Valuation Viewpoint Volume 24, Number 2 Summer 2019 Waterfalls and Hurdle Rates in Real Estate Private Equity by Madeline Strachota What is better: tiered returns or pari passu? It is up to you. Private equity organizational structures have various strengths and weaknesses. Appraisers encounter a wide variety of entity structures, including partnerships, limited liability companies (LLCs), and corporations, all organized in different ways. This makes understanding the governing documents of an entity essential to understanding the value of an interest in that entity. Common reasons for varying organizational structures include optimizing wealth transfer in estate planning, tax planning, limiting liability, aligning incentives, and assigning roles based on what each partner brings to a deal. As an asset class, private investment in real estate has grown substantially in the 21st century. Real estate private equity in the form of pooled funds for investment in real estate did not become popular until the 1990s. These funds grew out of private investors pooling capital to take advantage of falling real estate prices in the early 1990s and have continued to grow in popularity, especially in the build up to the Great Recession. In all economic cycles, investors choose real estate to add diversification to their portfolios and because the assets are income-producing, can hedge against inflation, and are tangible. Within real estate private equity there is a common entity structure that seeks to align entrepreneurs and investors: the equity waterfall. Each equity waterfall can be different. The main idea is to determine which partner or partners control day-to-day operations and how distributions are made to the different equity classes. Often, these funds are structured as partnerships with one general partner and many limited partners. Unlike entities that distribute capital on a pro rata (pari passu) basis according to the percentage of initial capital each investor contributed, waterfalls distribute capital unevenly among partners once certain performance milestones, or hurdles, are met. Why would investors agree to receive distributions that are not proportionate to their initial investment? The rationale is that entrepreneurs bring ideas and investors bring capital. Each partner needs to be compensated for what they contribute and the relative risk they bear. When capital is plentiful and good deals are scarce, structures tend to favor the entrepreneur. When capital is tight and deals are plentiful, structures tend to favor the capital providers. A waterfall structure also incentivizes the general partner to achieve higher returns, because at each higher return tier the general partner receives a disproportionately higher share of distributions compared to the limited partners. Often, the entrepreneur also bears most of the up-front costs associated with real estate development or investment, and must be compensated for this higher risk. Most waterfall models follow the same general principles. However, organizational documents can specify many different arrangements that materially affect management decisions and distributions. Governance and allocation terms are key differentiators, but numerous other provisions can also affect value. For example, a general partner or managing member may control the entity and receive separate returns, or interests may be equally divided with shared voting rights. Some equity partners may be entitled to a preferred return over others. Members, partners, or shareholders may be individuals or entities, each with its own structure. Examples of common provisions and their impact include: The provision: Distributions based on individual investments versus aggregate investments. The impact: If one investment performs extremely well and crosses the highest hurdle, while others perform poorly, the general partner may receive a large share of returns from the successful investment, and there may be no distributions on weaker investments. The provision: A clawback provision. The impact: If a fund does not perform consistently over time, prior distributions to the general partner can be clawed back and redistributed to limited partners. The provision: General partner participation in both voting and nonvoting equity pools. The impact: Whether the entrepreneur participates as a common equity investor, a controlling investor entitled to the promote, or both, will affect how equity splits flow. The provision: Different waterfalls for operating cash flow and reversion (sale) cash flow. The impact: If the operating cash flow waterfall favors the general partner more than the reversion waterfall, it may incentivize holding assets longer instead of selling. To fully understand the potential upside and downside of an investment, it is important to understand the governance of an organization with an equity waterfall distribution. Investors should also consider fees paid to entrepreneurs that flow through the income statement and are not treated as equity distributions. Real estate private equity has widely adopted waterfall structures for operating and reversion distributions. Although the intent is to align incentives and allocate risk efficiently, the complexity of these structures raises the question of whether they are always necessary. For those less experienced with this asset class, pooled fund structures can appear overly complex. Some critics argue that such structures resemble the opaque financial practices that contributed to the Great Recession. As with any partnership, fiduciaries are trusted to make value-creating decisions for all partners, and complex terms can be misused if investors do not understand them. The waterfall structure itself is not inherently problematic. It may create more work for accountants and appraisers, but many argue that it reflects an evolving sophistication in the industry and can efficiently allocate risk and reward. Time will tell whether investors demand simpler structures for the sake of transparency. Typical Waterfall Structure (Example) Step 1 Initial investment in the fund: $100,000 Entrepreneur invests $10,000 Other investors invest $90,000 Split: 10/90 Step 2 At the end of Year 1, the fund receives total cash flow (net operating income plus sale proceeds) of $120,000. Total return is 20 percent. Step 3 Distributions follow the equity waterfall outlined in the governing documents. An example structure: Return of capital: Entrepreneur $10,000 Other investors $90,000 Split 10/90 0 to 10 percent return tier: $10,000 total Entrepreneur $1,000 