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This practice note examines issues to consider when drafting the
promote mechanic provisions of a limited liability company
operating agreement (also referred to as the joint venture
agreement). Sample provisions illustrating the concepts discussed
in this practice note are included in the exhibit.
This practice note assumes that the limited liability company is
formed in a state with a statute similar to the Delaware Limited
Liability Company Act (6 Del. C. Sec. 18-101 et seq.). The members
of the limited liability company may be referred to herein as
members or partners. This practice note assumes familiarity with
basic principles of real estate joint ventures agreements.
For additional real estate joint venture resources, see Real Estate Joint Venture Resource Kit (90/10 Real
Estate Joint Venture).
The Promote
Promote mechanics are built into the distribution waterfall
provisions of a joint venture agreement. To understand promote
mechanics, one must also understand the distribution waterfall
provisions.
The distribution waterfall provisions dictate which of the
parties will receive cash returns on their investment and the
relative priority and timing of distribution of such returns. The
“waterfall” refers to the order in which available cash
is distributed to the parties, and the “promote” is
embodied in the waterfall.
The waterfall varies from deal to deal and is typically tailored
to the specifics of the transaction. The waterfall may also vary
within the same joint venture agreement for different categories of
available cash, such as operating cash flows and capital event
proceeds.
It is called a waterfall for good reason. The waterfall
structure can be visualized as water cascading down a series of
ponds. The water represents the available cash to be distributed to
the parties. Water fills the first pond in the sequence and, if
there is enough water, the excess water flows over the rim and down
into the next pond in sequence. Each pond represents a separate
agreement between the parties as to how available cash will be
split among them at that level.
The rim of each pond in this illustration is what is referred to
as the “hurdle.” Prior to reaching the rim of the first
pond (i.e., achieving any of the hurdles), the joint venture
typically distributes available cash pari passu, meaning each
party’s return ranks equally in priority, and pro rata in
amount, meaning relative to each parties’ respective percentage
ownership in the joint venture.
After a hurdle is achieved, a party may be entitled to a share
of profits that is greater than the pro rata share that the party
would otherwise be entitled to based on its ownership percentage.
This disproportionate share of the proceeds is the promote, or, as
known in other forms of alternative investment, “carry,”
and the right to a promote or carry is often called a promote
interest, carried interest, profits interest, or colloquially as
sweat equity.
The Sponsor and the Sponsor’s Promote
There are typically two types of parties to a real estate joint
venture: the sponsor and the capital investor(s). Sponsors play an
active role in the venture, sourcing, and securing property
investments, financings, and other equity investors. Underwriting
and due diligence for investments is often handled by the sponsor.
Sponsors also usually act as the managing member, managing the
joint venture and potentially the venture assets, including
day-to-day construction and development, operation and leasing of
the property, and its ultimate disposition. Greater risk comes with
the role of sponsor who often assumes responsibility for cost
overruns and provides a guaranty of recourse obligations in
financings, thereby likely reducing the cost of financing to the
venture. In this role, sponsors contribute their valuable
relationships, expertise, and experience to the venture.
While joint ventures of other alternative investment types may
be owned relatively evenly (e.g., 50/50 or 60/40), it is more
common in real estate joint ventures for the sponsor to own a much
smaller equity stake than the capital investors, for example,
2%-15% owned by the sponsor and 85%-98% owned by the capital
investors. Determining the percentage ownership interest of the
sponsor requires balancing two of the capital investors’ goals:
to have greater control over key major decisions typically given to
those with a significant majority equity stake and, at the same
time, for the sponsor to have a sufficient investment (or
“skin in the game”) so that the sponsor and
investors’ interests are aligned and the sponsor remains
committed to maximizing value.
The promote can be thought of as both compensation for the
sponsor’s critical role in the venture as well as a powerful
incentive tool motivating the sponsor to create value or discover
hidden value, and ultimately generate profits that exceed budget
and business plan expectations. Upon achieving such superior
returns, the sponsor would be entitled to the promote, that is, the
sponsor would receive an excess share of distributions at a level
greater than the sponsor’s percentage interest in the joint
venture. This kind of graduated profit-sharing mechanism
incentivizes the sponsor to outperform so that greater
distributions will flow into the downstream ponds in which the
sponsor will be entitled to a larger share. The details of the
profit-sharing agreements of the different ponds are called the
promote mechanics.
Keep in mind that a promote is separate and distinct from fees
that a sponsor may earn in a deal. Fees may include acquisition
fees, disposition fees, asset management fees, development fees,
financing fees, property management fees, leasing fees and
commissions, license/franchise fees, technical services fees,
pre-opening fees, purchasing fees, and guaranty fees. Although fees
are beyond the scope of this practice note, it is worth noting that
such fees may cause a misalignment of interest between the sponsor
and any investor in that the sponsor may have a relatively small
equity stake in the venture but can receive substantial fee income
even if the venture’s performance is below expectations and the
capital investors do not achieve their anticipated returns.
Calculating Available Cash for Distribution
In a real estate joint venture, there are generally two sources
for cash distributions:
- Operating cash flow (e.g., rental income from tenants)
-and- - Cash from liquidation, refinancing, casualty or condemnation
proceeds, or the sale of capital assets (or capital proceeds)
Each are often referred to as available cash or cash available
for distribution in the joint venture agreement. Available cash may
be offset by liabilities, including costs of sale, sums required to
redeem loans on a disposition, current liabilities such as debt
service, taxes, insurance, general operating expenses, and other
budgeted expenditures and reserves or other holdbacks for
contingent liabilities. As noted earlier, the sponsor will often
charge the joint venture a series of fees. These fees may be netted
from property cash flow and reduce the overall return and cash
available for distribution for the investors.
Parties to the joint venture agreement will heavily negotiate
the definition of available cash for distribution. See Related
Companies, L.P. v. Tesla Wall Systems, LLC, 159 A.D.3d 588 (2018)
as an example of litigation that may ensue when a joint venture
agreement fails to define available cash. Plaintiff Related argued
in its summary judgment motion that “available cash”
meant “any money that [the venture] has or is able to obtain,
irrespective of whether [the venture] operates at a profit or
loss.” Defendant Tesla argued that the term referred only to
“after-tax profits available to the company after the payment
of all costs and expenses.” Since the company had no cash, the
court ruled in favor of Tesla on Related’s motion and reversed
the lower court’s grant of summary judgment because the
existence of available cash was a condition precedent to passing
funds through the waterfall.
The sponsor may argue for an open-ended definition of available
cash to include, simply, all net cash proceeds received by the
venture from any source and determined by the sponsor or managing
member to be available for distribution. This would allow the
sponsor to exercise its judgment and reserve amounts for known or
anticipated future obligations. The investors, however, may prefer
that the definition of available cash set out the specific
obligations, liabilities, and fees to be deducted from gross
proceeds in determining available cash and will want a
nondiscretionary requirement for the sponsor to distribute such
available cash.
The net surplus cash then goes through the waterfall set out in
the joint venture agreement which will provide for the return of
equity, the payment of any agreed hurdle before the promote, and
then payment of the balance in the pre-agreed proportions which
gives the sponsor its promote. Available cash from revenue
typically will be paid either monthly or quarterly or more
frequently as the sponsor elects, and available cash from a capital
event will be paid within an agreed number of days following the
closing of the applicable transaction, such as five days, subject,
in each case, to the distribution limitations imposed by any loan
agreement.
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Originally published by LexisNexis Practical
Guidance.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
