Real estate sponsors typically invest their own capital alongside their equity co-investors in a deal. While sponsors can choose to align their capital with that of their investors, it is more common for them to earn the same returns, known as "pari passu," as other equity investors until they reach a specific return threshold, referred to as the "preferred return." Beyond the preferred return, sponsors start to receive a disproportionate share of excess profits, known as the "promote."

For example: A sponsor contributes 10% of their capital as part of the total equity required for a property acquisition and raises the remaining 90% from other investors. The sponsor's 10% equity is invested in the same entity as the other 90% co-investors, resulting in "Members" comprising 100% of the equity. The sponsor serves as the General Partner, while the investors are Limited Partners.

Below, we provide a comprehensive breakdown of the distribution and profit-sharing hierarchy, known as the "waterfall," which includes the sponsor promote, along with explanations for each tier:

Distribution Waterfall:

First, 100% pro-rata to the Members until each member has received an amount equal to a 10% IRR preferred return and its unrecovered capital contribution.

Explanation: In this initial tier, revenues are divided on a 90% (investors) / 10% (sponsor co-invest) basis until all parties have received a full return of capital plus a 10% annualised compounded rate of return. This tier represents the preferred return.

Second, 75% to the Members until each member has received an amount equal to a 20% IRR, and 25% to the General Partner as Promoted Interest.

Explanation: This constitutes the first tier of the promote. Beyond a 10% IRR, the sponsor begins earning 25% of all excess profits above their pro-rata share of profits from their 10% equity contribution. This disproportionate profit-sharing continues until the Members achieve a 20% IRR.

Thereafter, any remaining net cash shall be distributed 60% to the Members and 40% to the General Partner as Promoted Interest.

Explanation: This represents the second and final tier of the promote. Above a 20% IRR for all equity participants, the sponsor now receives 40% of all excess profits. When viewed from the perspective of investors versus the sponsor, investors receive 60% of 90%, equivalent to 54% of profits above a 20% IRR, while the sponsor receives 46% of excess profits above a 20% IRR, inclusive of their 10% equity contribution.

Why does the sponsor merit the promote? Investors might observe the above waterfall structure and conclude that if the property performs exceptionally well, the sponsor could potentially earn a larger sum than investors in the transaction. However, it's crucial to recognise that investors rely on the sponsor to carry out a range of critical tasks, including sourcing assets, conducting due diligence, negotiating deals, managing assets, and delivering investment returns. Given the substantial role the sponsor plays in the deal's success, it is reasonable for them to expect a greater share of profits than their proportional equity stake would suggest.

A Win-Win Scenario: The sponsor promote serves as an incentive for sponsors to exceed expectations and outperform the initial pro forma or business plan. If the sponsor surpasses expectations, they earn a bonus in the form of the promote. Equity investors also benefit from these additional profits, albeit to a lesser extent. Since investors depend on the sponsor to execute various critical tasks, offering a higher share of profits serves as a strong incentive for the sponsor to excel.

It's important to note that the structure of the promote can vary based on the sponsor and property type. Generally, the more effort required to achieve the targeted returns or the greater the complexity of the deal, the more favorable the promote splits may be for that particular deal.

Lastly, remember that the promote is distinct from any fees a sponsor may earn in a deal, which can encompass acquisition fees, asset management fees, and potentially disposition fees.

Direct investing: One of the advantages of the RealRaise platform is that it features a single promote paid to the sponsor. Platforms employing a special purpose vehicle (SPV) model for listing offerings may include a second promote. In this double-promoted structure, project profits are split twice—first between the platform and the sponsor, and then between the platform and the investor—before investors receive their share. RealRaise, on the other hand, adopts a direct-to-investor approach, avoiding the imposition of a second promote.