What are private equity returns?
Private equity returns are the returns that are realized from a private equity investment. Basically, how do people make money inside a private equity real estate investment or fund? There are usually several investors involved. And who gets paid first is based on the capital stack that we covered in another post.
Senior Debt Private Equity Returns
So, in the capital stack, starting at the bottom is the senior debt lender. These are banks that lend you money, or they could be private lenders, but they are people that are putting in probably the most capital in the investment and in the form of debt. And they make money based on the interest they charge for providing that loan.
And the other people that make money with the loan would be the originators and they earn an origination fee. So, any mortgage broker or somebody that facilitated or originated the loan also makes private equity returns
Mezzanine Debt Private Equity Returns
Mezzanine debt lenders make private equity returns the same way as the senior debt lenders in that they make interest on the loan that they provided.
Also, with the mezzanine loan, there might be some origination fees paid to another mortgage broker or loan coordinator. Plus, if the mezzanine debt holders convert their debt into equity, they have the potential to make private equity returns from the profits of the investment over a period of time, when the final sale of the investment is made and when the final sale of the real estate is made.
Preferred Equity Private Equity Returns
Next in line in the capital stack is the private equity investors. And these are the limited partners. These are the people that are supposed to be making the most private equity returns, or at least where most of the profits are being distributed.
So, they get what’s called a base return or preferred return which usually is in the 7% to 8% range. Preferred return is the return that is promised by the private equity real estate company as the minimum amount that the investors will receive before any additional profits are distributed to the general partners.
So, what happens is the limited partner investors will get their base return and then above and beyond that, they will usually get a return, an additional return from additional profits from the investment.
So, let’s say they have a preferred return of 7% and the overall profits from the investment come out to let’s say, 20%. Okay. So, that’s a difference of 13%. And that’s 13% shared between the general partners and the limited partners. The general partners usually get about 20% of that 13%. And then the balance, the 80%, goes to the investors, the limited shareholders, the limited partners.
So, the shareholders who are the limited partners which are the overall investors, the silent investors, get their base 8% plus they get 80% of any additional profits above and beyond their base amount.
Common Equity Private Equity Returns
And then finally, the common equity, which is the equity that’s owned usually by the general partners. And for their portion of their investment, they would get their return on their portion of the profits earned in the private equity investment.
Private Equity Firms
The general partner is usually the private equity firm, and they also get paid fees. And these fees are usually acquisition fees and disposition fees and management fees which are part of the private equity returns.
Acquisition fees are fees that these firms get paid when they go out and acquire a property.
So, if they purchase a property for, let’s say, $100M and they get a 2% acquisition fee, they will make $2M in that acquisition.
As well as when they went to sell the property. If they sold it for, let’s say $200M, they would get another, let’s say 1%. So, they would make another $2M on the sale of the property.
And finally, they usually get a management fee of, anywhere from 1% to 4%. So, let’s say if they got a 1% fee, they would make another $1M a year just on the management of that property.
And then finally they would also get a portion of the overall profits called carried interest. This is above and beyond what they contributed to the investment.
So, in the scenario, I talked about earlier, there was an additional 13% of profits. The private equity firm would make 20% of that 13% of the total profit.
Dividend Recapitalization
And then finally, there’s something called dividend recapitalization, which is where a special dividend is paid to all the shareholders by issuing new debt. Now that’s a more complicated scenario, but it’s used to provide liquidity to shareholders without impacting any of the ownership.
