Syndication Sponsor Shenanigans

16 Replies

My Dad is currently invested in a few syndicated multifamily deals, and one of them is stabilized and ready to market. 

Instead of selling it, the sponsor has decided to "recapitalize the property with new equity and debt amount".  Basically, he's doing a cash-out refi, distributing the proceeds, and plans to "exit" the investors from the deal (calling it a recapitalization). The Operating Agreement is silent on this process and says nothing about exiting upon refinancing, only upon dissolution of the fund after the assets are liquidated.

The sponsor is keeping the remaining 20% equity (after the refi) for himself. The annualized COC return on the deal is over 20%, so no complaints there. But if it were a sale, or true recapitalization, the investment proceeds would double that.

Does the sponsor have any justification or precedent in doing this, if it's not described in the OA?  He believes he does, but gives no details.  He's asked for a signed “assignment of membership interest” form, before distributing the proceeds from the refi.  Most of the investors, I believe, are Mom and Pop types, and don't know any better than to give back their interest.

I don't want to burn bridges with the sponsor, but I'm not willing to give up the significant $ that the OA entitles me to.  Any helpful thoughts or insights?  Is it time to contact an attorney? 

@Andrew Sol you need to carefully review the operating agreement, and if this provision obviously stands out to you in the agreement, yes, they can do it.

If it doesn't stand out to you, you should have an attorney review the operating agreement.  Sometimes these types of things can be written in a way where it is confusing so just because you don't see it doesn't mean it isn't masked in there in some way.

A sponsor can only unilaterally exit the investors if the operating agreement allows for it.  If it isn't in there, they can still do it, but only with the approval of the investors.  And I can think of very little reason why the investors would, or should, approve of such a move.

Now it is perfectly acceptable for a sponsor to take out cash from a refinance and distribute that surplus cash to the investors as a return of capital.  But after such return of capital, whether a partial return or a complete return, the investor should remain in the deal with the same ownership percentage.  Their preferred return would stop accruing (because preferred return is typically calculated on unreturned capital) but the waterfall rules on distributions would be otherwise unaffected.

There is another scenario where a sponsor might want to exit the investors by returning their capital plus profits.  This is a very difficult maneuver to execute because there are so many conflicts of interest.  But it can be done.  If I were a sponsor attempting such a move I would want to have at least one appraisal, perhaps two, and calculate the investor's economics under a conventional sale and try to duplicate those results as closely as possible. And then execute the move only with the approval of the investors after carefully outlining how we got to the numbers.  It's not something I've ever done, typically when it is time to sell, we sell. 

So my advice is to be sure you understand exactly what the sponsor is trying to do, and review the OA carefully and with the assistance of counsel if necessary.

@Andrew Sol I would have an attorney look at the OA. What is the deal structure of the management company and it's participation in this deal? There are so many ways a deal can be structured, It seems like this sponsor is saying he asked for funds to acquire an asset, paid all the investors the agreed upon earnings in this case 20%, and is now closing the fund and a separate entity is maintaining the asset because he sold it via new financing not associated with the fund. Am I following you, Is that correct?

How may deals does this sponsor have under his/her belt? If this is an experienced sponsor with a long track record there may be some language in the contract that is open for interpretation and he/she is taking advantage of it, If it's a new sponsor they may just be greedy.

What ever the scenario is you should not be worried about burning bridges with the sponsor by questioning the distributions on the deal, you're helping the sponsor more than they are helping you because you have the money they don't. If he's doing something shady burn that bridge down and build new ones with new and better sponsors.

Thanks for the feedback.  The language of the OA is pretty dense, but I've combed it and don't see any provision to require an early exit from the fund. 

@Brian Burke the sponsor needed an appraisal to complete the refi, but hasn't shared it with us. A commercial realtor gave a BPO for 20% higher than the refi amount. My gut tells me the sponsor sees that the deal did better than expected, and he feels 20% COC is adequate for the investors and he wants the remaining upside.

@Ray Johnson the sponsor owns the management company.  He's done a dozen deals over the last 10 years, but up until recently the investors have always stayed in the funds after a refi.  The waterfall gives the sponsor a 50% split of all proceeds after the preferred return & equity capital has been repaid.  There is no provision for an exit after a certain return is surpassed.  To my knowledge, he isn't closing the fund, only exiting the investors.  There is no separate entity maintaining the asset, and the project would certainly appraise for 20% more than the refi amount that he's disbursing.

