Learn a strategy for how sponsors in the real estate Opportunity Zone space can obtain both early liquidity and minimize their downside valuation risk with respect to the sponsor’s “promoted interest” over the minimum 10 year holding period required for a transaction utilizing the Opportunity Zone incentive.
What is a promoted interest?
In the real estate private equity world, a portion of a sponsor’s compensation is typically based upon the sponsor’s portion of an increase in value that the sponsor creates in the underlying asset as a result of the sponsor’s efforts. This is often referred to as the “promoted interest” and is essentially a share of profits that the sponsor obtains from the real estate venture.
Since it is typical to use a partnership for federal income tax purposes to hold real estate assets, Opportunity Zone transactions involving the development of real estate often involved either a limited partnership or limited liability company for both the qualified opportunity fund (the QOF) and the qualified opportunity zone business (the QOZB). Accordingly, the promoted interest is structured as an equity interest in the QOF or the QOZB so that the sponsor can obtain the long-term capital gains income tax rate on its allocated share of profits. Sponsors will not usually benefit from this incentive until a significant liquidity event occurs such as a sale of the underlying asset. Still, a promoted interest is intended to motivate the sponsor to create as much value as possible to the underlying real estate.
Challenges with Opportunity Zone transactions
Having to wait until the asset is sold to benefit from this portion of sponsor’s incentive compensation is a challenge with Opportunity Zone transactions because it is intended that the underlying real estate be held for at least 10 years from the date that the last investor has contributed capital to a QOF (i.e., the 10 Year Holding Period). Therefore, a sponsor needs to wait longer to benefit from this incentive in an Opportunity Zone transaction than a conventional real estate development transaction - where the asset is often sold shortly after stabilization.
Risk for sponsor – The runaway accrual
The 10 Year Holding Period is problematic for sponsors partly because a longer holding period means a longer accrual of the preferred return on the investors’ capital. The higher the accrual amount of the preferred return on the investors’ capital, the more difficult it will be for the sponsor to obtain any promote. In most cases, the investors need to receive both a preference on their capital and a return of their capital before the sponsor obtains any benefit from their promoted interest. As stated above, a significant liquidity event is needed for the sponsor to obtain the tangible benefit of its promoted interest. Below is a typical distribution waterfall for the distribution of sale or refinancing proceeds whereby the promote for the sponsor is 20% of the remaining profits:
(1) First, to the investors, in proportion to their accrued but unpaid 8% preferred return, until each of the investors have received cumulative distributions in the amount of their accrued 8% preferred return;
(2) Second, to the investors, in proportion to their unreturned capital contribution balances, until each of the investor’s unreturned capital contribution balance has been reduced to zero; and
(3) Third, (i) 80% of the remaining balance to the investors, in proportion to their relative percentage interests, and (ii) 20% of such remaining balance to the sponsor.
Clause (3)(ii) represents the sponsor’s promoted interest. Again, in order for the sponsor to obtain any benefit from the promoted interest, the proceeds to be distributed from the sale of the underlying real estate need to exceed the amount of the preference that has accrued to each investor in clause (1), plus the amount of each investor’s contributed capital as provided in clause (2). Specifically, the sponsor takes a risk that the accrual of the preference over the 10 Year Holding Period will accrue in an amount that significantly dilutes the potential amount of cash to be distributed to the sponsor in clause (3)(ii) upon a sale of the underlying asset.
Risk for sponsor - Loss of opportunity
Over the required 10 Year Holding Period, the price of the underlying real estate will likely fluctuate and the sponsor could lose out an opportunity to sell the underlying asset at a time that would maximize the amount that would be distributed to the sponsor with respect to its promote. Unfortunately, the most opportunistic time for a sale of the underlying real estate asset is probably at stabilization of such asset. However, a sale at such time would not avail the investors of the Opportunity Zone benefits.
Expected refinancing
Most sponsors intend to refinance the underlying real estate asset and make distributions of the excess cash proceeds prior to the date that the investors will be required to pay income tax on the eligible gain that was deferred with respect to the Opportunity Zone incentive. Based upon the distribution waterfall described above, in order for the sponsor to receive any portion of the excess refinancing proceeds, this amount needs to exceed the amount of the investor’s 8% preferred return plus the investor’s original capital. It appears to be a challenge for the sponsor to receive any cash from the distribution of excess proceeds from such a refinancing based upon the waterfall set forth above.
