When investing in a real estate partnership (also called a real estate syndication), you’ll encounter numerous terms to define the relationship.
General Partner and Limited Partner describe the roles and responsibilities of the investors and deal sponsors. A waterfall defines the structure by which returns will be paid. And in the waterfall, you’ll encounter the term catch-up provision.
In this article, we’ll define what a catch-up provision is, why it is used in syndicated real estate deals, and what it means to you, the investor.
What is a Catch-Up Provision?
In a private real estate deal, there are two primary roles:
- The sponsor/GP (general partner). The sponsor oversees sourcing, managing, and selling the property.
- The passive investor/LP (limited partner). Passive investors are invited to invest in the deal and receive distributions and a share of the return.
A catch-up provision is a specific clause found in partnership agreements that governs how profits are distributed between General Partners and Limited Partners.
In your typical private real estate deal, after LPs receive their preferred return, this provision allows the GP to receive an accelerated rate of profits until they "catch up" to their agreed-upon profit-sharing percentage. This bridges the gap between the initial preferred return phase and the standard profit-split arrangement.
When are Catch-Up Provisions Used?
You’ll encounter catch-up provisions in:
- Private equity funds
- Real estate investment partnerships
- Multifamily investment deals
They typically come into play in any investment structure that incorporates a preferred return mechanism. The provision becomes active after Limited Partners have received their preferred return, which is often set at 8%, but before the deal transitions to its standard profit-split arrangement, such as an 80/20 or 70/30 split between LPs and GPs.
Who Benefits From a Catch-Up Provision?
As we shared earlier, the catch-up provision allows the General Partner to receive an accelerated return from the deal. As a result, it’s the GP who is the primary beneficiary.
Why?
The catch-up provision allows GPs to receive their full promoted interest and help align their compensation with the overall success of the investment. Without a catch-up provision, GPs might find it challenging to achieve their target profit-sharing percentage, even when the investment performs well. The provision ensures they can eventually reach their intended share of the profits after LPs have received their preferred return.
Limited Partners aren’t left out of these benefits, though. Passive investors can indirectly benefit because the catch-up provision does the following:
- It keeps the GPs motivated to exceed the preferred return threshold.
- It aligns the interests of both parties.
- It offers transparency in the waterfall distribution structure.
- It strikes a balance between protecting the LPs' initial preferred return while still providing appropriate incentives for strong performance from the GP.
So the catch-up provision is not a one-sided feature of the deal. There are ways that passive investors can more directly benefit though: by investing as a Co-GP.
How Passive Investors Can Benefit: Invest as a Co-GP
In a Co-GP arrangement, you can invest passively like an LP but invest from the GP’s portion of the deal. This allows you to invest like an LP but earn like a GP without having to take on the sponsor’s responsibilities.
When a catch-up provision is activated, passive Co-GP investors benefit proportionally to their ownership percentage of the GP entity.
It's important for passive Co-GP investors to understand that their benefits from the catch-up provision are tied to the performance of the entire investment. They still need the project to perform well enough to exceed the preferred return threshold before the catch-up mechanism begins working in their favor. Additionally, their specific benefits will depend on how the Co-GP agreement structures the sharing of promote between operating partners and passive Co-GP investors.
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