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ficient (when added to the return of Investor'scapital) for Investor to achieve a 20 percent IRR,then the threshold would be reached and Operator would get 50 percent of all profit distributionsjust as it would ifthere were no soft hurdle at all,and in that sense, the soft hurdle would go away;and

if 50 percent of the profit distributions were notsufficient (when added to the return of Investor'scapital) for Investor to achieve a 20 percent IRR,then the threshold would not be met and Operatorwould not get 50 percent of all profit distributions; instead, the 50 percent share of profitdistributions that would otherwise go to Operatorwould go to Investor to the extent necessary tomeet the threshold.

Uncertainty of Soft HurdleA hard hurdle always reduces the amount of profit

distributions that may be shared by Operator (i f thereare profit distributions to share), whereas a sofi hurdleis contingent and may not result in any reduction at all.Tn the scenario described above, we know that 50percent of the profit distributions will go to Investor.However, the fate of the other 50 percent of profitdistributions is uncertain: all or some portion couldend up going to Investor and all or some portion couldend up going to Operator depending on the extent towhich Investor's 50 percent of profit distributions weresufficient to achieve Investor's 20 percent IRR. Afundamental question is what should be done with thismoney in the meantime? Should it go to Investor or toOperator?

Look-back vs. Catch-upThe "soft" 20 percent IRR hurdle would typically bestructured in one of two ways:

Look-back fo r Investor: one approach is to giveOperator 50 percent of the profit distributionsfrom the outset with a so-called "Look-back":the parties look back at the end of the deal and tothe extent Investor hasn't achieved a 20 percentIRR, Operator must turn over to Investor itspromote distributions (in this case, all of Operator's distributions .1

Catch-up fo r Operator: another approach is togive Investor 100 percent of the profit distributions until Investor achieves a 20 percent TRR,and then give Operator its share with a so-called"Catch-up": after Investor achieves a 20 percentIRR, Operator gets 100 percent 2 of all subsequenf profit distributions until profit distributionsare in a 50/50 ratio.

Operator may favor the Look-back because a Catch-upcould defer Operator's receipt and use of funds (especially if Operator believes there will be nothing to give

back under the Look-back). However, the Look-backis not likely to be favored by Investor for two reasons:first, if the soft hurdle comes into play, then Investormust chase Operator for Investor's deficiency (at a timewhen the money may be long gone and Operator maynot have the credit to back up its obligation to refundthe money); andsecond, even if Investor is successful in getting arefund from Operator, Investor does not get the use ofthe refund money until the Look-back, and consequently Investor's IRR may be reduced. 4

Many investors feel they should get 100 percent of thefirst profit distributions necessary to achieve the softhurdle, because Investor will always be entitled toretain this amount whereas if these profit distributionsarc initially split 50/50, Operator may ultimately berequired to turn over to Investor all or a portion of itsshare. If someone must get the money first, then giventhe issues associated with a potential Operator refund,Investor may insist that it be first in line.

Risk to Operator with a Look-backWith the Look-back approach, Operator is betting thatInvestor's share of profit distributions before the Lookback (in this case, 50 percent) will be sufficient toachieve Investor 's JRR. This wager is not without risk.In effect, Investor is loaning money to Operator (thatwould otherwise go to Investor to achieve its IRR). IfOperator wins its bet, the loan is forgiven. However, ifOperator loses, it may be obligated to repay all (orsome portion) of this loan, together with interest at theIRR hurdle rate (in this case, 20 percent per annum). Infact, under certain circumstances, Operator may endup with less whole dollar profits using a Look-backthan it would with a hard hurdle, as illustrated by thefollowing example: EXAMPLE. Assume the followingfacts: (i) Investor contributes $100 million as of thebeginning of Year 1, (ii) there are no other contributions, (iii) there is a refinancing distribution of $120million as ofthe beginning of Year 2, and a final distribution of $2 million at the beginning of Year 3, and(iv) there are no other distributions.Compare the results (I ) using a Look-back, (2) changing thc soft hurdle to a hard hurdle, and (3) using aCatch-up:

