Performance Measurement and Cash Distribution in Real Estate Private Equity Financing

Abstract

This case deals with the challenges of corporate decision-making under conditions of uncertainty in the real estate sector in Egypt. The board of a real estate company must make decisions on new project expansion and financing. While the board considers private equity as a credible external source of new project finance, its walkabouts pose operational and financing challenges which the chief executive officer must understand and resolve. The case begins by describing the complexities of the discussion in the board regarding the new project’s financing strategy. Subsequently, the case considers the discussion of company’s chief executive officer with an external corporate advisor on the effective use of private equity financing. Finally, the case provides a detailed analysis of the negotiation process between the chief executive with the private equity firm regarding the financing and waterfall rules for the distribution of the project’s net cash flows between the private equity firm and the real estate development company. The case aims to provide students with an understanding of the processes and complexities in corporate decision-making under conditions of uncertainty. The case describes these processes by referring to a renowned real estate development company in Egypt. The case begins with a short reference to the real estate development history in the country, it then introduces the company and describes the discussion in the board meeting regarding the challenges it faces in making the choice of private equity financing for a new project. The case also raises and discusses the important issue of seeking external advisory services. And finally it considers in detail the structure of private equity financing and the associated negotiation between a private equity firm and the real estate development company regarding the waterfall rules of potential cash flows.

This case was prepared for inclusion in Sage Business Cases primarily as a basis for classroom discussion or self-study, and is not meant to illustrate either effective or ineffective management styles. Nothing herein shall be deemed to be an endorsement of any kind. This case is for scholarly, educational, or personal use only within your university, and cannot be forwarded outside the university or used for other commercial purposes.

2024 Sage Publications, Inc. All Rights Reserved

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Resources

Appendix I – Cash Flow/IRR Computations

Project Information

  • All joint venture equity is invested at the beginning of the development period
  • Pre-development costs are negligible
  • The development period lasts 24 months
  • The project will be liquidated at completion
  • There is no revenue to be received prior to completion
  • The annual growth rate of net operating income is 3% post-development
  • The current and near-term forecast market cap rate is 9%
  • The development cap rate is 12%
  • The construction loan-to-cost (LTC) ratio is 70%
  • The loan-to-value (LTV) perm loan ratio is 60%
  • The borrowing rate of interest is 10%
  • Interest is capitalized on construction debt
  • The developer’s equity contribution is 10% and the investor’s equity contribution is 90%
  • The hurdle rate is 10%
  • Cash distributions are split between 25% to developer and 75% to Limited Partner

Panel A. Per $1 of cost, $1 is invested immediately and managing cash flow forecasts are $0.120 in year three, growing at 3% each year thereafter. The forecasted market value of the real estate asset at the end of each period can be found from the market cap rate. Since the market cap is NOI/price, price 2 NOI/market cap. If the market cap forecast is fixed at 7%, the value of the development per $1 of project cost at the end of the development period is $0.12/0.09 = $1.333 and it grows at 3% per year. The table below captures total cash flow per $1 of project cost and IRR for project holding periods of 2 to 5 years.

Panel B. Now suppose that the project is financed with construction debt and that the LTC ratio is 70%. In the event the real estate asset is held beyond the development period, assume that the development loan is refinanced with perm debt and that the LTV ratio of the perm loan is 60%. Note that a successful project will generate significant value-added (market value, net of total cost), and that refinance is an avenue for extracting a portion of that value-added. Thus, project market value post development is $1.333 (approx.) per $1 of cost. A 60% LTV perm loan generates $1.333 × 0.60 = $933, which, after paying off the construction loan balance, leaves $233 (60% of value-added). In contrast to construction debt, perm debt interest is paid in cash rather than capitalized. Residual value is simply asset market value net of debt and is the equity portion of asset sales proceeds. Total equity cash flow in any period is managing income net of interest payments, net refinance cash flow, and residual value in the last year of the holding period.

Panel C. Given the 90%/10% split in LP/GP equity, the cash flow waterfall is assumed pari pasu distribution until a 15% IRR has been earned on equity capital, with 75%/25% GP/LP split thereafter. These cash splits and the associated IRRS are provided assuming a 5-year total project life of which 3 years is the post development-holding period. Accounting balance is the prior period’s equity (net) balance and that period’s 15% preferred return. Equity cash flow is netted from this line to give the net preferred account balance to be carried forward cash flow is distributed pari pasu until the net balance is less than or equal to 0, that is until the preferred IRR has been met. A negative net balance represents cash flow that is distributed 25%/75%, i.e., cash flow over which the General Partner receives market preferred return payments (see next page for the calculation in the Excel file).

