JF2137: The Two Types of General Partner Catch Ups | Syndication School with Theo Hicks

July 09, 2020 | Joe Fairless | 00:20:38

JF2137: The Two Types of General Partner Catch Ups | Syndication School with Theo Hicks

In today’s Syndication School episode, Theo Hicks will be teaching you the two different types of General Partner Catch Ups. 

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To listen to other Syndication School series about the “How To’s” of apartment syndications and to download your FREE document, visit SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow. 


TRANSCRIPTION

Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.

Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.

Theo Hicks: Hello, Best Ever listeners and welcome to another episode of The Syndication School series – a free resource focused on the how-to’s of apartment syndication. As always, I’m your host, Theo Hicks. Each week, we air two podcast episodes that focus on a specific aspect of the apartment syndication investment strategy, and for a lot of these episodes, we offer some free resource. These are free PDF how-to guides, free PowerPoint presentation templates, free Excel calculator templates, something to help you along your apartment syndication journey. All these free documents, all of these past free Syndication School series are available at syndicationschool.com.

Today, we’re going to talk about how you, as a general partner, make money in apartment syndications. More specifically, we are going to talk about the GP catch-up. We’re gonna talk about everything you know about the GP catch-up. So the general partner catch-up is a distribution that goes to the general partner such that they have received their full portion of the deal’s profits.

So this GP catch-up is only going to be relevant when the compensation structure of the partnership between you, the GP, and your investors, the LPs, includes an overall profit split. So let’s say, for example, that you have a structure such that the LPs are offered a 7% preferred return, and then the profit split is 70% to the LP and 30% to the GP. Well, at the conclusion of the partnership, which means once everything’s said and done and you’ve had all of your cash flow, the property’s sold, all the money’s been distributed, at this point, then 70% of the total profits, again, ongoing cash flow and profits from sale, must have gone to the LP, and 30% of those profits must have gone to the GPs. So the catch-up will happen when there is a preferred return, which means that the LPs are receiving 100% of the first portion of the profits, and the GP catch-up will offset– allow the GP to catch up to their 30% portion at this point depending on the structure. Maybe the LPs have gotten 80%, 90%, 95% of the profits because of that preferred return. So we’re gonna go over some examples, but that’s overall what the GP catch-up is.

Now, there’s going to be two main types of GP catch-ups. So the one that is the most common is going to be the GP catch-up at sale, and the other one, which is a little bit less common, but you can still do, is going to be an ongoing GP catch-up. Now as we’ll see in our example, the advantage of the ongoing GP catch-up is that the GPs can receive distributions immediately, or at the very least, higher distributions immediately, rather than having to wait to receive the biggest distribution at sale. So whatever GP catch-up you decide to use, you’re gonna want to make sure that it’s properly defined in your waterfall that’s in the PPM, which explains how available cash is distributed and how cash at capital events are distributed. So we’re gonna go over examples for those two GP catch-ups.

I’m gonna try my best to have all this make sense by going over an actual example of numbers, but it might be easier if you have this blog post open that says “Everything You Need To Know About The GP Catch-up.” So if you’re listening to this on July 9th or later, then this blog is on the website which is called joefairless.com, or you can Google it. You can just type in ‘everything you need to know about the GP catch-up’ and all these data tables with an example cash flows that I mentioned in this episode will be there. But I’ll say it slowly; that way, it should make sense without having to see the actual blog post.

So for both GP catch-ups examples, we’re going to assume a 7% preferred return and a 70-30 profit split. We’re going to assume that the limited partners, in total, invested $1 million, and then the year one through five cash flow is going to be $71,000, $77,000 year two, $84000 year three, $93,000 year four, and $130,000 year five. You don’t need to memorize those ones for now, but just memorize 7% pref, 70-30 split, $1 million investment, and then the assumption after the $1 million in equity is returned at the sale, the remaining profits to be split is $1.5 million. So how would the cash be distributed to the LP and the GP if there was only a GP catch-up at sale? So when there is a GP catch-up at sale, the way that the waterfall works is that LPs receive their preferred return first, and then any profits above the preferred return are split 70-30, and then at sale, the LP receives their equity back. But before the remaining profits, that $1.5 million, is split 70-30, the GP will receive a catch-up distribution until they have received 30% of the cumulative cash flow up to this point.

So based off of that waterfall, in this blog post, there’s a breakdown of the cash flow to the LPs and GP. So year one, again, the total cash flow is $71,000, the preferred return amount for that 7% off of a million dollars is always gonna be 70 grand. So of that $71,000, the LP get $70,000. There’s $1,000 left; so 70% of that or $700 goes to the LP bringing their total year one cash flow to $70,700 and the GP gets 300 bucks, and the same thing happens in year two. So in year two, total cash flow is $77,000. So the first $70,000 goes to the LP as a preferred return, the remaining $7,000 is split 70-30, which is $4,900 to the LP, bringing their total year two to $74,920, and then $21,000 goes to the GP, and then same thing year three, same thing year four, same thing year five. So year five, for example, is $130,000; the first 70 grand goes to the LP and then the remaining $60,000 is split between the LP.

So the LP gets $42,000 bringing the total to $112,000 for the year and the GP gets $18,000. Now based off of the total year five cash flow to the LP and the GP, is $423,500 to the LP and $31,500 to the GP, and the total cash flow is $455,000. So based off of the LP’s portion of those profits, they’ve received 93.08% of the profits and the GPs have received 6.92% of the profits. Therefore at sale, the first portion of the $1.5 million goes directly to the GP until that allocation is 70-30.