(1) Look-back. With a Look-back, the first $100 million of the refinancing distribution would be used torepay Investor's capital contribution. The remaining $20 million of the refinancing distribution andfinal $2 million would be split equally (before theLook-back). Consequently, Investor's share of therefinancing distribution would be $110 million. Immediately before the refinancing distribution, I n v e s ~tor's $100 million investment would have grown(for IRR purposes) to $120 million (based on a 20percent annual return, assuming annual compounding) and therefore immediately after the refinancing

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Real Estate JV Promote Calculations:Catching Up WithSoft Hurdles

distribution, Investor would be $10 million shy ofachieving a 20 percent IRR. One year later, immediately before the final $2 million distribution,this $10 million deficiency would have grown to

(2) l iard Hurdle. With a hard hurdle, the entire $120million refinancing distribution would be used to

(3) Catch-up. With a Catch-up, the entire $120 million refinancing distribution would be used toachieve Investor's 20 percent IRR. The final $2 mil-

To summarize: with a Catch-up, Operator ends up with$2 million of "whole dollar profits" (i.e., the amountby which its distributions exceed its contributions);with a hard hurdle, Operator ends up with $1 millionof whole dollar profits; and with a Look-back, Opera

tor ends up with no whole dollar profits at all! Underthe Look-back approach, Operator takes $10 millionout of the refinancing distribution that might otherwisehave gone to Investor to achieve its 20 percent IRR.This leaves Investor with a $10 million deficiency inits 20 percent IRR. This deficiency grows to $12 million at the time of the final distribution and the $2 million retum component ends up wiping out the $2 million whole dollar profits Operator would have receivedunder the Catch-up approach. It is as though Operatorborrowed the $10 million from Operator at a 20 percentinterest rate.

$12 million; and immediately after the final distribution to Investor of $1 million, Investor would be$11 million shy of a 20 percent IR K Thus, theLook-back would work as follows:

achieve Investor's 20 percent IRR. The final distribution would be split equally:

lion distribution would be paid entirely to Operatorunder the Catch-up:

Admittedly, with the Look-back, Operator would getthe use of the funds that it must ultimately return andthis is not reflected in the above charts. Uut Operatorwould need to earn 10 percent pe r annum (on the$10,000,000 portion of the Look-back payment that it

held for one year) to get the same total dollars it getswith the hard hurdle, and 20 percent per annum to getthe same total dollars it gets under the Catch-up.To make the results more dramatic, we eould assumethat the final distribution were made after Investor'sIRR deficiency had more time to grow. For example,assume that the final distribution were made at a timewhen Investor's 20 percent IRR deficiency (which was$10 million immediately after the refinancing distribution) had grown to $20 million (which would occur inless than four years after the refinancing, assuming a20 percent annual rate, compounded annually), and that

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the amount of the final distribution were $10 million.Under these modified facts, Operator would still endup with no whole dollar profits using a Look-back, butwould end up with $10 million ofwholc dollar profitsusing a Catch-up, and $5 million of whole dollar profitsusing a hard hurdle.

What about an Escrow?Must the distributions in question (i.e., 50 percent ofthe first profit distributions that are necessary to achievethe 20 percent IRR, which would be distributed toOperator under the Look-back approach, but would bedistributed to Investor under the Catch-up approach)go to Investor or Operator? One might ask whether itmakes sense to deposit these distributions in cscrowuntil their ultimate disposition is certain (i.e., when the20 percent IRR is achieved without these distributionsor at the end of the deal). Howcver, if the money weregoing to an cscrow, then it would not be a distributionto Investor that would be applied towards the 20percent IRR, and Operator would get the worst of bothworlds: as with a Catch-up, Operator's reccipt of fundswould be deferred, and as with a Look-back, Investor'sIRR deficiency would be allowed to grow larger andreduce Operator's share of whole dollar profits.

In each of the alternative distribution waterfalls below,Investor receives a first level distribution to recoup itscapital,6 Investor also receives its 20 percent IRRbefi)re Operator receives any distributions and there issome form of Catch-up which, if there are sufficientdistributions, is (was) intended to result in a 50/50 splitof profit distributions.

Operator may prefer a Catch-up to either a Look-backor an escrow because it wants Investor to hit its IRRhurdle as fast as possible and maximizc Operator'sshare of whole dollar profits. For the balance of thisarticle, it is assumed that the Catch-up approach hasbeen adopted.

