A.CRE

Catch Up Provision

A provision included in certain real estate partnership agreements, whereby a special distribution tier is included in the equity waterfall that allows for the general partner (GP) to “catch up” with the limited partner’s (LP) cash flow distributions. The reason for why the general partner’s distributions might lag, or the amount that must be made up with the “catch up” tier,  depends on the terms of the partnership structure.

Catch up provisions are most common to structures where the limited partner receives 100% of distributions until it achieves some preferred return requirement, at which point the GP receives 100% of excess cash flow thereafter until some equitable balance between the LP and GP distributions is achieved.

For example, imagine a limited partner contributes 100% of required capital to a real estate venture in return for a 12% preferred return and 50% of all excess cash flows above that threshold. The agreement states that the limited partner will receive 100% of all cash distributions until it has earned a 12% internal rate of return, at which point the GP receives 100% of cash distributions until both partners have received 50% of profit distributions. Once the GP has caught up with the LP, both partners receive any remaining excess cash flow 50/50.

Putting ‘Catch Up Provision’ in Context

Scenario Overview:

Georgia Investment Partners, a real estate private equity firm based in Atlanta, Georgia, has identified a value-add opportunity in a 200-unit market-rate apartment community called Magnolia Heights Apartments. Located in a desirable suburb of Atlanta, this 1980s-era property requires renovations to modernize the units and common areas, which will allow the firm to increase rents and improve the asset’s overall performance.

Investment Structure:

Georgia Investment Partners is partnering with a limited partner (LP) who is contributing 90% of the required equity, amounting to $9 million of the $10 million total equity needed. Georgia Investment Partners, as the general partner (GP), is contributing the remaining $1 million. The partnership agreement includes a 9% preferred return for the LP, and a catch-up provision designed to align the interests of both parties.

Catch Up Provision Explained:

Per the agreement, the LP will receive 100% of the distributable cash flow until it has achieved a 9% internal rate of return (IRR) on its $9 million investment. This preferred return ensures that the LP’s risk is mitigated, given its substantial capital contribution.

Once the LP reaches the 9% IRR threshold, the catch-up provision kicks in. At this point, Georgia Investment Partners, as the GP, will receive 100% of the distributable cash flow until they also achieve a 9% IRR on their $1 million investment.

Illustrative Example:

Let’s assume that after several years of operations, the property generates sufficient cash flow and sale proceeds such that the LP has received $3.24 million in distributions, equating to a 9% IRR. Now, Georgia Investment Partners will begin to receive 100% of the cash flow until they too have achieved a 9% IRR on their $1 million investment, which would be approximately $360,000 in distributions.

Following this catch-up phase, any remaining profits will be split 50/50 between the LP and the GP.

Outcome:

This structure motivates Georgia Investment Partners to maximize the property’s performance so they can reach the catch-up phase and ensure both the LP and GP achieve their preferred returns. The LP is protected by the preferred return, ensuring they achieve a baseline return before the GP starts to benefit significantly from the deal.

The catch-up provision, in this case, ensures that both the LP and GP achieve their respective 9% IRRs before profits are split evenly, aligning the interests of both parties and providing the GP with strong incentives to exceed performance expectations.

Frequently Asked Questions about Catch Up Provisions in Real Estate Partnerships

A catch-up provision is “a special distribution tier… that allows for the general partner (GP) to ‘catch up’ with the limited partner’s (LP) cash flow distributions.” It ensures that both parties receive an equitable share of profits after the LP receives a preferred return.

Catch-up provisions are used to align incentives between LPs and GPs. They ensure that “both the LP and GP achieve their respective [preferred returns] before profits are split evenly,” motivating the GP to maximize performance.

The provision activates once the LP achieves its preferred return. Then, “the GP receives 100% of cash distributions until both partners have received [the same IRR],” effectively catching up the GP to the LP’s return level.

In the example, the LP received 100% of cash flow until achieving a 9% IRR on its $9 million. Then, the GP received 100% of distributions until reaching a 9% IRR on its $1 million. After that, profits were split 50/50 between LP and GP.

Catch-up provisions are triggered based on IRR benchmarks. The LP must first “achieve a 9% internal rate of return,” after which the GP can catch up by receiving all cash flow until achieving the same 9% IRR.

No, catch-up provisions are common but not universal. They are “most common to structures where the limited partner receives 100% of distributions until it achieves some preferred return requirement.”

The GP benefits by receiving 100% of distributions for a period once the LP’s preferred return is met, allowing them to “catch up” in terms of returns and profit participation, which aligns their upside potential with the project’s performance.

After the catch-up is complete and both parties have received their agreed IRRs, “any remaining profits will be split 50/50 between the LP and the GP,” or according to the final tier of the waterfall structure.

Click here to get this CRE Glossary in an eBook (PDF) format.
by