The five numbers, and the one the sponsor optimizes

Five numbers describe almost any syndication, and the reason sponsors can make weak deals look strong is that each number answers a different question. A deal that looks great on one can be ordinary on another, so a sponsor who leads with the flattering number is not lying, just curating. Knowing what each one measures, and which one the sponsor is being paid to maximize, is most of underwriting from the investor’s chair.

What each number actually measures

Cash-on-cash return is current income: the annual cash distributed divided by the equity invested. Put in $4 million, receive $180,000 a year, and the cash-on-cash is 4.5 percent. It tells you what the deal pays you while you hold it, and nothing about the sale.

Cap rate is the property’s unlevered yield, net operating income over price, covered in the underwriting article. It describes the building, before any debt or promote, and lets you compare properties on a common footing.

Debt yield is the lender’s safety number: net operating income divided by the loan amount. On $600,000 of net operating income against a $6.5 million loan, the debt yield is about 9.2 percent. Lenders watch it because, unlike a cap rate or a debt-service ratio, it cannot be flattered by low interest rates or a generous valuation.

Equity multiple is total dollars back over dollars in, ignoring time. Return $8 million on $4 million invested and the multiple is 2.0x. It tells you how much you made in total but says nothing about how long it took.

Internal rate of return, the IRR, is the time-weighted return, the one number that accounts for when the cash comes back. It is the most complete single figure and the most easily manipulated, because timing changes it dramatically.

Equity multiple and IRR can tell opposite stories about the same deal, and the gap between them is time.

Where two of them diverge, and why it matters

Equity multiple and IRR routinely disagree, and the disagreement is not a rounding issue, it is structural. Consider two deals that both return a 2.0x equity multiple. The first returns the money in three years; its IRR is about 26 percent. The second takes seven years to return the same 2.0x; its IRR is about 10 percent. Same total profit, wildly different IRR, and the only difference is speed.

Now the part that reaches into the investor’s pocket. The promote, the sponsor’s share of the profits, is very often measured against an IRR hurdle, as the economics section explains. That means the sponsor is paid on the number that rewards speed. A sponsor optimizing for IRR has a reason to sell quickly to lock in a high time-weighted return, even when holding longer would build a larger total multiple for the investors. The number the sponsor is measured against is the number the sponsor will steer toward, and it is not always the number that serves the investor.

The structuring consequence

Ask which number the promote is keyed to, because that is the number the deal will be run to produce. If the promote pays on an IRR hurdle, expect pressure toward a faster exit; if the investor’s own goal is total return over a long hold, those incentives are not aligned, and the misalignment is worth pricing before wiring. Never accept a single number as the verdict on a deal. A high IRR can hide a thin multiple, a fat multiple can hide a slow, mediocre IRR, and a strong cash-on-cash can sit on top of an exit assumption that never survives contact with the market.