Table 1. Cash flows, returns and pay-off distribution between developer and investors

Information

Growth rate = 3%

Interest rate = 10%

Market cap rate = 9%

Hurdle rate = 15%

Loan-to-cost ratio = 70%

PANEL A.

Year

Y0

Y1

Y2

Y3

Y4

Y5

IRR

Investment

−1

0

0

0

0

0

NOI

0.120

0.124

0.127

0.094

Market value

1.333

1.373

1.415

1.457

CF

0

1

2

3

4

5

5

2 Yrs

−1

0

1.333

0

0

0

0

15.47%

3 Yrs

−1

0

0

1.493

0

0

0

14.30%

4 Yrs

−1

0

0

0.120

1.538

0

0

13.76%

5 Yrs

−1

0

0

0.120

0.124

1.584

1.458

13.44%

PANEL B.

Y0

Y1

Y2

Y3

Y4

Y5

Y5

Investment

−0.4

0

0

0

0

0

NOI

0

0

0

0.120

0.124

0.127

0.094

Interest

0

0

0

0.133

0.133

0.133

0.077

Market value

0

0

1.333

1.373

1.415

1.457

Debt

0

0

0.933

0.933

0.933

0.933

0.771

Residual value

0

0

0.400

0.440

0.481

0.524

Refinance CF

0

0

0.233

PANEL C.

Y0

Y1

Y2

Y3

Y4

Y5

Y5

IRR

CF: 2 Yrs

−0.4

0

0.633

0

0

0

0

25.83%

CF: 3 Yrs

−0.4

0

0.233

0.440

0

0

0

21.89%

CF: 4 Yrs

−0.4

0

0.233

−0.013

0.481

0

0

18.70%

Y0

Y1

Y2

Y3

Y4

Y5

Y5

Acct balance

0.4

0.460

0.529

0.340

0.406

0.478

Cash flow

0

0.233

−0.013

−0.010

0.524

Net balance

0.460

0.296

0.353

0.416

−0.045

Cash splits

IRR

GP (0.25)

−0.04

0

0.023

−0.001

−0.001

0.084

0.124

26.08%

LP (0.75)

−0.36

0

0.210

−0.012

−0.009

0.509

0.712

18.13%

Appendix II – Figures and Tables in the Text

Table. Sales price growth in Cairo area, 2015

Sales Price Growth (Q2 2015)

Year-on-year (%)

Quarter-on-quarter (%)

New Cairo

8.0

1.0

Apartments

8.0

1.0

Villas

−7.0

0.0

6th of October

Apartments

26.0

−2.0

Villas

23.0

−2.0

Source: Jones Lang LaSalle

The graph is titled House Price Change, Annual (%). The horizontal axis lists the years and ranges from ‵07 to ‵09 with nil increments. The vertical axis lists the values and ranges from minus 20 to 50 in increments of 10. The approximate data from the graph is tabulated below.

Years

Nominal

Real

‵07

25

10

‵08

29

19

‵09

30

15

Figure 1. Real estate prices in Egypt, 2006–2010

A line graph shows a comparison of the nominal and real price changes in houses from ‵07 to ‵09.

The details are tabulated below.

Sales Price Growth (Q2 2015)

Year-on-year (%)

Quarter-on-quarter (%)

New Cairo

Apartments

8.0

1.0

Villas

minus 7.0

0.0

6th of October

Apartments

26.0

minus 2.0

Villas

23.0

minus 2.0

Figure 2. Sales price growth in Cairo area, 2015

A tabular column shows a comparison of the Year-on-year and quarter-on-quarter percentage of sales price for Q2 2015.

Source: Jones Lang LaSalle

Four illustration each are depicted on the left and right sides, respectively.

The illustrations on the left depicted from top to bottom are as follows.

The first illustration is a line graph that shows a comparison of the total population in millions from 1996 to 2036. The horizontal axis is labeled Year and ranges from 1996 to 2036 in increments of 10 years. The vertical axis is labeled Total population in millions and ranges from 20 to 120 in increments of 10. A trend line slopes upwards through 60 million to 113 million from 1996 to 2036. Another trend line slopes upwards through 60 million to 88 million from 1996 to 2036. An arrow indicates toward this trend line, which reads Fertility equals to replacement level. A horizontal dotted line is drawn through 60 million. The gap between the dotted line and 86 million is labeled Population momentum. The gap between population momentum and 113 million is labeled Fertility above replacement level.

