Sponsor Incentives in Real Estate Private Equity Offerings

In real estate private equity offerings, "promote" and “carried interest” are terms often used interchangeably, but they describe slightly different aspects of the compensation structure for general partners (GPs) or sponsors. Here's a breakdown:

1. Promote

• Definition: Promote refers to the share of profits allocated to the general partner (GP) as a performance-based incentive for successfully managing and delivering returns on the real estate investment. It represents the GP's "bonus" for exceeding a certain return threshold, such as the preferred return to limited partners (LPs).
• Mechanics:
• Limited partners typically receive a preferred return (e.g., 6-10%) on their invested capital before any profits are shared with the general partner.
• After the preferred return is met, the remaining profits are distributed according to the agreed-upon waterfall structure, where the GP receives a disproportionate share of the profits (the promote).
• Example: If the LPs invest 90% of the capital and the GPs invest 10%, the promote might allow the GP to receive 20-30% of the excess profits (even though they only contributed 10% of the capital).

2. Carried Interest

• Definition: Carried interest is the actual portion of profits that the general partner earns, based on the promote structure. It is the GP's "share of the upside" and is typically performance-based.
• Key Features:
• Carried interest is not a guaranteed payment; it depends entirely on the success of the investment.
• It is calculated after LPs receive their preferred return and sometimes after the return of their capital contributions.
• The amount and timing of carried interest depend on the agreed-upon profit distribution waterfall.

Relationship Between Promote and Carried Interest

• Promote is the concept or mechanism that allows the GP to earn carried interest.
• Carried interest is the specific amount the GP receives under the promote structure.

Example Scenario

1. Capital Structure:
• LPs contribute $9 million (90%).
• GPs contribute $1 million (10%).
2. Preferred Return:
• LPs are entitled to an 8% annual preferred return on their $9 million.
3. Profit Distribution:
• After the LPs receive their preferred return, profits are split:
• 70% to LPs.
• 30% to the GP (this 30% is the promote).
4. Outcome:
• If the total profits are $5 million:
• LPs receive their preferred return (8% of $9M = $720,000).
• Remaining profits of $4.28 million are split 70/30:
• LPs receive $2.996 million.
• GPs receive $1.284 million (this is the GP's carried interest).

Why It's Important

• Aligns Interests: Promote and carried interest align the incentives of the GP with the LPs by rewarding performance.
• Risk-Reward Balance: GPs take on significant risk in structuring and managing the deal, so the promote serves as compensation for taking on that entrepreneurial risk.

If you’d like to explore specific structures or scenarios in detail, feel free to ask!