In a previous post on understanding the relationship between a GP and an LP, I touched on how the General Partner contributes a small portion of the required equity, but will generally earn a return in excess of their pro-rata contribution. In effect, the GP earns two streams of income from the property, including:
1) Their pro rata share of the investment (e.g. 10% equity contribution), and
2) A "promoted" interest in the investment returns after some return hurdle is achieved and surpassed.
The latter stream, the "Promote," is used to incentive the GP to achieve an above-average investment return. The promote can be calculated a number of ways - on a cash flow basis, with IRR hurdles or even with equity multiple hurdles.
Today, we'll focus strictly on a share of cash flow after a preferred rate of return is achieved.
The attached waterfall hypothesizes a deal whereby $2,500,000 of equity is required, of which the LP will contribute 90% and the GP will contribute the balance of 10%. The model includes two "tiers," the first of which is a preferred rate of return (12%) and the second being a split of available cash flow above the preferred rate of return.
In this example, both the GP and LP earn a pro-rata share of returns up to a 12% preferred rate of return. The model includes an accrual, such that any distribution shortfalls are compounded and paid at such a time that the property's cash flow can support the preferred rate of return.
After the preferred return is paid current, the balance of available cash flow is split as follows (feel free to play around with these splits in the model):
LP - 80%
GP - 10%
Promote - 10%
The GP's share of all remaining cash flow remains a constant 10%, whereas the LP's investment is "promoted" by 10%. That is, the LP is giving up 10% of their post preferred cash flow to the Sponsor (the GP) as compensation for strong investment returns.
In that only the LP is being promoted, you'll see that the GP's internal rate of return (IRR) and their Multiple on Invested Capital (MOIC) is at the property level, whereas the LP's returns are lower due to compensation being paid as a "promote" to the Sponsor.