Source: RAND Corporation

The second illustration is a bar graph that shows a comparison of the educational attainment for preparatory, secondary, and college for 1988, 1998, and 2006. The graph is titled Educational Attainment among 21–24 year-old cohorts. The horizontal axis lists the cohorts Preparatory, Secondary, and College. The data from the graph is tabulated below.

Cohorts

1988

1998

2006

Preparatory

43

53

69

Secondary

38

48

65

College

7

11

17

The third illustration is a line graph that shows a comparison of the urban and rural population across six years. The graph is titled Urban and Rural population. The horizontal axis lists the year from 1950 to 2055 in increments of 15. The vertical axis lists the values ranging from 0 to 70000 in increments of 10000. The Urban trend line shows an upward solid line curve. The Rural trend line shows a fluctuating solid line curve with an upward slope across the years and a decline toward the last two years.

The fourth illustration is a line graph that shows a comparison of crude birth and death rate across seven years. The graph is titled Crude birth and Death rate. The horizontal axis lists the year from 1955 to 2045 in increments of 15. The vertical axis lists the values ranging from 0 to 50 in increments of 10. The Crude birth rate trend line shows a downward fluctuating solid line curve. The Crude death rate shows a fluctuating solid line curve with a dip across the years and a rise toward the last two years.

The illustrations depicted from top to bottom on the right side are as follows.

The first illustration is a map of Egypt depicting the population by governate along a horizontal bar graph depicting the total population by age group. The illustration is titled Population by governate, 2014. The details from the map are tabulated as follows.

Population in millions

Governate

8.0–10.0

Cairo

6.0–7.9

Al Jizah

4.0–5.9

Tanta

2.0–3.9

Al Fayyum

1.0–1.9

Al Isma’iliyah

0–0.9

Janub Sina

A horizontal bar graph shows the population percentage across different age groups. A caption reads total population 83.7 m. The details from the graph are tabulated below.

Age Group

Population percentage

0–14

32.1%

15–24

17.8%

25–54

38.4%

55–65

5%

65 plus

4.8%

The second illustration shows a bar graph titled Percentage of increase in Refugees by Country – (Registered). The horizontal axis lists the countries. The vertical axis is labeled Change % and ranges from 0% to 400%, in increments of 50%. The data from the graph is tabulated below.

Countries

Refugee percentage

Jordan

331%

Lebanon

242%

Turkey

179%

Iraq

199%

Egypt

338%

Total

240%

The third illustration shows a line graph titled Egypt per capita GDP and energy consumption. The line graph shows a comparison of Egypt's GDP and energy consumption from 1970 to 2012. The horizontal axis lists the years in increments of 3. The vertical axis on the left is labeled per capita GDP $US 2005 and ranges from 0 to 1,800 in increments 200. The vertical axis on the right is labeled per capita energy consumption TOE per annum and ranges from 0.0 to 1.2 in increments of 0.2. A caption within the graph reads Energy Matters euanmearns.com BP and UN data. The approximate data from the graph are tabulated below.

Years

GDP

Energy

1970

380

0.18

1973

390

0.18

1976

400

0.20

1979

580

0.40

1982

680

0.60

1985

820

0.50

1988

830

0.55

1991

850

0.54

1994

1000

0.56

1997

1,200

0.60

2000

1,200

0.70

2003

1,220

0.80

2006

1,400

0.90

2009

1,600

0.99

2012

1,620

1.00

The fourth illustration shows a line graph titled Egypt's Stock Market. A line graph shows a comparison of the EGX 30 Index from Jan-13 to Jun-13. The horizontal axis lists the years and ranges from Jan-13 to Jun-13. The vertical axis is labeled EGX 30 Index and ranges from 4,000 to 6,000 in increments of 200. The approximate data from the graph is tabulated below.

Years

EGX 30 Index

Jan-13

5,600

Feb-13

5,500

Mar-13

5,000

Apr-13

5,200

May-13

5,400

Jun-13

4,800

Figure 3. Economic and social trends with positive influence on the demand for real estate

An illustration depicts five line graphs and three bar graphs that depict the trends for real estate.

Three illustration each are depicted on the left and right sides, respectively.

