CRYSTALLIZATION OF THE PROMOTED INTEREST : A STRATEGY FOR OPPORTUNITY ZONE SPONSORS
95 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 .
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 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 .
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
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