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Hello Spencer,
I’m curious if you will consider discussing how to model GP’s “Catch Up” and “Clawback” Provision?
Thanks,
Kyle Chuang
Another great question!
First an important point on the subject of JV partnership provisions. There are so many variations of these (and other) provisions that it’s impossible to definitively say: “this is how you model a catch up or clawback“. To illustrate what I mean, read Stevens A. Carey’s paper on the subject: ‘Real Estate JV Promote Calculations: Catching Up With Soft Hurdles” where he gives at least half a dozen examples – each that would be modeled differently from the next. And those are just a handful of the dozens of variations you might run into.
So rather than teach you how to model one or two methods, it’s more important to become proficient at modeling waterfall tiers, tracking capital accounts and required returns/distributions, and calculating contributions and distributions accurately. Once you’ve mastered that, you’ll find you’re able to model all sorts of different JV structure provisions without issue.
With that said, allow me to give an overview of the two provisions you bring up and offer high-level suggestions for how to model each.
Clawback Provisions
In my experience, Clawback provisions are most commonly used in JV structures with multiple investments being made by the partnership (i.e. portfolios or multi-phase developments). Clawback provisions are meant to protect the LP from scenarios where later investments underperform earlier investments. So for instance, if cash flow from later investments is insufficient to pay the LP its preferred return and/or return capital, the LP would have the right to “clawback” earlier distributions made to the GP.
Here is a resource you can read on the subject.
Carey also brings up a variation on the clawback concept, even though he refers to it as a “lookback”. He uses it in the context of a single investment, where profits are distributed to the GP before the LP reaches its preferred return hurdle. In the event the investment closes and the LP hasn’t hit its hurdle, the GP would have to return a portion of the profits it has received. I’ve never seen an LP agree to this structure, although I’m sure it happens.
Modeling this involves tracking the cumulative amount distributed to the GP, and using that amount as a cash flow source at reversion from which to distribute back to the LP in the event the cash flow from the property is insufficient to hit the LP’s required return.
Catch Up Provisions
In my experience, Catch Up provisions are most common to pref equity structures or to JV structures where the LP has a priority right to distributions up until it earns its preferred return. Or in other words, in structures where the LP receives 100% of distributions until it hits its preferred return hurdle.
Let’s assume the LP and GP agree that profits should be distributed (i.e. Profits = Total distributions minus amount required to repay contributed capital) 50% to the LP and 50% to the GP until the LP has earned a 10% IRR on its investment. However, the structure requires that 100% of the distributions be made to the LP until the LP has achieved its required return. Thereafter, the GP is entitled to 100% of the distributions until it has received 50% of the profits (i.e until the GP has “caught up” with the LP). Once both the LP and GP have each received 50% of the profits and the LP has earned a 10% IRR, the waterfall proceeds to the next tier.
Modeling this involves tracking the profit distributed and what share is owed to the GP (i.e the GP’s required distribution). Once the LP has hit its required return, excess cash flow is distributed 100% to the GP until it has hit its “required distribution” or in other words until the GP’s profit distributed equals the LP’s profit distributed in that tier.
Thought I’d share an example I quickly put together of how you might model a Catch Up provision.
Click here to download the template used in this video
Kyle,
This question inspired me to build a real estate equity waterfall with catch up and clawback provisions included as options. You can check out the model here:
https://www.adventuresincre.com/real-estate-equity-waterfall-model-catch-up-clawback/
At some point, I’ll create a supplementary lecture to this course with a Watch Me Build showing you how to add model the catch up and clawback provisions. I’ll notify you in this thread once that happens.
Spencer
I’ve since created a lecture on the GP Catch Up concept in our Advanced Concepts course. In that lecture, I share both a catch up to net profit, as shown here, as well as a catch up to a given IRR hurdle. You can find that lecture here:
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