Recently, we had an A.CRE reader ask us about the mechanics of Preferred Return distributions in our equity waterfall models with IRR hurdles. Specifically, he questioned the timing of when and how Preferred Return vs Return of Capital were distributed. In this blog post, I’ll share the response I gave him in order to help others using our equity waterfall models with IRR to better understand the methodology we use in those models.
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Understanding the IRR Preferred Return Hurdle
For those who are unfamiliar with the concept of an IRR preferred return hurdle, allow me first to explain. An IRR preferred return hurdle in a real estate equity waterfall is a minimum internal rate of return that one or more of the partners must achieve before a disproportionate share of the excess cash flow (i.e. the promote or carried interest) can be paid to the sponsor/GP.
What’s important to remember is that it’s impossible to hit an IRR hurdle without returning 100% of contributed capital. You can test this by running an IRR calculation in Excel. For instance:
- Assume a 10% IRR preferred return hurdle
- Assume an investor contributes 1,000 to an investment
- Assume an investor receives an amount in distributions each year equal to 10% of its initial contribution
- Assume that 0 has been distributed toward returning capital to the investor
What is the investor’s IRR at the end of a five-year period of the scenario above? The answer is NOT 10%, but rather -19.40%. Or in other words, the investor has NOT yet hit the 10% IRR preferred return hurdle.
In order to do so, the investor must a) receive an amount in distributions each year equal to 10% of its initial contribution AND b) receive a full return of its capital. When that is the case, the resulting IRR is 10%.
- Click here to download this example calculated in Excel
Preferred Return vs. Return of Capital Distributions in our IRR Equity Waterfall Models
Returning to the question raised by the A.CRE reader. He presented us with a scenario where the LP must hit an 8% preferred return IRR hurdle before the GP earned a promote. In his specific scenario, the model split distributions to cover both the preferred return and the return of capital contributions, such that the project had an 8% IRR.
- Click here to view the Real Estate Equity Waterfall Model – IRR and Equity Multiple Hurdles that the A.CRE reader was using in his analysis
The question arose about the actual timing of how the distributions were split, as it seemed the preferred return was being frontloaded in the first year vs. being spread out over the hold period. The numbers were specific to the user’s model, but the concepts apply generally. And so this was my response:
The IRR Hurdle and Time Value of Money
To hit an 8% IRR, two things must happen:
- Some amount of cash flow above capital contributed must be distributed to the partner (i.e. the preferred return)
- The entire amount of any capital contributed must be returned to the partner
Now what’s interesting about an IRR hurdle, due to the time value of money, is that the amount needing to be distributed increases as the time that hurdle goes unhit increases. If the hurdle is hit on day 1, the preferred return amount is approximately 0.
Whereas, if the hurdle is hit on day 3,650 the preferred return amount is several multiples of the total amount contributed. Thus, the two are intertwined and hence both exist in the same tier: as those two forms of distributions are really one and the same.
Which Distribution Happens First – Preferred Return or Return of Capital?
Now the issue users often get caught up on is the timing of how preferred return and return of capital are distributed. Does the first dollar go toward preferred return? Does it go towards return of capital? Or does it go towards some mix of the two?
For instance, if 1,021,352 must be distributed against a 900,000 contribution in order to hit an 8% IRR hurdle, when does the 121,352 of preferred return get distributed and when does the 900,000 in return of capital get distributed?
The reality is that it doesn’t actually matter whether the preferred return dollar was distributed first or the return of capital dollar was distributed first. Both must occur to hit the hurdle, with the allocation of those distributions to preferred return vs return of capital being irrelevant to hitting the hurdle.
Refer to the Partnership Agreement
Now with that said, the allocation of those distributions is relevant to the extent that the partnership agreement spells out which is paid first (or some mix). In this particular model, I assume that the partnership agreement calls for the preferred return to be paid first (a common structure I personally use), followed by a return of capital. Again, the order of these two might differ from agreement to agreement, but the end result from the perspective of modeling an IRR hurdle is identical.
Preferred Return First, Return of Capital Second
So, let’s take as an example our Real Estate Equity Waterfall Model with IRR Hurdles together with the scenario of an 8% preferred return, over three years, against a 900,000 contribution of capital. In practice, every dollar available to distribute to a partner must be distributed until that partner has hit an 8% IRR.
In this case, the first hurdle is hit in year three when 1,080,557 has been distributed such that the LP has earned an 8% IRR.
And at the point that the 1,080,557 had been distributed, and since the partnership agreement calls for the preferred return to be paid first, the accounting group can determine that the first 180,557 distributed constitutes the preferred return while every dollar thereafter constituted a return of capital.
And since more than 180,557 was available to distribute in year one, the entirety of what constitutes preferred return was distributed in that first year, with every dollar thereafter being considered return of capital. But again – with an IRR hurdle – the timing is a distinction without a difference.
Or in other words, the breakout of distributions of preferred return and return of capital are handled as follows.
- At the point that the preferred return hurdle is hit, a lookback occurs during which the distributions are split first to preferred return and second to return of capital
- All distributions first go toward the preferred return required to hit a given IRR hurdle over a given period of time
- Once that event has occurred, all distributions thereafter go toward a return of capital
Hopefully, that provides some greater color on the nature of preferred returns and how they’re accounted for in financial modeling. Getting to this point in your modeling proficiency will really highlight your value among your peers!