This template describes real-world mechanisms of distributing profits between project participants. It starts with modeling a distribution to a preferred partner, who has priority rights on the distributions and receives a guaranteed return on his investment, until his contribution is repaid. Even thereafter he might be eligible to some equity incentives (kickers), which are included in this model as well.
Remaining profits are then distributed between common shareholders. A common setup in many private equity and other investment ventures is when a minority partner (general partner) carries out investment management activities. To motivate the general partner his proportion in profits can be made higher than merely his equity share if the project performs well.
This mechanism is called ‘carried interest’ and is normally set up in tiers, or buckets. Every tier corresponds to a certain level of profit to limited partners. Within every tier profits are distributed between GP and LP in a certain proportion. When a tier is filled, distribution moves to the next tier. Every successive tier has a distribution proportion more favorable to the general partner.
Under most carried interest arrangements, there are three hurdles introduced:
Hurdle 1 – preferred return. This covers the initial investment and some minimum profitability (e.g. 20%).
Hurdles 2 – catch-up. Once the interests of limited partners are satisfied, the general partner ‘catches up’ on his profits.
Hurdle 3 – carried interest itself. The general partners starts getting an even higher share of profits.
This template has four levels of tiers but can be amended to a higher number if needed very quickly. It can be built into your financial models, used for the calculations of actuals (also when payments occur at non-regular intervals) or for making accounting accruals.
The template is made in a very structured way which allows putting it, if required, into deal documentation and correspondence.