GP Distribution using GP Capital Account

[Anonymous]

Hey Spencer,

Regarding the Frost and Main Partnership Modelling assignment, I took your advice and decided to build my own excel model from scratch. I mostly follow the same format as your template, except I decided to model out a capital account for the GP in each hurdle the same way we do for the LP, to do a GP IRR check.

In doing so, I noticed I was limiting my GP distribution to it’s capital account balance. For example, my formula would be something like =MIN(GP Beginning Balance + GP Required Return – GP Prior Distributions, Available Cashflow * GP Distribution %), whereas your formula is simply =(LP Distribution/LP Distribution %)*GP Distribution %. I hope this link works – If you take a look at my attached Excel Model, it is in Month 120 of Hurdle 2 that our GP numbers start to differ.

I understand that the terminology in the Partnership Agreement says something like “Excess cash flow will be distributed to X% to the partners in accordance with their partnership percentages, and Y% to the GP as a promote until the LP has achieved Z% IRR”, but don’t we need to hold the GP to the same Z% IRR in each hurdle as well? Because otherwise, the GP always gets a higher IRR than the LP in the 2nd,3rd hurdles.

Thanks a lot Spencer! It’s these nitty gritty stuff in partnership modelling that always gets me every time…

Josh

[Spencer Burton]

Hey Josh,

I’m glad you’re getting into the nitty gritty and building these models yourself – this is how you learn!

To your question, you state: “I understand that the terminology in the Partnership Agreement says something like “Excess cash flow will be distributed X% to the partners in accordance with their partnership percentages, and Y% to the GP as a promote until the LP has achieved Z% IRR” – and you’re 100% on target here.

But remember, what the statement is saying is that the GP is distributed X% and the LP is distributed Y% in each tier until the LP hits Z% IRR target. Or in other words, irrespective of the balance of the GP’s capital account or the GP’s IRR at any point, once the LP hits a hurdle, the distribution %s change.

It just so happens in this case, that the GP and LP are distributed pro rata based on their ownership share in the first tier, such that the GP’s IRR and LP’s IRR upon hitting the first tier IRR are the same. But as soon as the GP is distributed a share of the distributions above its pro rata share in subsequent tiers (e.g. 2nd, 3rd, etc), its IRR will be greater than the LP’s IRR.

This is the purpose of the promote. To pay the GP an outsized share of the cash flow distributions when the GP exceeds the LP’s expectations (i.e. preferred return).

In terms of the model you built.

Attached find your model with my notes and changes highlighted in yellow.

Again, the GP is not targeting a required return – only the LP is. And since the GP gets an outsized share of cash flow in subsequent tiers (ie. 2nd, 3rd, 4th), once the LP hits its required return in the 1st tier, the GP’s IRR will be higher than the LP’s as cash flows in to the subsequent tiers.

Let me know if you have any questions!

Spencer

[Anonymous]

Thanks for the clarification Spencer!

I did read a little bit more in to Stevens Carey’s paper you posted, and he also suggested under section 8.1 that accounting for the service partner’s IRR will indeed complicate things past the first hurdle. But you put it in context for me perfectly when you said that the IRR is only a target for the LP, and not the GP.

I was initially confused because for the cash-on-cash hurdles we worked on earlier, we had to model the capital account and returns for both the LP and GP. Partnership modelling is really proving to be conceptually difficult for me because of all these finer details. You mentioned before that a lot of lawyers end up making it in real estate profession, guess it’s not hard to see why!

And definitely you’re right – whereas previously I was leaning more on using your excel templates to get through the accelerator, I am starting to instead model everything from scratch. It not just helps me understand the concepts better, but also makes me more comfortable with speed on the keyboard.

Thanks again for the help/tips! Cheers

[Spencer Burton]

Glad to hear it Josh – Keep the great questions coming!

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