Now in order to calculate that, you want to do a formula. So the formula is 70 over 30 – so 70 over 30 is the profit split – equals the $423,500, which is the LP divided by x – we’re solving for x – plus $31,500. So what we’re saying is that we want to force that $423,500 to be 70%, and they want to force the GPs receive 30%. They’ve already seen $31,500. So we’re solving for x, and so when you do the formula – and this is just using algebra – x equals $150,000. So the first portion of the $1.5 million goes to the GP as the catch-up and that amount is $150,000. When you add that to the $31,500 you already received, that brings our total to $181,500. LPs still received the same $423,500. So that ratio is at 70-30, so the 70-30 split is achieved.

So for that formula, if that didn’t make sense, you’re gonna want to check out that blog post. It’s whatever the LP profit split is divided by the GP profit split equals whatever the LP have received so far, divided by x, plus whatever the GP has received so far, and when you solve for x, that is what the GP catch-up is going to be at a sale. So at this point, now that $150,000 has been removed from the $1.5 million, you’re at $1.35 million that’s left to be split, and now since the overall split is at 70-30, now you can split this 70-30 which equates to $945,000 to the LP and $405,000 to the GP. That way, we need to do the updated cash flow model; year one, two, three, four to remain the same; year five, you add in the profits at sale, and you have a total cash flow of $1.955 million with 70% or $1.3685 million going to the LP, and then $586,500 going to the GP, but again, which is 70-30. So that’s the first one.

The second one is going to be the ongoing GP catch-up. So for this waterfall, the LPs still received their preferred return first. However, before the remaining profits are split 70-30, the GP is going to receive their catch-up distribution, and this distribution is going to be equivalent to, in this case, 70-30 split. So you calculate this catch-up distribution similar-ish to how you calculated the catch-up distribution at sale. So you’re gonna want to solve for x again. So this time, it’s going to be the profit split to the LP divided by the profit split to the GP equals the preferred return to the LP divided by x. So in this case, it’ll be 70 over 30 equals 7, which is the preferred term, over x and we solve for x. This one’s pretty simple because it’s 70-30, 7-3. But if it’s an 8% preferred return or a 10% preferred return, the calculation wouldn’t be as simple. So what that means is that the GP receives a 3% return based on the total LP equity investment.

So the waterfall is 7% preferred return to the LP, 3% preferred return to the GP, 70-30 split thereafter. Any unpaid GP catch-up is accrued and paid out when possible. So what that means here is that since you got a million-dollar investment, 7% that is $70,000, which that’s the annual distribution to the LP, and then 3% of a million is gonna be $30,000. That’s what’s annually owed to the GP, which means that in order to pay out both preferred returns, in a sense, the deal is a cash flow, a $100,000.  Remember, in our sample deal, it does not cash flow $100,000 until year five, which means that year one, year two, year three, year four will have an accrued GP catch-up which won’t get paid out until sale. So in year one, the cash flow is $71,000. The LP receives their $70,000 and the GP receives the remaining $1,000, but since they’re owed $30,000, the extra $29,000 accrues. Now in year two, the cash flow is $77,000, which means that the LP receives their 70 grand and the GP receives $7,000. However, since they’re owed $30,000, that extra $23,000 is accrued, and that is in addition to the $29,000 that was owed previously, which means the total accrual is $52,000. So you follow the same logic. At the end of year five, the cash flow is $130,000, which means LP gets $70,000 and the GP finally gets their full $30,000. Now there’s $30,000 that is left over, but this does not get split 70-30 because the GP is still owed their preferred return that accrued during years one through four.

So that full $30,000 goes to the GP and that will pay down their accrued amount by year four. Based off of the sample numbers the total accrual was $75,000, so the GP is now only owed $45,000. So in year five, the LP is receiving $70,000 and the GP is receiving $60,000; so very close. Every single year, since this deal did not exceed the combined distributions owed to both LPs and GPs, the LPs receive $70,000 every single year. Now at sale, after the LP equity is returned, the next step in the waterfall is to pay out the accrued amount owed to the GP which is a $45,000. Then the remaining $1.455 million is split 70-30. This is $1,018,500 to the LP and $436,500 to the GP. Now, just because the LP only received a $70,000 each year ongoing, because of that, they received a much larger distribution at sale.

What you’ll find is that the total distribution to the LP and GPs are the exact same for the ongoing catch-up or the catch-up at sale because the split is still 70-30. The only difference is how that money is distributed. So since the GP catch-up at sale allows the LP to make more money faster compared to the ongoing GP catch-up, the cash on cash returns are obviously going to be the same, but the IRRs are going to be a little bit different. So for this specific example, it’s not that big of a difference. The IRR for the catch-up at sale is 7.39 and the ongoing IRR is 7.32. So not that big of a difference, but there’s still a difference in the IRR. But overall, the GP catch-up at sale is gonna be a lot better for the LPs and the ongoing GP catch-up is going to be much better for the GPs. Even though at the end, the LPs and the GPs make the exact same.

So keep in mind that the views and opinions expressed in this document that you can look out for the data table as well as this episode are for informational purposes only and should not be construed as an offer to buy or sell any securities or consider any investment or course of action. I’m just here to tell you how the GP catch-ups work. So that concludes this episode. Again, that blog post with the data tables is everything you need to know about the GP catch-up. So definitely check that out. Check out some of our other syndication school episodes, as well as the free documents we have available. Those are available at syndicationschool.com. Thank you for listening. Have a best ever day and I’ll talk to you tomorrow.

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