A.CRE

Promote

A financial interest provided to the sponsor (investment manager) as an incentive to maximize performance. This is typically an outsized share of the profits, payable once the investors have received back their entire initial capital contributions and achieved certain profit thresholds (i.e. preferred return). Also referred to as the promoted interest, or carried interest.

Putting ‘Promote’ in Context

Scenario Overview:

Blue Cone Capital, a real estate private equity firm specializing in value-add investments, identifies an underperforming neighborhood shopping center in suburban Dallas, Texas, named Highland Plaza. The shopping center is 85% occupied with a mix of local and regional tenants, but many of the leases are below market rates, and the property needs cosmetic upgrades to attract more foot traffic and increase rental income.

Investment Strategy:

Blue Cone Capital acquires Highland Plaza for $12 million, with plans to invest an additional $2 million in renovations and tenant improvements. The goal is to increase occupancy to 95% and bring rents up to market levels, significantly boosting the property’s Net Operating Income (NOI) over a five-year hold period. The total project cost is $14 million, which includes the acquisition, renovation costs, and closing fees.

Promote Structure:

To incentivize strong performance, Blue Cone Capital structures the deal with a promote, or carried interest, that will reward them if the investment performs well. The equity investment is $5 million, contributed 100% by Blue Cone Capital’s investors, with the following promote structure:

  • Preferred Return: 8% annual preferred return to investors on their $5 million equity contribution.
  • Promote Split: After the preferred return is met and the investors have received their capital back, remaining cash flows are split 30% to Blue Cone Capital as a promote with the remaining 70% distributed to the investors.

Performance Outcome:

Over the five-year hold period, Blue Cone Capital successfully implements its value-add strategy. The renovations attract new tenants, increasing the occupancy to 95%, and rental rates rise by 15%. At the end of five years, Highland Plaza is sold for $18 million, generating significant profits.

Here’s how the promote works in this scenario:

  • Total Profit: The property sells for $18 million. After paying off the $9 million debt and returning the $5 million equity, the remaining profit is $4 million.
  • Preferred Return Calculation: The investors are first paid their preferred return of 8% per year, which amounts to approximately $2 million over five years.
  • Profit Split: After the preferred return, $2 million in profit remains. This amount is split 70/30:
    • Investors receive 70% of $2 million = $1.4 million.
    • Blue Cone Capital receives 30% of $2 million = $600,000 as the promote.

Conclusion:

In this hypothetical scenario, Blue Cone Capital’s promote incentivizes them to maximize the value of Highland Plaza, aligning their interests with those of their investors. By successfully executing the value-add strategy, Blue Cone Capital earns an additional $600,000 in promote, on top of any returns from their own equity investment. The promote structure is a critical tool in aligning the interests of the sponsor with those of the investors, ensuring that both parties benefit from the successful execution of the business plan.

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