The illustrations on the left depicted from top to bottom are as follows:

The first illustration is a pie chart that shows a comparison of the break-up percentage of the remittances of Egyptians from different countries. The graph is titled Egypt: Remittances of Egyptians working abroad by country, FY 2008/2009, according to the Central Bank of Egypt. The details from the chart are tabulated below.

Countries

Percentage

Saudi Arabia

12.5%

Kuwait

20.4%

UAE

17.7%

USA

29.1%

Other Countries

20.3%

The second illustration is a bar graph that shows a comparison of the Consanguinity rates of four governerates from 2000 to 2008. The graph is titled Egypt – regional Consanguinity Rates, 2000, 2005, 2008. The horizontal axis lists the years and ranges from 2000 to 2008. The vertical axis lists the values and ranges from 0.0% to 60.0% in increments of 10.0%. The approximate data from the graph are tabulated below.

Governerates/Years

2000

2005

2008

Urban governerates

29.0%

22.0%

22.0%

Lower Egypt governerates

34.0%

28.0%

22.0%

Upper Egypt governerates

48.0%

42.0%

41.5%

Frontier governerates

47.0%

41.0%

35.0%

The third illustration is a line graph that shows a comparison of the oil Production and Consumption from 1965 to 2010. The graph is titled Egypt – Oil Production and Consumption. The horizontal axis lists the years and ranges from 1965 to 2010 in increments of 3. The vertical axis is labeled thousand barriers a day and ranges from 0 to 1000 in increments of 100. The approximate data from the graph are tabulated below.

Years

Production

Consumption

1965

110

120

1968

100

102

1971

110

110

1974

150

150

1977

200

200

1980

250

300

1983

360

400

1986

400

410

1989

425

470

1992

410

405

1995

465

500

1998

550

570

2001

520

510

2004

550

550

2007

680

600

2010

710

700

The illustrations on the right depicted from top to bottom are as follows.

The first illustration is a pie chart that shows a comparison of the break-up of the ODA disbursements of different countries. The pie chart is titled Disbursements, By Donor's share of Total $1.54 billion (constant 2011 US$). The data from the graph are tabulated below.

Countries

Percentage

United States

19%

France

15%

Japan

12%

Kuwait (KFAED)

10%

Germany

11%

Arab Fun (AFESD)

10%

EU Institutions

9%

United Arab Emirates

2%

OFID

1%

Denmark

1%

Italy

1%

United Kingdom

1%

Netherlands

1%

IDA

1%

Canada

1%

Greece

1%

Other small donor's (<$10M)

3%

The second illustration is a chart that shows a comparison of the congested hours from 7 AM to 7 PM in 11 corridors. The chart is titled Congested hours. The horizontal axis lists the corridor numbers and ranges from corridor 1 to corridor 11. The vertical axis is labeled times of the day and ranges from 7AM to & PM. The approximate data from the graph listing the non-congested hours are tabulated below.

Corridor No./Dir

Non-Congested hours

Corridor 1

Dir 1

7 AM to 8 AM

Dir 2

 

Corridor 2

Dir 1

 

Dir 2

9 AM to 10 AM

Corridor 3

Dir 1

 

Dir 2

9 AM to 10 AM

Corridor 4

Dir 1

7 AM to 8 AM

Dir 2

 

Corridor 5

Dir 1

 

Dir 2

7 AM to 8 AM, 10 AM to 4PM

Corridor 6

Dir 1

 

Dir 2

7 AM to 8 AM

Corridor 7

Dir 1

7 AM to 8 AM

Dir 2

7 AM to 8 AM

Corridor 8

Dir 1

7 AM to 9 AM, 10 AM to 4 PM

Dir 2

7 AM to 8 AM, 9 AM to 11 AM, 6 PM to 7 PM

Corridor 9

Dir 1

7 AM to 8 AM, 10 AM to 11 AM

Dir 2

9 AM to 10 AM

Corridor 10

Dir 1

 

Dir 2

7 AM to 8 AM, 5 PM to 6 PM

Corridor 11

Dir 1

7 AM to 8 AM

Dir 2

 

The third illustration is a line graph that shows a comparison of the income levels and the real growth percentage. The graph is titled Real growth in household income (PPP USD terms). The horizontal axis lists the income levels and ranges from 500 to 5500 in increments of 500. The vertical axis lists the values and ranges from minus 14.0 to 0.0. A caption reads Real growth in household income (%). The approximate data from the graph are tabulated below.