Other investors $9,000 Split 10/90 10 to 11 percent return tier: $1,000 total Entrepreneur $150 Other investors $850 Split 15/85 11 to 12 percent return tier: $1,000 total Entrepreneur $200 Other investors $800 Split 20/80 12 to 13 percent return tier: $1,000 total Entrepreneur $250 Other investors $750 Split 25/75 Above 13 percent return tier: $7,000 total Entrepreneur $2,100 Other investors $4,900 Split 30/70 Total distribution of $120,000 results in: Entrepreneur: $13,700 total, a 37 percent return Other investors: $106,300 total, an 18 percent return Under a pari passu structure (no waterfall), both the entrepreneur and other investors would receive a 20 percent return. The additional return to the entrepreneur in the waterfall structure is known as the promote. Mergers and Acquisitions by Jim Clancy, Managing Director, Hennepin Partners Strong M&A Market Pushing Higher Valuations and Increasing the Number of Transactions Led by a strong economy and a prolonged bull market in equities, middle market M&A has experienced strong growth in both deal volume and valuation multiples. According to PitchBook, private equity firms closed more than $400 billion of middle market M&A transactions in 2018. Robust fundraising and significant cash reserves among strategic buyers have supported this activity. Lenders have also provided favorable financing conditions. Competition among buyers with ample capital is driving historically high valuation multiples across sectors, including industrial technology and software. Industrial Technology and Software: Non-tech Companies Using M&A to Stay Ahead Non-technology strategic buyers have completed more technology acquisitions than technology buyers for several consecutive years. As technology-driven disruption affects many industries, traditional companies increasingly use acquisitions to obtain new capabilities rather than develop them in-house. Public markets have generally rewarded these strategies. Non-tech acquirers are sometimes willing to pay higher multiples for technology assets, reflecting the value placed on digital transformation and innovation. ASSA ABLOY Acquires KEYper Systems Hennepin Partners recently advised on the sale of KEYper Systems, a Charlotte, North Carolina-based supplier of electronic and mechanical key management systems, to ASSA ABLOY. KEYper Systems offers advanced software solutions and has a strong presence in the U.S. automotive segment. ASSA ABLOY, a global leader in door opening solutions, gained access to new technologies, products, and markets through this acquisition. Sale of Former First Precinct by Victoria Mercer Seller: Goldman Sachs/R2 Buyer: Fifth Street Commons LLC Sale Date: Early May 2019 Sale Price: $900,000 The historic building at 25-33 South Fifth Street in Minneapolis served as the Minneapolis Police Department’s First Precinct for 25 years. Constructed in 1885 as two connected buildings, one portion has two stories and the other has four. Over time, it has housed the Chamber of Commerce and Robins Kaplan. The building has been vacant since the First Precinct relocated nearly 10 years ago and is currently gutted. It was purchased for $1.9 million in 2014 and assessed at that value earlier in 2019. Due to the extent of needed renovations and the seller’s preference for an as-is cash sale, buyer interest was limited. Fifth Street Commons LLC plans to renovate the property, including updating the HVAC system to be independent from the neighboring building and connecting the property to the downtown skyway system. The design will highlight exposed brick and timber. The second through fourth floors are planned for office tenants, and the first floor will be used for a non-retail business storefront. Upon completion, the renovated Class B space is expected to rent at approximately $25 to $28 per square foot gross with an expense stop. Market Trends and Value Indicators Office Buildings – Downtown Office Buildings – Suburban Retail Centers Industrial Buildings Apartments New Housing Starts – Midwest* Productivity** U.S. Unemployment *Source: United States Census Bureau **Based on available productivity data Rates of Return and Risk Hierarchy 30-Year Treasury: 2.94% Aaa Bond: 3.53% Bbb Bond: 3.82% Commercial Mortgage: 4.75% – 5.50% Institutional Real Estate: 6.0% – 7.5% Non-Institutional Real Estate: 8.0% – 10.0% S&P Equity (Duff & Phelps): 10.30% Equipment Finance Rates: 10.0% – 12.0% Speculative Real Estate: 11.0% – 16.0% NYSE/OTC Equity (Duff & Phelps): 13.70% Land Development: 12.0% – 25.0% NYSE Small Cap Equity (Duff & Phelps): 16.73% As of June 10, 2019. Sources include the United States Census Bureau, Pratt’s Stats, Bureau of Labor Statistics, Bureau of Economic Analysis, The Conference Board, Yahoo Finance, Duff & Phelps. Shenehon Company makes every effort to ensure the accuracy of information but does not guarantee it. About Shenehon Company Shenehon Company is a real estate and business valuation firm serving private and public sector clients throughout the United States. The firm’s combination of real estate and business valuation expertise supports a wide range of services and solutions to complex valuation issues. Shenehon Company is dedicated to equipping clients with the tools they need to make informed and knowledgeable decisions regarding capital investments. Areas of Expertise: Allocation of purchase price Asset depreciation studies Bankruptcy proceedings Charitable donations Commercial properties Condemnation Contamination impact studies ESOP/ESOT Estate planning Feasibility analyses General and limited partnership interests Gift tax evaluations Going public or private Highest and best use studies Industrial properties Insurance indemnification Intangible asset valuation Internal management decisions Investment counseling Land development cost studies Lease and rental analyses Lost profit analyses Marriage dissolution Mortgage financing Multi-family residential properties Municipal redevelopment studies Potential sales and purchases Railroad right-of-ways Special assessment appeals Special purpose real estate Tax abatement proceedings Tax increment financing Utility and communication easements Contributors: H. Ellis Beck Jim Clancy Robert Strachota Madeline Strachota Victoria Mercer Copyright 2019. Valuation Viewpoint is prepared and published by Shenehon Company. Opinions regarding business and real estate valuation issues have been carefully researched and considered by the authors. Readers should consult their own advisors before making business decisions.

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