Th e Catch-upHow docs the Catch-up work? This article next considers a number of distribution waterfalls with Catch-upsactually encountcred by the author with facts modifiedto fit the following example. 5 EXAMPLE. Assume thefollowing facts: (i) Investor contributes $100 millionas of the beginning of Year I, (ii) there are no othercontributions, (iii) there is a distribution of $200 million as of the beginning of Year 2, and (iv) there are noother distributions.With a soft 20 percent IRR hurdle, the intended resultwould be that $100 million would go to Investor torecoup its contributions and the remaining $100 million would be split equally because Investor wouldachieve its 20 percent JRR without the soft hurdle:

A Dangerous Waterfall (that Never CatchesUp)

In one partnership agreement, the drafter provided fora first level of distributions to Investor to recoup capitalfollowed by a second level to Investor to achieve a 20percent IRR. The drafter created a third level o fdistributions to Operator intended to recoup the secondlevel distributions that were diverted from Operatordue to the soft hurdle (i.e., 50 percent of the secondlevel distributions). The distribution waterfall lookedsomething like this:



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Distribution Waterfall No. 1 (Defective)

(Catch-up level equal to 50 percent o/Investor 's r e / e r e f l t i a l p r ( i f i i ( l i $ t r i b ~ t i o n s ) :

irst L ~ v c l(Investor 's Preferential Ca ital Distributions): 100 percent to Investor pntH Investor has recouped alf its capital; . " .......... ,

Second Level Jnvestor's Preferential Profit Distribut ions : 100 percent t o ' I n V e ~ t o r ; , p n t i l l n v e s t o rhas receivednvestor's then "20 percent ]RR Deficiency" (i.e., the amount then necessary.;fOr1nvestdr.to achieve a 2ercent IRR)" . . ...... '. .'hirdLevel 'Operator's Catchwu }: 100 percent to Operator until it hasreceived'S()percent of the distribution,

nderthe second level above; and ..ourlh Level: 50 percent to Investor and 50 percent to Operator.

Under this provision, the distribution splits would beas follows:

Somchow Operator got shorted out of $5 million. Howdid this happen? Investor effectively received $JO million of what would otherwise (absent the soft hurdle)have been Operator's distributions in the second level.To put the parties back in balance, Operator shouldhave received $10 million back from Investur (by get

ting the next $10 million of Investor's distributions).Instead, it got $10 million back from the partnership(by getting the next $10 million of distributiuns); but50 percent of these distributions would have gone toOperator anyway so (under the provisions above)Operator picked up only an extra $5 million (i.e., 50percent of$10 million). That is why the $10 milliondistribution Icft Operator $5 million short.

Confusing the Source of PaymentThe error made in Distribution Waterfall No. IS a

surprisingly common mistake in distribution calculations, namely, confusing the partnership and a partneras the appropriate source of payment. Specifically,when one partner is entitled to a payment from theother partner, whether as a Catch-up or otherwise, adistribution level in the amount of the payment may

not work, because it makes the partnership the sourceof the payment: it may reduce the distributions that therecipient partner would othcrwise receive and therebyeffectively have such partner pay itself for a portion ofthe payment.

Investor as the Source of PaymentA correct way to draft the distribution splits in Distribution Waterfall No. I would be to have the sameCatch-up amount paid solely out ofInvestor's distributions as follows:

Distribution Waterfall No. 2

(Catch-up paid out o(Jnvestor distrihutions equal to 50 pe rcent olInv estor 's preferential profit distributions):

First Level (Investor's Preferential Capita] Distributions): 100 percent to Investor uutil Investor has recouped alof its c a p I t a l ; ,Second Level (Investor's Prcferential Profit Distributions): 100 percent to Investor in an amount equal to the then20 perccnt IRR defiCIency;andfhird Level: 50 percent to Operator and 50 percent to Investor; provided, however, that all distributions under thishird level that would otherwise be paid to Investor shall be paid instead to Operat()r until Operator has receivedfrom the distributions that would otherwise have been made to Investor under this third level an amount equal to50 percent of the total distributions under the second level. ..

