If you are an investor in alternative investments or are looking to invest in them for the first time, you will eventually bump into a concept called a “promote”. A promote is used when the alternative investment structure has general partner (GP) shares and limited partnership shares. A promote is the GP’s share of profits above a predetermined threshold; in many instances, the promote is also referred to as carried interest.
How do you calculate it?
If the investment is in real estate, the limited partners (LP) receive a preferred return tied to the specific internal rate of return (IRR). After the LP investors receive their preferred return, the GP can then start to get a piece of the returns above that preferred return. For example if the investment has a preferred return of 9%, the investors get their 9% before the GP gets anything. Once the preferred return is satisfied, anything above that preferred return is split between the GP and LP members. One typical split is a 70/30 split. Once the preferred is paid to the investors, anything above that is split with 70% going to the LP’s and 30% going to the GP investors. The IRR and profits split between the GP and LP are collectively called the Waterfall.
When does a GP get their promote?
The GP will get their promote when they earn it by providing the preferred return to the investors. In most cases the GP investors only get paid during a capital event which in the real estate sector a sale. Many alternative investments have this LP/GP structure. Private equity and real estate funds are the most common.
Now the good news- Traditionally the GP shares are purchased by the “big guys”. These are the investment banks and investment companies that you would recognize their name. And the LP’s are for the “regular folks” who still need to be accredited (see below). Recently, we’ve seen alternative investments allow individual investors to buy the GP shares. The down side is this has less predictable income since the preferred return goes to the LP and the GP’s upside is at the end of the deal when the real estate is sold. The GP is not for anyone, but historically it wasn’t available to anyone who wasn’t a large firm. That is changing and giving accredited investors options they did not have before.
What makes someone accredited?
There are two primary ways to qualify as an accredited investor in the United States:
Income:
Individual: Net income of at least $200,000 in each of the two most recent tax years and a reasonable expectation of reaching this income level in the current year.
Joint: Combined net income of at least $300,000 in each of the two most recent tax years and a reasonable expectation of reaching this income level in the current year.
Net Worth:
Individual: Net worth of at least $1 million, excluding the value of your primary residence.
Joint: Combined net worth of at least $2 million, excluding the value of your primary residence.
This requirement safeguards both individual investors and the market from undue risk exposure by ensuring investors are financially prepared to engage in higher-risk opportunities.
Additional Considerations:
Entity Accreditation: Certain entities, such as corporations, trusts, and partnerships, can also qualify as accredited investors if they meet specific criteria.
State-Specific Requirements: Some states may have additional requirements or exemptions for accredited investors.
A promote might sound complicated, but it’s important if you’re getting into alternative investments like real estate or private equity. Simply put, a promote (also called carried interest) is the General Partner’s (GP) reward for doing well. They only get a share of the profits after investors, called Limited Partners (LPs), receive a minimum return, known as the preferred return. This setup motivates the GP to make smart decisions and grow profits.
While the idea makes sense, the way promotes are paid can be tricky. GPs usually have to wait for certain events—like selling a property—before they see their share of profits. The profits are split based on a system called a “waterfall,” which ensures investors get paid first. Lately, these GP shares have become available to individual accredited investors, not just big companies. But with more opportunity comes more risk, as these returns are unpredictable and depend on how well the investment performs.
Waterfall distributions can be tricky to set up and even harder to explain clearly in operating agreements. It’s important to get them right and have experienced professionals review them. How profits are divided during the investment can make a big difference in the returns investors see. Clear rules about who gets what and when—especially during the life of the project—are key to making sure everyone gets their fair share.
It’s also crucial for investors to understand the rules for becoming accredited. You need to meet income or net worth requirements to qualify, which helps make sure people are financially prepared for the risks involved. Knowing how a promote works can help investors make smarter choices, balancing the rewards of these investments with the challenges and risks they carry.
Securities are offered through Arkadios Capital. Member FINRA/SIPC. Advisory services are offered through Creative Capital Wealth Management Group. Creative Capital Wealth Management Group and Arkadios are not affiliated through any ownership.
This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice.
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