Equity Fund Structure

Commercial Real Estate Investing
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Equity Fund Structure

Clay Manship
Indianapolis, IN · Member since 2013 · 549 posts · 310 votes

All, I am currently in the process of raising a $500,000 equity fund to purchase a $1.5MM apartment complex. I am curious as to how you would structure this deal among partners. Here is the way it is currently set up:

Partner 1 - $100K

Partner 2 - $100K

Partner 3 - $100K

Partner 4 - $100K

Partner 5 - $100K

*However, the managing company/partner of the fund will own 20% to compensate for the ongoing management of the LLC and the property.

I have seen waterfall models where there is a "return on capital" and "return of capital" where the investor is paid a preferred return on their current outstanding amount of capital that has not yet been returned. Is this common? What then happens after each partner gets their original $100K returned, plus their preferred return? How do they continue to receive distributions/compensation for being involved in the fund?

Just looking for how you all might structure something like this. My securities attorney and I are working on it currently and wanted to get some input. Fire away!

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  • Dion DePaoliPro Member
    Real Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes
    12y

    Capital structures with preferred returns are not uncommon. In my experience, and I have operated several, those tend to be an easier 'sale' to the limited investor. Usually a PR structure has an equity kicker for the investor, so they share in the upside. The higher the PR, the less the upside share. That said, you have get the investor into the deal and they will look to all of the features including the PR, share arrangement and even your management portion and how that manager portion comes out and when.

    I would keep an eye on the registration structure here, this could quickly start bumping up against Blue Sky laws unless this can qualify as a covered asset under your registration which means if it does not qualify, you will have to adhere to federal laws and state laws which might add more administrative fees for filings, reporting and alike. Your SEC attorney will cover that with you.

    As far as what happens with investor capital, that gets written into the documents. In order to pay each investor to zero, the asset investment horizon will be pretty long as it would be presumed that payments from rents after expenses will not be large enough to reduce the investor(s) investment dollars in a short time frame. So an 'exit' event would likely need to be in the works such as liquidating the property through a resale or taking out the investor's interest through a refinance. A poorly structured event may require you to purchase the asset from the holding company to take out the investors instead of essentially buying them out. All of that is within your documents.

    Typically the waterfall is the top down allocation of the net income from the asset. That is really all 'waterfall' means, who gets paid first, second and so on. In common structures the asset expenses/fees net out, then the manager fee, then the investor get's their PR. So, in this case, property expenses which would include all debt service to the senior lender comes off the top. Then a manager fee might apply, if you can get that in there and then remittance to investors are under that.

    Keep in mind as well, attaching the debt to this puts your investors in a first loss position. The reverse of the waterfall. Top down is who gets paid first. Bottom up is who looses first.

    It's not clear from your post, but it sort of sounds like you have a PR plus a 20% equity share. Likely as the Managing Member or General Partner. This means the investor is entitled to the PR plus 80% of the net gain upon liquidation/settlement. To some degree you have to do what you can do to attract investors, but bear in mind the barometer to this is a 2% and 20% structure. Where the manager takes a 2% manager fee and shares in 20% in the net gain. In those structures investors do not get a PR. What I am saying is, if you are going to offer a PR, that 80% net share seems a tad high but that also might be what you have to do in order to get an investor.

    Just make sure you keep running numbers on your proposed structures so you do not over promise PR and starve the deal of cash flow and gain.

    As far as the difference between return "on" and return "of", those are two different concepts. Usually the structure with a PR is a return "on" the investment dollars. Distributing the PR does not usually reduce the investor investment basis or Net Asset Value (NAV) in this type of deal, a single asset structure. Since the asset is still owned, the investors money is still in it, the PR is his share of the cash flow from the asset while his cost basis stays the same. If you paid the PR plus on any given period, the plus would usually reduce the NAV and then become a return "of" capital. If no plus payments are made with the PR, then the entire NAV of each investor comes out and is paid back first upon liquidation/settlement, then the net gain is divided/shared according to agreement. The investor total return would be the sum of all is PR plus the gain. If you have plus payments in there, you have to account for the reduced NAV and time in order to properly calculate the Total Return.

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  • Xi Zhu
    Investor · New York, NY · Member since 2011 · 25 posts · 6 votes
    12y

    @Dion depaoli thanks for sharing!

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