What is a Catch-Up Provision?
The waterfall structure in a syndication deal outlines how profits are distributed among partners and investors. It defines the priority of distribution and often ensures that the limited partners (LPs) receive their expected preferred returns before the general partners (GPs). Typically, the first distribution made is to cover the preferred return, which is a fixed percentage of the invested capital that LPs receive before GPs receive their share.
The Purpose of Catch-Up Provisions
To protect the interests of the GPs, a catch-up provision is often included alongside the preferred return. This provision is designed to allow the GPs to ‘catch up’ on their proportionate share of profits once the LPs have received their preferred return. In simple terms, the catch-up provision enables the GPs to receive a larger portion of the profits until they have earned the same return as the LPs.
Example of a Catch-Up Provision
Let’s consider an example to better illustrate how the catch-up provision works. Suppose a real estate syndication has a preferred return of 7% for LPs, and the profit split after the catch-up provision is 70% for LPs and 30% for GPs. Initially, all profits will be distributed to the LPs until they have received their preferred return of 7%.
Once the LPs have achieved their preferred return, the catch-up provision comes into play. From this point forward, the GPs receive the entire profit distribution until they have ‘caught up’ to the return percentage as disclosed in the split. In our example, if the LPs have already achieved their 7% preferred return, the catch-up provision allows the GPs to receive the remaining 3% to ‘catch-up’ in profit distributions.
After the GPs have caught up to the LPs, the remaining profit distribution shifts according to the predetermined split. In our example, the distribution would then follow a 70% to LPs and 30% to GPs split for any additional profits generated by the investment.
The catch-up provision serves as a mechanism to align the interests of both LPs and GPs. It ensures that LPs receive their preferred return and that GPs are adequately compensated for their efforts in managing the investment. By granting the GPs a catch-up opportunity, the provision incentivizes them to maximize the property’s performance and strive for higher returns, benefiting all parties involved.
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