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Under this provision, the distributions would be allocated as follows (where the Catch-up, which is the

Partnership as Source of PaymentTo repeat, Distribution Waterfall No. I had a $10 million Catch-up payment by the partnership, whichresulted in a $5 million net gain to Operator (becauseOperator effectively bore 50 percent of the payment).Distribution Waterfall No.2 fixed this problem bychanging the source ofthe payment. This problem canalso be fixed, without changing the source of payment,by increasing the Catch-up level (under the facts in ourexample) to $20 million (so that it covers not only $10million of distributions that would otherwise have gone

proviso in the third level, is indicated below on a separate line):

to Investor, but also the corresponding $ J0 million ofdistributions that would have gone to Operatoranyway). In other words, this alternative solutionincreases the Catch-up level so that it covers not only50 percent of the distributions under the second levelbut also 50 percent of the Catch-up distributions

themselves (i.e., 50 percent of the total distributionsunder the second and third levels). In this way, the goalof the Catch-up level is clearly achieved, namely, toincrease Operator' s share of all profit distributions (i.e.,all distributions above $100 million) to 50 percent.

Distribution WaterfalJ No.3

(Catch-up level equal to 50 percent o f all profit distribution until caught up):

First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped all

of its capital;Second Level (Investor 's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20percent IRR deficiency;Third Level (Operator's Catch-up): 100 percent to Operator until the total distributions it has received under thishird level equal 50 percent of the total distributions under the second level above and this third level; and

Fourth Level: 50 percent to Investor and 50 percent to Operator.

Under this provision, the distributions would be allocated as follows:



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This provision could have been written with distribution levels (without a proviso) as follows:

First Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recoupedall of its capital;

Second Level (Investor's Preferential Profit Distributions): 100 percent to Investor until it receives the then 20percent lRR deficiency;

Third Level (Operator's Catch-up): 100 percent toOperator until it has received the amount by which (A)the aggregate amount which would have been distributedto Operator (under the Fourth Level below) but for theoperation of the second level above and this third level, isgreater than (B) the aggregate distributions received byOperator; and

Fourth Level: 50 percent to Investor and 50 percent toOperatoL

The problem with Distribution Waterfall No, 5 is thatit is not clear, It is not dissimilar to having a Catch-upin the amount necessary to put Operator in the sameposition it would have been in without a soft hurdle. Intheory, this is fine, but the provision doesn't tell youhow to do it.Gregg Hanks, a very careful and thoughtful attorney inArizona, once encountered this provision, and wasconcerned with a potential ambiguity in determining(in clause (A what "would have been distributed toOperator." Distr ibuted from what? I f the quotedlanguage were read to refer to what "would have beendistributed to Operator" from all the profit distributions prior to the Catch- up 9 (i.e., the 2 nd level distributions in the restated provision above or equivalentlythe first $20 million of profit distributions in our

, ,

example), then the language would be the equivalentof Distribution Waterfall No.1: Operator would receive a Catch-up equal to $10 million of profitdistributions. But Investor would have already received$20 million of profit distributions. Thus, althoughOperator would receive what it would have receivedfrom the first $20 million of profit distributions, Inves

tor would have received more. Gregg wanted to makesure both Investor an d Operator received the profitdistributions they would have received in the absenceof the soft hurdle (namely, equal amounts alter Investor recoups its capital).While the accountants arc likely to do a better job thanthe lawyers in reaching the correct result, it is generally preferable to avoid any doubt as to the ultimateoutcome. Faced with this issue, Gregg might havesubstituted Distribution Waterfall No.2, 3 or 4, but hewas also faced with the common elient mandate ofworking with (and doing as little damage as possibleto) the language before him. He therefore did what isgenerally advisable in such situations: eliminate perceived ambiguities and do an example.To assure the correct result, Gregg wanted the amountthat "would have been distributed to Operator" to bebased on grossed-up profit distributions that wouldyield what Investor actually received (when received)and an equal amount of profit distributions for Operator, as indicated in the next Distribution Waterfall.Thus, Distribution Waterfall No.5 may be fixed byrevising the Catch-up so that it gives Operator what itwould have received from hypothetical distributions(without the soft hurdle) that would have given Investor what it actually received, when received:

