off 8% and in year 3 it throws off 12%.  Up to this point the investor has received 100% of the cash flow because 4% accrued from year 1 and didn't get caught up until year 3.

As to waterfall structure, hurdles can be based on IRR or Cash on Cash. In the case of an IRR hurdle, return of capital has to happen by definition in order to hit the IRR hurdles, so effectively all cash goes to the investor until they not only receive the preferred return but also have received all of their capital back. This rarely happens during a hold period, so this means that all of the sponsor's promote comes out of the sale.

A cash-on-cash based waterfall can be structured such that the hurdles can be met from cash flow alone, with return of capital happening only at capital events such as a cash-out refinance or sale. Sometimes you'll see distributions first classified as a return of capital and the preferred return second...this is done to reduce the preferred return by constantly lowering the investor's capital account. Nevertheless, in the case of a CoC waterfall you CAN hit the hurdles during the hold period and collect promotes prior to the sale. But you're unlikely to see it for 3-4 years because accrued pref usually sucks up the cash in the early period as income is increased from renovations or churning the rent roll.

On the topic of making a living, it is in everyone's interest that the sponsor be compensated and keeps the lights on.  This is why it's tough for new sponsors to break into this business.  You don't earn a lot along the way, but you have to earn something.  Somewhat of a catch-22.  When I started doing pooled multifamily investments I had a well-established flipping business and other income property of my own, so that's how I paid the bills.  Some people keep their day jobs at first, until the business grows enough to earn a living.   This business is one where you earn a payday, not a paycheck.  Something to consider and plan for as you get started.

That said, you won't get very far if you have no money.  Lenders often look for a net worth equal to the loan amount and cash reserves at either some number of month's of debt service or some percentage of the loan amount.  So if you aren't already financially stable it's best to work on that before taking in investor dollars.  You'll need cash for earnest money deposits, lender deposits, third party inspections, due diligence costs, etc before you see your first OPM dollar.  Plus, if you are investing outside of your home turf you'll burn a lot of coin on travel expenses before you lock up a deal.  This is why you charge acquisition fees.  We've probably put out $20K to $50K in expenses by the time we even get a deal in contract and none of that cost is reimbursable.  Just one more reason to fill up the piggy bank before you get going.  And think about getting a partner with a sizable balance sheet and cash reserves if you don't have that yourself.