Promote, Incentive Fee, Carried Interest - A Passive Investor’s Guide to Understanding This Type of Fee
This article is a deep dive of a topic recently covered on the Breneman Blueprint, hosted by Breneman Capital founder Drew Breneman.
In a previous blog, we covered transaction and management fees, and the different kinds you can expect to find as you invest passively in real estate. This is a continuation of this recent article in which we will be covering incentive fees and how they work.
What is an incentive fee?
An incentive fee (oftentimes called the promote or carried interest) is where the manager of the investment, also known as the sponsor or GP, will receive a disproportionate share of the profits of an investment relative to the initial funds they contributed to acquire the asset—only after a deal outperforms certain pre-determined return hurdles.
How do incentive fees work?
Incentive fees work around these hurdles that are determined before an asset is acquired. These usually vary, but the most common structure today is an 8% preferred return. What this means for you as the passive investor (hereon out referred to as the LP) is that the first 8% of all returns go to you as the passive investor. In today’s investment environment, cash returns on a given year are typically below 8%, so an LP will receive 100% of the returns and the amount that was not distributed will accrue.
Distributions usually follow this order: Preferred returns due or unpaid/accrued from prior years, then all initial investment capital is returned, and then the remaining profit is split between the GP and LP - it is at this point when the promote kicks in. For example, a common structure you will see is a 70/30 split after the first hurdle. In this case, that would mean that after LPs receive their 8% return, their initial capital back, and then they will receive 70% of the remaining total profits and the sponsor/GP will receive the other 30% of the remaining total profits.
This works as an incentive for the GP to maximize the performance of the property, as their own returns are dependent on an investment outperforming, and aligns an investor’s incentives with their sponsor’s.
Incentive Fees in Riskier Deals
In developments, value-add strategies, lease-ups, or other risk-creating strategies, you may see promotes that reward sponsors more for achieving higher returns than the typical 8-15% that can be expected in private real estate investing. This is done with the addition of more return hurdles, with each subsequent hurdle rewarded sponsors with greater returns as a percentage of total profits.
Take the following promote structure:
8% Preferred Return
Return of Capital
70%/30% Split Until 12% IRR
50%/50% Split Thereafter
This structure works functionally the same as the one previously discussed in the “How Do Incentive Fees Work?” section, but once 12% a IRR (or sometimes annual return instead of IRR) is met for the LP, the rest of the total profits are split evenly, 50% going to each LPs and the GP. This is done as a way to incentivize timely and proper investment strategy execution by the sponsor and rewards successful execution of higher risk, higher return strategies.
accruing & Compounding Returns
A key thing to be aware of regarding preferred returns is whether the preferred return accrues if it is not paid out. If it does not accrue (also known as non-cumulative), you will lose out on the preferred return for that given year if you do not reach the return hurdle. As an LP, you should focus on investing in opportunities that have the preferred returns accrue. This is the most common arrangement and the fairest to LPs.
On top of this, returns that accrue can also be compounding or non-compounding. To explain this, let’s continue exploring the original waterfall we discussed with an 8% preferred return. Suppose that 5% is distributed during a year in the investment cycle, meaning that the investor did not receive 3% of their preferred return. In the case where the returns that accrue are not compounding, the dollar amount that would make up that 3% return would be fixed in time, and it will be paid out whenever it is next possible in the investment’s life cycle. If the 3% were compounding, however, that 3% that accrued would also continue growing at the same rate as the preferred return. This means that the dollar amount that made up the 3% of accrued returns would grow 8% yearly, meaning your deferred returns will continue growing throughout the life cycle of the investment.
LPs should focus on investing in opportunities that have a cumulative and compounding preferred return. This is the best for LPs and what we offer at Breneman Capital.
Catch-Ups
Catch-ups are another waterfall structure that are less common in syndication investments due to them being slightly more complicated. Catch-ups work very well for long-term holds which are more rare in the syndication and private investment space. Let’s say the goal of the GP and LP is to split the returns 70/30, meaning the LPs get 70% of all returns and the GP gets the remaining 30%.
One way to do this is to simply split the returns 70/30 from day 1, which some partners do with their investors with great success. If you wanted to split 70/30 but have the sponsor receive their incentive fee only AFTER a preferred return was paid and initial capital was returned, then you want to utilize a catch-up and it would look like this:
Preferred return of 8%
Return of Capital
Catch-Up (100% to GP)
70%/30% split thereafter
In this scenario, after the LP receives their 8% preferred return and their initial investment capital is paid back, then the catch-up will kick in and the GP will be distributed 100% of all distributions until all aggregate distributions between GP and LP have been split 70%/30%. After they have reached a 70%/30% split on aggregate distributions, the GP and LPs will split 70%/30% thereafter. The split during the catch-up period does not always need to be 100% to the GP. If there are multiple tiers in the waterfall based on an IRR for example, then having a GP catch-up % of less than 100% would be possible as well.
This is an excellent structure for long-term holds thanks to the incentives that both parties have. The GP has the opportunity to split 70%/30% in aggregate vs only 70%/30% after a preferred return hurdle so they would be incentivized to hold for the long term and manage the deal for many years. Compare this with investments using a traditional waterfall with return hurdles to hit and multiple tiers in the waterfall that allow the sponsor to get up to a 50%/50% split in the final tier. A sponsor may be incentivized to sell an asset quickly, generate a high IRR, and get into the higher incentive fee tiers (50%/50%) even though the LPs could continue have continued to benefit from holding the asset for longer.
With a catch-up structure, GPs are being paid more evenly across the lifespan of the investment and are incentivized to think long-term with an asset as a way to maximize their returns.
More Info
It is important to be well informed surrounding fees when you invest passively in real estate, so that you may best evaluate sponsors and the investment opportunities they present.
Watch or listen to the full Breneman Blueprint episode to learn more about investment fees through your preferred podcast destination below:
Listen to the episode on Apple Podcasts
Listen to the episode on Spotify
Dive Deeper
To learn more about investing passively in real estate, please download our Real Estate Investor Guidebook for Passive Investors by clicking here: Guidebook Download.
About Breneman Capital
Breneman Capital is a private real estate investment management firm specializing in the multifamily property sector. Breneman Capital employs a deliberate investment approach, leveraging data analytics and proprietary technology to generate superior risk-adjusted returns for investors.
To begin receiving high-quality investment opportunities from us, sign up today.