Distribution Waterfall No.6

(Catch-up level equal to amount Operator would have rece ivedfrom profi t distributions, without soft hurdle, thawould have generated the aC,ttlal amolmts received by Investor when received):

First Level (Investor's Preferential Capital Distributions); 100 percent to Investor until Investor has recouped alpf its capital; and "Second Level: 50 percent to Operator and so percent to Investor.!Notwithstanding the foregoing, inno evel1t shall Operator be entitled to any distributions until Investor haseceived the then 20 percent JRR DeficiJ1cy;un4wheIlJhere is t1020, percent IRR Deficiency, all distributions will

be made to Operator until it has received the ,ariIotintby which (A) the aggregatcamount which would have been

distributed to Operator if (x) this sentence did not existand(y) the, amounts distributed resulted in lnvestor receiv.ng the same amounts that Investor did in: fact receive (when received), is greater than (B) the aggregate distribuions previously received by Operator. "

Under Distribution Waterfall No.6, the first $120 million would be distributed 100 percent to Investor tosatisfy the soft 20 percent IRR hurdle. How should theCatch-up distribution be calculated? In order for Investor to have received $120 million without the soft20 percent IRR hurdle, there would have been distributed an aggregate amount equal to $140 million (sothat Investor would have received the first $100 mil-

lion and 50 percent of the next $40 million, whichwould add up to the $120 million total actually receivedby Investor). The Catch-up would therefore be the $20million Operator would have received from this hypothetical $140 million distribution.Thus, the distributions would be allocated as follows:



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Real Estate JV Promote Calculations: CatchingUp WithSoft Hurdles

This o r course is the correct result, because we havegrossed up the distributions (in clause (A) above) tomake sure the amount Operator receives is consistentwith the ultimate 50/50 split we are trying to achieve.However, the wording ma y be confusing and on e o fDistribution Waterfall No.2, 3 or 4 may be easier tounderstand.

Distribution Waterfall No.5 could also be fixed by using the Catch-up amount interpretation Gregg wantedto avoid, bu t making Investor the source of payment,as was done in Distribution Waterfall No.2:

Distribution Waterfall No.7

(Catch-up fiwn Investor equal to amount Operator would have received from second level distributions, withousoft hurdle):

!r,-irst Level (Investor's Preferential Capital Distributions): 100 percent to Investor until Investor has recouped al101'its capital; andSecond Level (Investor's Preferential Profit Distributions): 100 percent to Investor in an amount equal to the ther120percent IRR deficiency; andtrhird Level: 50 percent to Operator and 50 percent to Investor.Notwithstanding the foregoing, all distributions that would otherwise be made to Investor under the third level\Shall be made instead to Operator until Operator has received from the distributions that would otherwise haveIbeen made to Investor under the third level an amount equal to the distributions Operator would have received, ihere ha d been no second level above, from the amounts actually distributed under the second level above.

Distribution Waterfall No.7 may still be confusing andone of Distribution Waterfall Nos. 2, 3 and 4 would bepreferable. If forced to use a Distribution Waterfallsuch as No.6 or 7, an example is highly recommended.

Summary of Catch-up Alternatives1n sum, the amount of the Catch-up should take intoaccount the source of payment and the language shouldbe clear for future readers of the partnership agreement; if confusing language cannot be avoided, thereshould be an example. Distribution Waterfall No. Icontains a faulty Catch-up: it uses the partnership as a

source o f payment for a Catch-up amount that wouldbe correct only if the source of payment were Investor.

This problem is solved in each of Distribution Waterfall Nos, 2, 3 an d 4. Distribution Waterfall N o . 5contains potentially ambiguous language which, without an example, might lead to the wrong result. Distribution Waterfall Nos. 6 and 7 are an improvement overDistribution Waterfall No.5 , bu t still may need anexample to avoid confusion. The author's preference isDistribution Waterfall No.3 because it explains themethodology without obscuring the intent o f th eparties.

For the scenario described in this article,W some of thepossible Catch-up formulations can be outlined as fol

lows:

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ConclusionSoft hurdles and Catch-ups frequently find their wayinto real estate joint venture documentation. Whi Iethey involve simple concepts, they are sometimes

complicated and obfuscated in their wording andapplication. With a little patience and thought, theycan and should bc crafted in a manner that is easy tounderstand and implement.