I've never needed an attorney for anything related to these syndications. How would I go about finding an atty informed in these matters? Securities attys ain't cheap.  Also, I don't personally know any of the other investors, but I suspect they are not sophisticated in these matters.  What are my ethical obligations in reaching out to them with this info?  I expect most or all have relinquished their membership, as the sponsor requested.  Or should I just deal with the sponsor and not involve the others?  I suspect several of them are in other deals with the sponsor.

@Andrew Sol perhaps you've done this already, but in my opinion, the best starting point would be to contact the sponsor directly and ask about the plan.  What you are describing seems so unusual that it would be interesting to hear the sponsor's take on it.  And if in fact they are proposing to do exactly as you described, I'd ask them to point to where in the partnership agreement that is allowed.  If they can't, then it's probably not allowed.  It's just usually best to try to discuss these types of issues with the sponsor before having to take the route of spending a lot of money on lawyers.  But if they are ripping you off, then lawyer it up!  Just my $0.02.

@Andrew Sol Great advice on offer but you might want not want to go the lawyer route. This is assuming you have a max. $200-300K investment or something in that range. The reason is very simple: Lawyer fees will eat into whatever you can get from the Sponsor. 

Currently, you are getting a health return. Take the money and make it a point to never deal with a, possibly, unscrupulous individual again. 

Lawyering up sounds nice but it costs major $$$ especially if the other party has an in-house attorney. 

@Brian Burke

I have a question for you after reading this thread.  I have learned so much.  Thank you! 

Assuming the following situation: Sponsor refinances the project and returns all of the original capital plus preferred return to all investors and the remaining split is 50/50 (sponsor/investors) post refinance.  The property is old (1970s), but in a hot market (think Bay Area San Francisco) and was renovated 5 years ago by the Sponsor when this syndication was formed.  What happens if the Sponsor decides to hold the property for a long period after the rehab and refinance because it is in a good market and a cash cow.  The investors only have equity in the deal at this point.  Let's say 10 years go by (post refinance) and a major capex item comes up (ie. replace galvanized plumbing or roofs, or the sponsor wants to do a major rehab again to improve rents)...

1) Would the Sponsor do a capital call to the investors to pay for these capex items or new rehab?  

2) Would the Sponsor be wise to have a reserve in place after the refinance to pay for these future items so a capital call is not needed?

3) What if certain investors don't want to stay in the deal as long as the Sponsor and wants to cash out their equity after the refinance.  How should a Sponsor handle this situation?  

I really appreciate your insights for us newbies who are trying to understand how this works in the real world. 


Sounds shady to me but depends on the operating agreement.  And I agree with @Brian Burke - contact the sponsor and have him point it out in the OA.  If he realizes there is no specific language he may pause especially if he realizes a lawsuit may come down the pike.  With my equity investors, our goal on refi is to pay everyone back so they are into the investment for little to zero.  If they were to relinquish their equity they have to be bought out of their portion at fair market value.  My goal on every deal is to make money for my investors even at the expense of my profits... and time.  I'd rather make less on a deal if it means all of my investors will do the next deal with me.  They have and I intend to continue that trend year after year.

@Linda Thompson slightly off-topic but you should also check out this thread: I bring this up because the question in that thread related to how splits work after capital has been returned, which is similar to your scenario so you might find it an interesting read.

As to your question, you should carefully read the operating agreement, especially as it pertains to the length of the investment.  If the company's business plan was to acquire, improve, and hold for five years, the sponsor cannot unilaterally "decide" to hold the property longer unless the operating agreement allows for it, or establishes a procedure for it.  Most operating agreements will specify how long the property is to be held, and may or may not provide for some period of extension options at the discretion of the manager.  Extensions beyond that would require a vote of the members in most cases, but check your operating agreement because terms may vary.

Personally I think it's bad business to promise investors one thing, and then do another, and holding for longer than promised would fit into that category.

Having said that, let's assume they can do it, and decide to do it.  You had three questions in that instance:

1. They could if the operating agreement allows them to.  They could also refinance, assuming the property increased in value enough to allow for a cash-out refinance and the proceeds were enough to fund the capital improvements.  Or they could sell instead of doing the improvements.  Check your operating agreement for the provisions governing capital calls.

2. Most lenders require borrowers to deposit money every month into a lender-controlled account to reserve for future replacements.  This account can only be drawn to pay for capital improvements with proof that the work was done.  The question would be--is it enough?  The sponsor could also elect to retain additional cash for added reserves.

3.  The sponsor should be following the operating agreement and sticking to the business plan, to prevent such a problem in the first place.  Barring that, any procedure to exit an investor would be controlled by the language of the operating agreement and may vary.  Setting aside the legal aspects for a moment, from a business perspective they should offer to buy you out at a market price, or higher, as they created this situation, not you, by deviating from the business plan.

Hope that helps!