Distributions to Investors: What You Need to Know

Limited Partners vs. General Partners

In business, a partnership can be best explained as two or more parties coming together to manage and operate an investment, and in doing so share in potential liabilities and profits. There are various ways to structure the parties within a partnership, two examples are Limited Partners and General Partners. A Limited Partner is best understood as a party that is only responsible for their pro-rata contribution of the capital committed or invested. Limited Partners could consist of a single investor or a limitless number of investors. The Limited Partners often have restricted responsibilities and do not participate in investment operations. General Partners, on the other hand, play an active role in investment management and operations. With this added responsibility often comes unlimited liability for the legal and financial dealings of the investment.

Investment Level Distributions: IRR Hurdles and Promote Split

Regarding the expected return of an investment, the cash distributions flow through a waterfall which splits the distributions between the Limited Partner and General Partner based on return thresholds, usually IRR (Internal Rate of Return) hurdles. IRR hurdles are used to ensure that the first dollars are sent to the Limited Partners and then as the investment performs better and achieves higher IRRs, then promote (also called carried interest) is paid to the General Partner. Promote is best thought of as the share of investment profit paid to the General Partner for a successful investment. The concept of a promote split is to reward the General Partner, after the initial pari passu distribution, for the financial success of a project through splitting the excess profit above certain IRR hurdles. Below is an example of the various promote splits applied to our Office Development model. There are three different promote splits, with the IRR hurdle increasing with each consecutive promote split.  In the example below, the Limited Partners initially invested 95% of the capital required with the General Partner investing the remaining 5% of the cashflows.  The distributions are split pro-rata (90% LP; 10% GP) until the LP has achieved an 8.0% IRR.  After the LPs have achieved a 8.0% IRR, then the GP would receive promote of 12% and the remaining 88% of the distribution would be split pro-rata (90% LP; 10% GP) until the LPs have achieved a 15.0% IRR. After the LPs have achieved a 15.0% IRR, then the GP would receive promote of 20% and the remaining 80% of the distribution would be split pro-rata (90% LP; 10% GP).

A distribution at a Fund is similar to an investment level distribution, but usually a Fund has a catch-up tier that is often excluded from investment level distributions. A catch-up tier is usually the first tier after the first, preferred return tier. Prior to the catchup tier, 100% of the cashflows have been distributed to the Limited Partners. The purpose of the catchup tier is for the General Partner to catchup to a certain percentage of profit distributions (usually 20% or 30%).  In this tier, the General Partner receives a percentage of the distributions until they achieve the desired percentage of profit distributions. After the General Partner has achieved the desired percentage of profit distributions, then all future distributions would stay at that same profit split.

Fund Distributions: American vs. European Waterfall Structures

There are two types of distribution waterfall structures: American and European. The specifics of the Distribution Waterfall mechanics are typically detailed in the distribution section of the Limited Partnership Agreement (“LPA”). An American-style distribution waterfall favors the GP as it allows them to receive promote distributions before the LPs have received their entire capital back plus a specified preferred return. American-style distribution waterfalls will require that LPs only earn capital back and preferred return for the specific deal the distributions are coming from. On the other hand, a European-style distribution waterfall is applied at the fund level and tends to be more beneficial for the LP. Under the European style, the GP will not receive promote distributions of any kind until all the LP’s capital contributions have been repaid and their preferred rate of return has been reached. Because of this, it is possible for the GP to wait years to receive their promote distributions (~6 years on average for a European-style closed-in fund with a 10-year investment term). If a fund performs well, then the GP would likely still receive the same % of profits in either an American or European-style fund. However, the American style would pay the GP earlier. When a fund reaches mid-tier returns or lower, then the American style could still see the GP receiving promote distributions even if the fund achieves negative returns, which would not happen in the European style waterfall.

Eric Bergin