Preferred Return Calculation

[Anonymous]

7 years, 5 months ago #2458

Good chance this is user error, but I’m trying to create a model with an 8% pref to the LPs followed by a 70/30 split on anything above that (70% to the LPs, 30% to the sponsor). In the required return line for the sponsor, the model appears to be trying to give the sponsor the 8% pref along with the LPs, rather than just the LPs. I have Hurdle 1 set up as at 8% pref with 0% to the sponsor and 100% to the LP. Then Hurdle 2 is anything from 8% to 200% IRR with 30% to the sponsor and 70% to the LP. Is that the right way to set it up?

Thanks.

[Spencer Burton]

7 years, 5 months ago #2852

Thanks for pointing this out! This is not necessarily an error (the outcome is still correct), but it does suggest that the ‘Sponsor Capital Account’ lines on the Equity CF and Sponsor CF tabs are superfluous. I’ll remove references to the ‘Sponsor Capital Account’ in the next version of the model, to avoid confusion in situations where the Sponsor is not owed a preferred return.

This really gets to the waterfall’s methodology. Here’s why the outcome is still correct, even when the waterfall model is showing a growing Sponsor Capital Account:

The base line assumption, is that the LP’s capital account during development and operations grows by the rate of the preferred return (D18). Distributions in hurdle 1 (Preferred Return and Return of Capital) are then made based on the assumption entered in the ‘Distribution as %’ table (H17 and I17). Methodologically speaking, hurdle 1’s sole purpose is to pay down the LP’s capital account, irrespective of the sponsor’s capital account balance. And since the LP capital account grows at the rate of the preferred return, hurdle 1 also indirectly pays the preferred return amount owed to the LP; assuming there is sufficient cash flow to do so. Consequently, the amount distributed to the Sponsor in hurdle 1 is purely the difference between the amount distributable to the LP in order to pay off the LP’s Capital Account, grossed up by the LP’s Distribution share in hurdle 1 (I17). The balance of the Sponsor’s capital account, grown or not by the rate of the preferred return, does not affect the amount distributed to the Sponsor in hurdle 1 or any other hurdle. You can see this formula for the Sponsor’s hurdle 1 distribution in row 59 of the Equity CF tab.