LSI 2010 Real Estate Joint Ventures conference materials.pdf

John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 6
Foreclosures, deeds-in-lieu and distressed sales are of course the painful exceptions. The
prospective investor will want to know whether the fund sponsor will have discretion to reinvest
recovered investment capital, instead of distributing capital proceeds back to the investors, and,
if so, under what circumstances. Such discretion is uncommon but possible. By contrast, it is
quite customary for the fund manager to have broad authority to establish a certain levels of cash
reserves, for certain purposes, at the fund level. Prospective investors should focus on the
purposes, circumstances and amounts of such reserves, since reserves will reduce “net” cash
flow and “net” capital proceeds available for distributions to fund investors.
Distributions – The Waterfall and Other Issues. The stated formula for distribution of net
proceeds realized from operations, or from a capital event, will be of real interest to the
prospective investor. Such formulas are typically referred to as “the waterfall,” and they are not
unlike those found in real estate joint venture agreements, although the economic results may be
considerably different (depending on a host of considerations). Most commonly (and
generalizing somewhat), the distribution formula will promise three levels of distributions:
(a) first, distributions to the investors until they have realized a stated “preferred
return” on the investors’ capital (either limited to the investors’ capital in the capital asset giving
rise to the distributable proceeds, or on total invested capital);
(b) distributions to the investors until they have received a return of their invested
capital (again, measured either with respect to the capital in the subject capital asset, or a
cumulative basis); and
(c) distributions to the investor and the fund manager effecting a final division of
remaining distributable proceeds between the investors (as a group) and the fund manager, in
proportions having little to do with the amount of invested capital, in order to give to the fund
manager a “carried interest” in the profits of the enterprise as a reward for his services.
Typically, the fund manager will also commit to invest a certain amount of his own
capital in the fund (usually in the range of 1%-5% of total commitments to the fund), because
prospective investors usually expect (or require) the fund manager to have some of his own skin
in the game. For purposes of the waterfall, the fund manager as capital investor may be treated
in a manner indistinguishable from all other investors (i.e., as part of the “investor group”), or the
distributions with respect to his capital investment may, at each of the first two tiers, be expressly
subordinated to the distributions at that tier to all other fund investors.
There are important details to be addressed at all tiers in the waterfall, but, frequently, the
carried interest tier commands greatest attention and is the source of greatest controversy. The
amount of the carried, or “promoted,” interest received by the manager is of course a key
consideration. During the boom years, the classic formulation in the world of hedge funds and
private corporate equity funds was the “80/20 after an 8”, meaning that the preferred return at
tier two of the waterfall was set at 8% per annum and the third tier featured a 20% promoted
interest for the fund manager. As market conditions became more heated, there were reports of
funds offering smaller preferred returns and requiring a larger percentage promote (perhaps 25%-
30%) for the fund sponsor.
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Law Seminars International | Real Estate Joint Ventures and Funds | 02/09/10 in Seattle, WA
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