APPENDIX

Generalized Scenario for a Single PromoteHurdleThis Appendix considers a generalized scenario assuming a single promote hurdle (after all capital isrecouped) that is soft, and in this generalized contcxt:

describes alternative Catch-up fommlations; and

compares Investor's IRR and whole dollar returnsunder the Catch-up approach and Look-backapproach.

Generalized AssumptionsAssume the following facts: (1) there is a partnershipbetween two partners, an investor ("Investor") and anoperator (' Operator' ), which contribute all the capital( " C " ) to the partnership in accordance with theirpartnership percentages, (2) distributions are to bemade first to the partners "pro rata" (i.e., in accordance with their partnership percentages) unti I they getall their capital recoup, and Operator is entitled to apromote equal to " p " (this is a percentage) of all profitdistributions (with the balance of the profit distributions distributed pro rata), subject to a single promotehurdle (after all capital is retumed) which is soft, and(3) (unless otherwise indicated) there arc sufficientdistributions to complete the Catch-up.

Generalized Distribution WaterfallI f a Catch-up approach is used, the distributionsdescribed above could be written as follows (using provisions similar to Distribution Waterfall No.3):



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" I ~ ~ ~ ;'

' ' ~ ,..

'

' f ' } ~: ~ ~ ~ : ~ \ '

~ ;' ~ ~ ~ ~

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Real Estate JV Promote Calculations:CatchingUp WithSoft Hurdles

' ' ' ~ ~ n ~ n i l i z e d O i s t r i b.. ion Waterfall s i n g e a t e h ~ ~ p,

, irst LeveE Tothe p a ~ e r s p r o r a t \ u n t i l a l l,capital is recouped;econclLeycl:. To the partners pro rata until they receive the soft hurdle; " " ' i . . . . . . .hird Level.: tOO. perc"entt6 ((? OP


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p =s. -.

B ~L -

~ : Thisth e case. ... .

The Transposition under the Catch-up ApproachThe heavily shaded distributions in the above chart arcequal in amount- bu t one goes to Operator as apromote (second level shaded portion) and one goes tothe partners in accordance with partnership percentages (third level shadcd portion). Thc soft hurdle, whenusing the Catch-up approach, simply reverses the order

(i.e., transposes the recipients in the second and thirdlevel shaded portions): Operator's promote share ofthe second level (i.e., the heavily shaded portion) isdiverted to the partners (in accordance with partnership perccntages) to pa y the soft hurdle and then thenon-promote share of the third level (the heavilyshaded portion) is diverted to Operator (to effectuatethe Catch-up). It is a perfect match and therefore, aslong as the distributions are adequate, reversing theheavi Iy shaded distributions accomplishes the sametotal distrihutions (ignoring the time value of money)

To see this, note the following:Prior to the Look-back Payment. Th e side-by-sidechart above shows that the distribution amounts undereach approach will be equal if there is enough to distribute, but Investor gets its money at the same time orsooner under the Catch-up approach. Therefore, beforeany Look-back payment, Investor's whole dollar return(i.e., the whole dollar amount of the distributions

to each Member as though there ha d been no softhurdle.

IRR and Whole Dollar ComparisonsThus, assuming that distributions are sufficient tocomplete the third level, the same amount will bedistributed to Investor under each approach throughthe first 4 levels and the only differences between the

two approaches will be timing (as to the second andthird levels) and the Look-back payment. (For simplicity we refer only to Investor for the balance of this Appendix, bu t the statements made apply to all capital ona pro rata basis.) Moreover, based on the generalizedassumptions in this Appendix, and assuming there areno contributions after distributions, it follows that theIRR and whole dollar returns of Investor satisfy thcfollowing relationships (where " C U " means Catchup, " L H " means Look-back an d " W D R " meanswhole dollar return):

ignoring the time value of money) and IRR under theCatch-up approach cannot be less than what they areunder the Look-back approach. 19 Does the Look-backpayment change these relationships?After th e Look-back Payment - IR K Assuming nocontributions are made alter distributions, t.he IRR n: -lationship should not change because the Look-backpayment can't make the Look-back I RR any greater