Income (l.E.)

Growth Percentage

Next 12 months

Last 12 months

500

minus 9.0

minus 11.8

1500

minus 8.2

minus 11.9

2500

minus 6.0

minus 10.0

3500

minus 4.4

minus 9.0

4500

minus 5.9

minus 6.0

5500

minus 6.1

minus 4.0

Figure 4. Economic and social trends with negative influence on the demand for real estate

An illustration depicts four graphs and three charts that depict the trends for real estate.

The text along the left shows the governance principles that read as follows.

The ability of boards to adhere to good corporate governance practices remains the main challenge in terms of implementing the OECD Principles. More specifically:

* The line between board oversight and day-to-day management is often blurred.

*The majority shareholder and not the board plays the lead role in selecting, monitoring, and replacing executives.

* Executive remuneration is not linked to long-term company performance.

* Companies do not have robust risk, internal control, and audit policies in place.

Along the right a horizontal bar graph shows a comparison of the percentages of various OECD principles of Chapter VI. The graph is titled Level of implementation vis-à-vis the OECD Principles. The details from the graph are tabulated below.

OECD Principles

Chapters

Percentages

VI A. Acts with due diligence, care

46%

VI B. Treat all shareholders fairly

67%

VI C. Apply high ethical standards

32%

VI D The board should fulfill certain key functions

49%

VI D 1. Strategic oversight

47%

VI D 2. Monitoring corporate governance practices

47%

VI D 3. Selecting, replacing, compensating executives

54%

VI D 4. Aligning executive and board pay

38%

VI D 5. Transparent board nomination process

40%

VI D 6. Oversight of insider conflicts of interest

64%

VI D 7. Oversight of accounting and financial reporting

47%

VI D 8. Overseeing disclosure and communications

58%

VI E. Describe objective judgement

44%

VI E. 1. Independent judgement

27%

VI E 2. Clear and transparent committees structures

60%

VI E 3. Board commitment to responsibilities

43%

VI F. Access to information

38%

The bottom of the page displays images of Jeff Skilling, Sherron Watkins, Andrew Fastow, and Enron. Followed by a caption that read GateKeepers and a logo.

Figure 5. Egypt’s implementation of the OECD principles on corporate governance

An illustration depicts a snapshot of the principles of Corporate governance along with horizontal bar graph depicting a break-up percentage.

The graph is titled MENA-Focused Private Equity Fundraising, 2007 – Present.

The horizontal axis lists the years and ranges from 2007 to 2015 YTD in increments of 1. The vertical axis on the left is labeled No of funds closed and ranges from 0 to 35 in increments of 5. The vertical axis on the right is labeled Aggregate Capital raised ($bn) and ranges from 0 to 8 in increments of 1. The data from the graph are tabulated below.

Years

No. of Funds Closed

Aggregate Capital Raised ($bn)

2007

24

3.7

2008

30

6.9

2009

10

1.6

2010

11

0.9

2011

18

1.8

2012

13

1.5

2013

13

4.0

2014

9

1.6

2015 YTD

12

4.2

Figure 6. Private equity fund-raising trends in the MENA region

A bar graph shows a comparison of the number of funds closed and aggregate capital raised in MENA region.

The graph is titled Middle East Private equity deals (2010–2015). A text above reads, 39% of PE deals in Middle East with “buy-and-build” strategy. 47% of “buy and build” deals focused on geographic expansion, remaining on value-chain growth. A caption along the top left corner of the graph reads Share of total deals (%).The approximate data from the graph are tabulated below.

Deals

Percentages

Total

100%

Individual deals

61%

Buy-and-build

39%

Geographic expansion

24%

Both Geo Value chain expansion

29%

Value-chain expansion

53%

The Boston Consulting Group

A curly bracket encloses Geographic expansion and both Geo Value chain expansion to indicate 47%.>

Figure 7. New strategies in private equity investment in the MENA region

A bar graph shows a comparison of the the private equity deals in the Middle East.

This case was prepared for inclusion in Sage Business Cases primarily as a basis for classroom discussion or self-study, and is not meant to illustrate either effective or ineffective management styles. Nothing herein shall be deemed to be an endorsement of any kind. This case is for scholarly, educational, or personal use only within your university, and cannot be forwarded outside the university or used for other commercial purposes.

2024 Sage Publications, Inc. All Rights Reserved

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