Cash-on-Cash Hurdle Waterfall Question

[The A.CRE Team]

This question originally came in via email.

Spencer,

For your Cash on Cash Hurdle Waterfall, would it make more sense for the LP (and GP) formulas for Contributions and Distributions on the Pref Return to pull off of Before Tax Cash Flow (Capitalized Expenses and Operations Only) on row 35 rather than off of Net Property-Level Cash Flow on row 37?

On the Promote part after this for remaining cash flow you do reference row 35, which makes sense since we just want to focus on the operating cash flow for this part.

Thanks

[Spencer Burton]

Hi,

Great question! The broader answer to this question is that it depends on the wording of the JV agreement. But in this case, either way will work. Allow me to explain why.

Unpaid Preferred Return Accrues

If you recall, the partnership agreement reads as follows: “Partners to be paid an annual 8% preferred return on the current balance of each partner’s capital account, distributed equally per each partner’s ownership share; any unpaid preferred return to accrue to the partner’s capital account”.

The key part is “any unpaid preferred return to accrue to the partner’s capital account.” So in periods when there is insufficient operating cash flow to pay the full required preferred return, the capital account of the partner grows. At the capital event, that shortfall is paid by capital event funds prior to any capital event funds going towards promote.

Modeling this in Practice

The practical impact of this, from a modeling perspective, is that we can model contributions and distributions from either the ‘Before Tax Cash Flow (Capitalized Expenses and Operations Only)’ line or the ‘Net Property-Level Cash Flow (After Debt but Before Taxes)’ line and the result will be identical. Allow me to prove this out.

Attached find a modified version of the ‘Cash-on-Cash Hurdle’ exercise file from the course. Highlighted in yellow you’ll find the modifications as follows:

1) Row 46 (LP Distributions) and row 53 (Sponsor Distributions) now pull from row 37 (Net Property-Level Cash Flow) rather than row 35 (Before Tax Cash Flow).
2) Cell R90 on the DCF tab set to 0, to assume a scenario where there is 0 operating cash flow in year 10

Click here to download the modified version
Click here to download the original, but with 0 operating cash flow in year 10

If we then take the original method, and set operating cash flow to 0 in year 10, we get the following returns for the LP and Sponsor:

• LP Profit: 22,186,612
• LP IRR 11.76%

• Sponsor Profit: 10,605,622
• Sponsor IRR: 28.58%

In the modified method with the above changes instituted, we get the following returns for the LP and Sponsor:

• LP Profit: 22,186,612
• LP IRR 11.76%

• Sponsor Profit: 10,605,622
• Sponsor IRR: 28.58%

Digging into the cash flows, what we see is that the unpaid preferred return in the original version is paid by capital event funds as part of the preferred return hurdle. Whereas in the modified version, the unpaid preferred return is paid as part of the ‘Net Cash Flow at Capital Event’ hurdle. But the end result is identical.

For Consistency the Modified Method is Better

With all of that said, and the reason I spent so much time talking through this, is that the modified method you suggest is better. That’s because, as you rightly point out, the Preferred Return hurdle is meant to model cash flow during operation. Thus, it makes sense not to pull capital event cash flows into that tier, but rather pull them into the ‘Capital Event’ tier and make up for preferred return shortfall there.

Now again, this is largely semantics since the end result is the same. But for consistency, the modified method is better.

Thanks again for bringing this point up!

Spencer

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