Timing is everything

To align the interest between partners, economic and corporate governance terms are often negotiated. But one issue is left out

July 4, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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There is a symbiotic relationship between the general partners and the limited partners of a real estate fund. The general partners, often weary of regulatory scrutiny, regain an independent thought and conduct by entering into a private partnership. The limited partners benefit from a greater sense of control over their capital and lessen the exposure to the vicissitudes of capital markets.

The life cycle of an investment fund is discernible. In the first year, managements typically spends time and effort marketing the fund to prospects. The fund prospectus describes the strategy, the management, and the opportunity. After raising enough capital, management spends the second to fourth years withdrawing capital and investing in real estate opportunities. And, in seven to ten years, the fund sells its real estate positions and returns capital to limited partners. This stage is the realization, or returns and exit stage.

Negotiations between the limited partners and the fund managers are plentiful. To name a few, Management Fees, calculated as a percentage of the committed capital, range between 1.5 to 2.5 percent. Carried Interest, the fund managers’ share of the profits generated by the fund, is often 20 percent of the fund’s profits. Hurdle rate clause is the internal rate of return the fund manager must achieve before the general partner receives any Carried Interest. Depending on capital market conditions, the Hurdle Rate is typically in the range of 7 to 10 percent.

General partner and limited partners entity structure example
Table A:  Common entity structure

Corporate governance terms are disparate. Key Man clause requires certain executives to take an active role in the management of the fund. Clawback Provision requires the GP to return capital to LPs in excess of the agreed profit split between the GPs and LPs. Investment Restrictions impose a minimum level of diversification in the fund’s investments, geographic exposure, and level of indebtedness. Distribution Waterfall is a mechanism providing an order of distribution to LPs first before the GP receives carried interest.

Timing is everything for the success of startup companies, notes Bill Gross of Idealab, a venture capital firm. It is no different in real estate. The timing of the purchase and sale of real estate is the largest contributor to value. And while Carried Interest, Hurdle Rate and Distribution Waterfall are sumptuous tools to align incentives between the general partners and the limited partners, the quest for a crystal ball prevails.