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Real Estate JV Promote Calculations: CatchingUp WithSoft Hurdles

than the target IRR (assuming it is worded to cover nomore than the deficiency in the target IRR):

If the Catch-up IRR were not achieved, then alldistributions would ultimately be pro rata underboth approaches, but the pro rata distributionswould he received at the same time or soonerunder the Catch-up approach (so for Investor, CUIRR ~ LB IRR); and

If the Catch-up IRR were achicved, then theLook-back payment would at most result in thesame IRR (so for Investor, CU IRR ~ LB IRR).

Remember that we are assuming that no contributionsare madc after distributions. The results may be different otherwise: it is possible that Investor ends up with

Under this example, there is a $20 IRR deficiency atthe end of the dcal (before the Look-back payment).This IRR deficiency would be recoupcd under theLook-back approach to achieve the target 20 percentIRR hut Investor would be left with the deficiencyunder the Catch-up approach (assuming thcre is noclawback).20After the Look-back Payment - WDR. What about thewhole dollar returns? Before the Look-back payment,the distributions under the Look-back approach are lessthan or equal to the distributions to Investor under theCatch-up approach. After thc Look-back paymcnt, thisrelationship is reversed, with the Look-back distributions to Invcstor (including the Look-back payment)being greater than or cqual to the distributions to Investor under the Catch-up approach:

I f the required Look-back payment were zero(whiCh means the target IRR were achievedwithout a Look-back payment or there were noprofit distributions), then it is obvious from theside-by-side chart above that the pro rata distributions under either approach would be equal (sofor Investor, CU WDR ::::; LB WDR).

If the required Look-back payment were positiveand after the Look-back paymcnt, the target IRRwere achieved, then the total pro rata distributions received under the first three Look-back

a deficiency under the Catch-up approach (i f there isno clawback) and achieves or gets closer to its targetIRR under the Look-back approach. For example, using the facts in the scenario described at the beginningof this article (i.e., a partnership between Investor andOperator where Investor puts up all the capital anddistributions are made 100 percent to Investor until Investor recoups its capital and then profit distributionsare split SO/50 subject to a 20 percent per annum softhurdle preference to Investor), further assume a $100contribution at the beginning of Year I followed by a$140 distribution at the beginning of Year 2 and a $20contribution at the beginning of Year 3 just at the timeof dissolution before the Look-back:

levcls and under thc final Look-back paymentlevel would be at least as much as the amount ofpro rata distributions under the first three levelsof the Catch-up approach, because the lattcramount was necessary to achieve the target IRRunder the Catch-up approach and would be received at the same time or later under the Lookback approach (so for Investor, Cl l WDR ::::; LBWDR).

I f he required Look-back payment were positiveand after the Look-back payment, the target IRRwere not achieved, then all profit distributionswould go pro rata under the Look-back approach(i.e., all promote distributions are refunded) andobviously, this amount can't be less than the prorata profit distributions under the Catch-up approach because it is the maximum possibleamount (so for Investor, CU WDR ::::; LB WDR).

As shown in the body ofthis article (under the heading"Risk to Operator with a Look-Back"), it is possiblefor Investor to get significantly more distributions(ignoring the time value of money) under a Look-backapproach than under a Catch-up approach. Such aresult assumes, of course, that Investor is able to collect the Look-back payment. In the author's experience, most investors would prefer not to take that collection risk and instead receive their money sooncr andboost their IRR. And this is generally fine with many,

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if not most, operators by reason of the same analysis:as long as there are no contributions after distributions,Operator may get its money sooner with a Look-back,but it will never get less and may get more with aCatch-up.

I Other fonnulations of the Look-back arc possible, butthis is a common fonnulation encountered by the author. Allreferences to the Look-back in this article assume thisformulation.

2 Some investors require a percentage (greater thanOperator's normal promote share, which promote share is 50percent under the scenario described in this article) that isless than 100 percent. For simplicity (and given the assumptions in this article), it is assumed that thc Catch-up percentage is 100 percent.

