When a sponsor assembles the finance for a real estate transaction, there are two groups—apart from the lender—with vested interests who need compensation for their roles: the sponsor and the investor.
After the bank or non-bank lender has been paid a direct interest return on the debt they provided, these groups share the profits from the transaction between them.
The sponsor is paid what is called, in real estate language, a ‘promote.’ In the non-real estate investment world, this is known as ‘carried interest.’
The purpose of the promote is motivation and incentive for the sponsor to do their best to ensure a successful, profitable project.
Essentially, this means that the sponsor receives a share of the property upside for finding and managing the deal, as well as—in some cases—for renovating the asset and managing property operations and resident relationships.
In a typical fund structure, the investors will be paid a preferred return out of available cash flow, which is the equivalent of interest on their invested capital, plus the lion’s share of any profits.
The remainder of the profits is paid to the sponsor in the form of the promote.
Seasoned sponsors will often provide for different tiers—called breakpoints—of promote to reward increased investment by individual investors, and may offer increased preferred returns to incentivize investors—particularly when raising capital in fund structures.
Fund II Structure
For example, in Trion’s Fund II, the investors receive differing pro rata shares of the upside, depending on how much they have individually put into the fund, with Trion retaining the remainder as the promote.
By creating different investment hurdles, partners making larger investments are provided a greater share of the profits.
Specifically, if somebody invests over $1 million, they receive 78 percent of the cash flow from their investment.
If somebody invests $250,000 to $1 million, the investor receives 76 percent, and if somebody invests $50,000 to $250,000, they will receive 74 percent of the profit.
Some funds have significantly different breakpoints, with much wider variances—or none at all.
It is not uncommon to see breakpoints with 5 percent variations, for example: 70 percent, 75 percent, and 80 percent.
With Fund I Trion had no breakpoint, while with Fund II we wanted to reward investors who showed a greater commitment, while at the same time not making it too punitive to our smaller investors, because they’re the backbone of our community.
Another common structure often seen in funds is where, rather than breaking against the amount that somebody invests, the breakpoints are against IRR hurdles.
For example, after an 8 percent preferred return, the investors may receive the first 80 percent of profits, with the sponsor’s promote at 20 percent.
Then, after a 14 percent IRR, investors will get 70 percent, and the sponsor’s promote would be 30 percent.
We have seen sponsors offering preferred returns as low as a 6 percent, and smaller shares of splits.
The Impact of the Cycle
For splits to reach the 50:50 level, experienced sponsors will typically suggest that level of promote only when investors have achieved 16 percent IRR or more.
That said, for common equity, it won’t often get to that point.
This is because when a project has the potential for such high returns, it makes more sense to offer investors lower risk, lower return participation where they still do very well.
For example, if a deal has the possibility to of hitting a 30 percent IRR—more common during early cycle periods than late—sponsors are going to be more inclined to load it up with preferred equity offering 12-13 percent interest rates with no share of profits, because it provides strong returns to investors while rewarding sponsors for taking on higher risk.
In later cycle periods where deals are more likely to pencil to 17 percent project-level returns or so, which translates into 14 percent IRR investor-level returns, putting 12 percent preferred equity doesn’t make sense.
Avoiding The Double Promote
One thing investors should remain alert to with a fund is the possibility that a sponsor may be double promoting them.
One way this can happen is where a sponsor is running a fund while simultaneously investing outside of the fund.
For example, on a typical standalone structure there might be 75 percent split to the investor, 25 percent to the sponsor after the pref has been paid, manager catchup, and capital returned.
Then, in the sponsor’s fund, there’s also that share.
A double promote, or double-dipping, would be where the sponsor’s fund invests into a deal but is not the sole investor.
In this case, investors in the fund would be paying the sponsor a promote at the fund level and paying a promote at the deal level.
It’s something that sponsors do—and is oftentimes overlooked by investors—but it’s not something that Trion does.
While our funds do invest alongside investors in individual deals, we rebate Trion’s upside at the deal level back to the fund, and we don’t take our promote on that deal on the fund’s investment—instead rebating it back to the fund.
The result is that Trion only gets an upside when the fund metrics are achieved, not on any specific investment that the fund is invested in.
This is something investors should look carefully at when investing in funds that themselves invest in different projects.