We get requests from time to time to explain what is known as the “catch-up” mechanism as it relates to real estate private equity funds. See below.
(Please read the post closely – we have chosen our words carefully as there is a lot of important nuance to communicate!)
The catch-up is a method for allowing a real estate private equity fund’s Manager’s share of net cash flows to defer to those of the Investors until a predetermined investment performance milestone is achieved by the Limited Partners (the Investors), after which point the profit cash flows to the Manager are “caught-up” by taking a pre-negotiated portion of cash flows that contribute towards the Manager to achieve up to but no more than this pre-negotiated share.
This is best explained further with an example real estate private equity fund profit-sharing structure:
Let’s say the Limited Partners (also known as the LPs) invested 95.00% of the capital in the fund, and the Sponsor invested the remaining 5.00%. The Sponsor creates an entity for this particular finite fund known as the Fund Manager, and populates this entity with individuals (“members”) that are otherwise employed by the Sponsor (i.e., multiple partner-level employees of the Sponsor entity).
With respect to cash flow partitioning, first, the Limited Partners are typically entitled to a Preferred Return – let’s say it’s an IRR-based 9.00% annual return on a cumulative, compounded basis. The LPs are paid this Preferred Return at a predetermined frequency (typically quarterly), and these payments are known as Distributions.
After these Distributions have been made to the LPs, we come to the Net Cash Available To LP and Fund Manager line item, and it is from this net line item that the Fund Manager is compensated using the “catch-up” mechanism.
The way this might work is that from this net line, the Fund Manager will take a negotiated share of these net cash flows (typically 20.00%) up to a negotiated overall, cumulative share of total profits (to make matters more difficult for teaching purposes, this is also typically 20.00%, so we’ve formatted this one in bold green).
The catch-up is effected through a formula that will run a test to continue to take 20.00% of net cash flows only up until the point of the Fund Manager having taken the 20.00% of cumulative net profits.
The formula says the following:
IF there is Net Cash Available to LP and Fund Manager in the current period, THEN take the lesser of:
a) 20.00% of that Net Cash, and
b) 20.00% of Cumulative Net Cash Flow for LP and Fund Manager less all Fund Manager net cash received to date.
…Otherwise, don’t pay anything to the Fund Manager. In other words, return a $0 amount if there is no Net Cash Available to LP and Fund Manager, or once the Fund Manager has been apportioned 20.00% of cumulative net profits and they are cut off and no longer participate in any further positive cash flows.
If you want to learn all of this in the context of a spreadsheet, buy our Private Equity Fund Modeling Self Study Tutorial.