3 All "subsequen t" profit distributions may bemisleading. The Catch-up normally applies only when thehurdle is satisfied. Thus, if there were a subsequent contribution by Investor, there might be a new hurdle deficiency and

the Catch-up would stop until the new hurdle deficiency weresatisfied.

4 This problem could be solved by imposing an interestfactor, but most operators would ratber use a Catcb-up approach than have an obligation to repay all of their promotedistributions plus interest (especially at 20 percent pe rannum). Also, although Investor's IRR may be enhanced bythe Catch-up approach, its share of whole dollar prolits maybe reduced becausc it is not kecping its money working aslong at a 20 percent rate, as illustrated in the next section.See Appendix for general discussion oftbe relative IRR andwhole dollar returns under the two approaches.

Ii This example is given in the context of thc scenariodescribed at the outset (in the first paragraph) of this article.

6 The recoupment of capital is a hard hurdle. The returncomponent of the 20 percent IRR requirement (i.e., theamount of profit distributions necessary to achieve a 20pcrccnt IRR) is in effect the actual soft hurdle.

7 Howcver, thc numbers will not always be so obvious.For example, if Operator's promote were 20 percent insteadof 50 percent, then, Operator would be entitled to 20 percentof the total distributions under the Second and Third Levelsso that x equals 20 percent (x + S), in which event x equals(20 percent/SO percent) S, which equals 25 percent S. SeeAppendix for a more general formulation.

S This percentage will vary depending on the deal. Forexample, under the facts presented in endnote 7 above, theappropriate percentage would be the percentage equivalent

of20/80, which is 25 percent.D Another interpretation, which would lead to the correct

result, is that the quotcd language refers to what' would have

been distributed to Operator " from all profit distributionsuntil the Catch-up is completed.

10 See Appendix for more generalized scenario.n This is similar to a word version of the Catch-up

formula in Distribution Waterfall No.2.

IZ This is similar to a word version of the Catch-upformula in Distribution Waterfall No.3.

13 See Distribution Waterfall No.2.

14 See Distribution Waterfall No.3.15 See Distribution Waterfall No.4.16 See Endnote 2 above.17 In the body of this article, Investor contributes 100

perccnt of the capital, so that all distributions to Operator arepromote distributions. In this Appendix, Operator contributesa pro rata share of he capital, and is cntitled to both (I ) a prorata share of the distributions (along side of Investor) on account of its capital contributions an d (2 ) promotedistributions. Basically, all the capital is treated alike, butOperator has two roles, as (I ) an investor, and (2) a promoter,and it is important to distinguish the two. In any case, the

soft hurdle relates only to thc promote and therefore theamount received as the Catch-up includes only promotedistributions. This can be a source of confusion when theCatch-up level is not 100 percent (see endnote 2) and Operator is receiving pro-rata (non-promote) distributions at thesamc timc it is receiving the Catch-up.

IS If Investor contributes 100 percent of the capital, thesource in this column is Investor's distributions aftcr it hasachieved thc soft hurdle. I f Investor and Operator both contribute capital, then thc source in this column is Investor'sand Operator's prorata (non-promote) distributions after theyhave achieved the soft hurdle.

19 It may seem intuitively obvious that if the same amountof distributions is received sooner, then the IRR will increase.But with positive and negative cash flows (where distributions arc positive cash flows and contributions are negativecash flows), it is possible not only to have multiple IRRs, butalso in some cases, to reduce one of the IRRs (in some cases,the lowest, and in some cases, the highest) by acceleratingdistributions. To avoid these complications, this Appendixassumes that contributions do not occur after distributions(so there is no more than one change of sign among the cash/lows). With this assumption, it is not difficult to show thatan acceleration of distributions increases the IRR, but theproof is beyond the scope of his article. For more on multipleIRRs, sec Carey, "Real Estate IV Promote Calculations:Recycling Profits," Real Estate Finance Journal (Summer2006) at Appendix.

20 The Look-back described in this article is a fonn of

clawback, but it may not elfectuate a complete adjustment.See Example I in Carey, supra, for which such a clawbackwould have no elrect.



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Copyright 2008 Thomson/West. Originally appeared in the Spring 2008 issue of Real Estate Finance Journal. For more information on the publication, please visit http://west.thomson.com. Reprinted with permission.

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