LSI 2010 Real Estate Joint Ventures conference materials.pdf

John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 7
It is not unusual for a prospective lead investor in a new fund, who is prepared to make
an early and disproportionately large capital commitment, to ask for a share of the fund
manager’s promoted interest, as the reward for this investor’s lead commitment to the fund (a
form of early market validation). This sharing of the sponsor’s promoted interest may be
addressed expressly in the fund documents, or it may be covered in a side letter between the fund
manager and the lead investor, making the sharing relatively invisible to later investors. The
effect of sharing the promoted interest will be to diminish the overall return to the fund’s
sponsor. The possibility of extra benefits flowing to an early fund investor, by means of a side
letter agreement, may prompt later investors to ask for a “most favored nations” clause in their
subscription agreements.
In the case of a fund designed for multiple assets, an important question is whether net
cash flow and net capital proceeds from each asset will be tracked and distributed (according to
the waterfall) separately, or whether all proceeds from all assets will be considered fungible,
pooled, and distributed periodically over time on an aggregate and cumulative basis. Under the
former approach, the fund sponsor may begin to receive distributions on account of its promoted
interest quite early in the life of the venture, perhaps even when the first capital transaction
occurs if the harvested asset has been exceptionally profitable. Under the latter approach, the
third tier of distributions is not reached until much later in the life of the fund, even if the fund is
quite successful.
In the case of a fund with multiple assets, if the manager’s promoted interest return is to
be calculated on a cumulative basis, the investors must protect themselves against the possibility
that the most profitable assets will be harvested first. The result of that scenario might be the
fund manager will receive one or more “third tier” distributions in recognition of his promoted
interest in the sold assets, and the fund’s less profitable (or unprofitable) assets will not be sold
until the end of the fund’s life. The effect of that sequence may be that, on a cumulative basis,
the fund manager received a greater distribution that he is strictly entitled to collect, because of
the early year promote-level distributions based only on the most profitable assets. The
customary protection against this form of abuse is the clawback provision, an explicit promise by
the fund manager to return to the fund (for distribution to the investors) the amount of excess
distribution to him. There are many significant details to be addressed in an effective clawback
provision, including the time period during which the investors may trigger the provision
following liquidation of the fund, the mechanics for using it, the actual scope of the clawback
obligation (e.g., whether it calculates the clawed-back amount on a before-tax or after tax basis),
and the credit strength standing behind the obligation.
The importance of the promoted interest as an element of the economics of a real estate
fund (and a driver of the incentives of the manager) cannot be overstated. Under current federal
tax laws, if appropriately structured and documented, promoted interest distributions will be
taxable to the manager only as capital gains, even though arguably earned in consideration of the
services rendered by the fund manager. As this paper is being written, the taxation of promoted
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Law Seminars International | Real Estate Joint Ventures and Funds | 02/09/10 in Seattle, WA
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