In this lesson, we will dive more into the structure and performance requirements of the contract. We will focus on the performance metrics and also discuss the profit participation structures.
When pitching a deal to a JV partner, the following numbers should all be included in the pitch book. There are three important metrics that we will focus on for these JV deals. The first is IRR. IRR is the “internal rate of return” for the entire project. Within the IRR, we are concerned with the Deal IRR or the IRR for the project that was funded. After the Deal IRR, we have the Investor IRR. These are the equity investors who have partnered together, and based on the contract and equity “put in,” they will receive a certain amount of the total IRR. Finally, we have the Sponsor IRR. Once the investors are paid back, the sponsor will also have a portion of the remaining IRR.
The second metric is the Gross Return Multiple. The Gross Return Multiple is the private equity measurement that will value the return paid to an investor. It is the second measurement because this amount is named after the amount of return for the entire deal (IRR) is realized. Again, it will be determined by the amount of equity “put in” by each investor. Similar to the IRR, we are concerned with the Deal Multiple, Investor Multiple, and Sponsor Multiple.
The third metric is Total Dollar Profits. The Total Dollar Profits is the actual profit amount that each participant will receive from the deal. Similar to the IRR and Gross Return Multiple, we are concerned with the Deal Profit, Investor Profit, and Sponsor Profit.
The graphic below displays the three metrics and what is measured by each metric.
For every JV deal, there are punitive clauses for the operating partners. There are four main clauses that we are concerned with for this course. The first clause is Cash Equity vs. Market Equity. When considering a partner, JV equity investors want to see partners that have “something to lose.” Cash in the deal, or “skin in the game” is what the lenders/investors want to see. If they are putting their money into the deal, they want the partners to have something to lose as well, so they work hard to make the deal a success. Equity is not always as transparent as it should be, so due diligence should be completed to determine what the equity is actually worth.
The second clause is Control Shifts. This occurs in the event of the General Partner not performing correctly or in the case of a default where the equity investor would become the General Partner. If the sponsor does not meet its business plan, it is common for the equity partner to be able to step-in and take over the deal.
The third clause is Claw Backs. This clause would be implemented as recourse to the operating partners if certain return thresholds are not met. These are generally focused on operator fees and control rights. Again, due diligence should be performed prior to the deal to determine all of these rights.
The fourth clause includes additional opportunities. Opportunities are generally found in the following areas:
- An illiquid owner whose property has capital needs.
- An over-leveraged owner who has trouble servicing the debt.
- A marginal owner who has not taken care of the property.
- Partnership disputes.
- Temporary market distress, where a market has fallen out of favor.
These three “opportunities” or events would cause action to be taken by the equity investors to ensure the deal is not a failure.
In terms of profit participation structures, there are four structures that are common for JV equity deals. Let’s explore each of these approaches.
The first structure is the Straight Line Approach. This is the most simple of the four structures. In this case, the sponsor receives a percentage of the deal profits, after the preferred return. Let’s consider an example. The sponsor receives 50% of profits after a 10% preferred return.
The second structure is the IRR Look-Back Approach. This structure is typically used by an institutional partner. The institutional partner wants to ensure that it will be paid a specific yield for the investment. Thus, there is no preferred return. This waterfall is as follows:
- Institutional investor equity returned
- All profit until an IRR is achieved (18%)
- All remaining proceeds go to the sponsor
The third structure is the Fixed Exit Fee. In this approach, the institutional partner is focused on whole dollar profit. They are insisting that after their principal investment is returned, they receive a pre-agreed upon amount of profit first, then the rest of the profits are distributed to the sponsor. An example is below:
- Preferred return
- Return of equity
- All profits to investor until a specific dollar amount is achieved
- Remaining cash flow to the sponsor
The fourth structure is the IRR Waterfall. This is the most common for JV equity. In this model, all equity is treated Pari Pasu. There is a preferred return hurdle, and the sponsor receives more profit as the IRR of the transaction increases. Below is an example of the IRR Waterfall.
During a JV deal, there will be times when a partner chooses to leave the deal. In participation transactions, the profits cannot be easily realized until the property is sold to a third party. In many cases, the sponsor wishes to keep the property, as well as repay the lender. The following discussion includes three basic types of buy/sell arrangements.
The first arrangement is the Mandatory Sale. During this arrangement, after a period of time, either side can sell the property. The side that wishes to sell puts forth a number. If the other side does not want to buy at that number, the property goes to market. If an offer is submitted for 95% of the number presented, it must be accepted.
The second arrangement is the Shotgun Approach. In this arrangement, when one party (Party A) wants to buyout the partner’s interest (Party B), the following will occur:
- Party A gives Party B a price.
- Party B can then either accept the price or buyout Party A at the same price.
The third arrangement is the Appraisal Buyout Method. In this method, at the end of two years, the property is appraised and the borrower can “buyout” the deal for the appraised value. If the borrower does not buy it, the property goes to market and is sold at the highest offer.