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Recently we have received multiple requests for assistance with the equity joint venture partnership equity multiple hurdle concept and how to implement it in a spreadsheet. We explain it below.

Context. In JV partnerships for real estate transactions, there are multiple equity entities that come together to accomplish the goal of consummating the development or acquisition of land and/or operating properties. These equity partners are taking risk jointly, and they set up a contractual structure that governs not only how each of their equity contributions go into the transaction, but also how cash comes out (both return of capital and return on capital). Let’s use an example of a two-player structure, composed of a Sponsor entity and an Investor entity (both special-purpose vehicles/LLCs specific to the subject transaction).

What is a “hurdle”? A hurdle is a stipulated level of equity performance below and up through which certain cash distribution mechanics are in place, and above which alternate distribution mechanics are in place. For example, there may be a hurdle of cumulative, compounded Preferred Return of an annual IRR of 8% to the Investor*, below which and up through the Sponsor and Investor equity entities are returned their invested capital pari passu (pro-rata to investment proportions, simultaneously). (*Hurdles are based on either the deal-level equity performance, or more typically, the performance of the equity of the larger of the equity investment players in the deal.)

Above that 8% IRR hurdle (i.e., >8.0000%), perhaps there is a residual split where the Sponsor gets 30% of all excess cash flows above and beyond those dollars that go towards return of capital to both parties and payment of the Preferred Return to both parties, and the Investor gets 70% of all these excess cash flows.

How does the equity multiple hurdle work? Described above is an IRR-based hurdle structure. An equity multiple-based hurdle structure is simply one in which the level of performance being measured is measured according to how many times invested equity is returned as opposed to an IRR measurement. An example of a multiple on equity is an investment of $100 and a net cash flow at end of the transaction of $200. This equals an equity multiple of 3.00x (“3 times”), meaning that you received your $100 back not just once (return of capital) but three times (the $100 back to get you to breakeven, plus the $200 in profit).

The formula for equity multiple is: (Net Cash Flow to Equity/Equity Investment) + 1     (all values in this formula are assumed to be positive numbers)

How to set up an equity multiple as a hurdle in a waterfall. First we need to know which equity multiple is being used (deal-level vs. Investor). Let’s assume for this example it is the Investor’s equity in question, and that the hurdle is a 1.20x hurdle.

Now we set up our waterfall projection line items as such from top to bottom:

[A] Beginning Balance (Ending Balance from prior period; show as positive value)

[B] Investment Amount (amount invested by Investor, if anything, in each period; link from cash flow tab; show as positive value)

[C] Maximum Potential Payment at Hurdle Multiple (1.20x in this case) (only applies if A <>0; calculated amount =(-Cumulative sum of Investment Amount through current period*Target Multiple less Cumulative sum of Distributions through prior period)

[D] Distribution (amount paid out to Investor, if anything, in each period; show as negative value) (calculated amount =

Lesser of: pro-rata share of cash flow at this tier * total deal net cash flow in each period, and Beginning Balance,

Plus if the pro-rata cash flow dollar amount is greater than C, and if A is also positive, then add the net of C and A, otherwise add nothing.

[E] Ending Balance (calculated amount = A + B + D)

[F] Net Cash flow to Investor (calculated amount = B + D)

[G] Cash flow to Sponsor (calculated amount = F/Investor pro-rata share of cash flow at this tier * Sponsor pro-rata share of cash flow at this tier)

[H] Cash flow remaining to be distributed at subsequent tier(s) (calculated amount = Project-level cash flow Distribution - F – G)

Once we get to line H, we can evaluate the Investor’s equity’s performance further with another equity multiple hurdle (something greater than 1.20x in this example), or an IRR-based hurdle, or if there are no further hurdles, simply split the residual cash flow amounts as stipulated in the JV operating agreement (e.g., 30% to Sponsor and 70% to Investor).

If you want a full treatment of JVs for single transactions, purchase our Level 3 Bootcamp.

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