How a promote works in a real estate waterfall
The promote is the most misunderstood line in real estate finance, and it is the one that decides how everybody behaves.
By the CRE Modelling team
Here is the version nobody explains properly.
The structure
The LP puts in most of the money. The GP puts in a little and does the work. Profits are split in tiers, and the GP’s share rises as returns rise.
Say the structure is an 8 percent preferred return, then 80/20, then 70/30 above a 15 percent IRR. Now watch what that does:
- Below 8 percent, the GP earns nothing beyond fees and the return on its own co-investment.
- Between 8 and 15, the GP takes 20 percent of the upside on almost none of the capital.
- Above 15, the GP takes 30 percent.
The second tier is where the money is made. Which is why sponsors fight over the hurdle, not the price.
A three-tier split, worked
£10.0m of equity goes in, £9.0m from the LP and £1.0m from the GP, and £18.0m comes back after five years. Capital and the preferred return are shared pro rata; the promote is the GP’s share above its 10 percent stake:
| Tier | Total | LP | GP | |
|---|---|---|---|---|
| 1 | Return of capital | £10.00m | £9.00m | £1.00m |
| 2 | 8% preferred return, 5 years, simple | £4.00m | £3.60m | £0.40m |
| 3 | Up to the 15% hurdle, split 80/20 | £2.50m | £2.00m | £0.50m |
| 4 | Above the hurdle, split 70/30 | £1.50m | £1.05m | £0.45m |
| 5 | Total | £18.00m | £15.65m | £2.35m |
| 6 | Of which promote (GP above its 10% share) | £0.55m |
On £1.0m in, the GP takes £2.35m out, and £0.55m of that is promote: money it would not have seen on a straight pro rata split. The two upper tiers are where it came from.
The bit that catches people in interviews
The same returns produce different GP economics depending on whether the waterfall is European or American. In a European waterfall the promote is paid only after all capital is returned across the whole fund’s deals. In an American waterfall it is paid deal by deal, so the GP can take a promote on an early winner even if a later deal loses money. Same returns across the fund. Different incentives.
If you cannot model a waterfall, you cannot tell whose interests you are actually underwriting.