Crystalizing the promoted interest
One alternative for the sponsor is to negotiate with the investor the ability to make an election to “crystalize the promote.” By crystalizing the promoted interest, the distribution waterfall is changed from a layered hurdle approach to a straight up percentage interest between the investors and the sponsor. This will have the impact of freezing the value of the real estate asset for distribution purposes based upon what the investors and the sponsor would receive upon a hypothetical sale of the assets and a distribution of the excess cash at the time of the election.
An election to crystalize the promote is often made at the time of a certain milestone, such as stabilization. Having an election at the time of such milestone is usually beneficial for the sponsor because it establishes a value for the crystallization when the hypothetical liquidation proceeds should result in an advantageous percentage as it relates to the sponsor as compared to the investors because of the shortened period for the accrual of the investor’s preferred return. This should also protect the sponsor from downward fluctuations in the value of the real estate over the 10 Year Holding Period.
Example – No preference on capital
Assume that a number of QOFs formed by high net worth individuals contribute an aggregate amount of $10 million to a QOZB. The QOZB obtains a $10 million loan and then acquires and develops a parcel of real estate for $20 million. The distribution waterfall is the same waterfall as described above but without a distribution to the QOF investors for a preference on their capital in clause (1).
In the fourth year, after the developed property has reached stabilization, the property is worth $30 million. If the property were to be sold at such time, the sponsor would obtain $2 million of hypothetical liquidation proceeds, or 10% of the total $20 million of hypothetical liquidation proceeds (after paying off the debt). If the sponsor made the crystallization election at such time, then the distribution waterfall would result in the sponsor having a percentage interest of 10%, and the QOF investors having a percentage interest of 90%. In the eleventh year, the property has decreased in value to $26 million. If the property were sold at such time without a crystallization election having been made, then the sponsor would receive $1.2 million of liquidation proceeds (after the loan is paid off), but would receive $1.6 million had a crystallization election been made.
The same analysis can be undertaken with respect to refinancing the asset and distributing the excess proceeds. Assume that the asset was refinanced in the sixth year after the crystallization election was made in the fourth year, and the excess proceeds for distribution are $4 million. Without the crystallization election, all of the excess proceeds would be distributed to the QOF investors. With the crystallization election, the sponsor would receive $400,000 of the $4 million of excess proceeds.
Tax issues
The negotiation between a sponsor and an investor with respect to crystallization election often involves the resolution of an income tax issue. This tax issue depends upon whether the assets of the QOZB can be revalued (resulting in a corresponding book-up to the capital accounts of the partners/members) as a result of the crystallization election.
Sponsors often use forced allocations in their applicable limited liability company or limited partnership agreements. This means that profits or losses generated in each year of the entity will be allocated in a manner to each member/partner, after taking into account any distributions and contributions, so as to bring the capital accounts for each member/partner to the amount that such member/partner would receive in a hypothetical liquidation of the entity each year. Without a revaluation of assets (and the booking-up of the capital accounts of the members/partners), ordinary income could be disproportionately allocated to the sponsor over the 10 Year Period to increase its capital account to the amount of cash it would receive under a hypothetical liquidation of the entity. However, a book-up of capital accounts could also result in more ordinary income being allocated to the QOF investors during the same period.
The Treasury Regulations provide a specific set of circumstances allowing for a revaluation of assets (resulting in a book-up of the capital accounts). It remains unclear as to whether the making an election to crystalize the promote allows for such a book-up of the capital accounts of the members/partners. As a result, a sponsor should consider negotiating with the investors for a book-up of capital accounts, or to manufacture a transaction, such as a small redemption at the time of the crystallization election, where it is clear that a book-up of the capital accounts can occur. At the very least, the sponsor should negotiate a provision to receive mandatory distributions in an amount so that its direct and indirect equity holders can satisfy their income tax obligations from an allocation of taxable income from the entity.
Because of the required 10 Year Holding Period, sponsors should consider negotiating with investors for an election to crystalize the sponsor’s promoted interest. This freezes the value of the promoted interest to reduce the impact of the fluctuations that could occur during the 10 Year Holding Period. Still, investors may push back on this request for a number of reasons including with respect to having a revaluation of the assets (and a corresponding book-up of capital accounts). In any event, the sponsor should make sure that it obtains tax distributions from the entity because of the potential for phantom income.
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