Syndication Structures - Return of Capital

[Trey Wheeler]

Hi BP Community! My question relates to syndication structures with respect to how a sponsor categorizes cash distributions. 

If you have syndicated a MFH deal, have you chosen to categorize the cash distributions (whether a pref or straight-split) as a return-of-capital, or, as a return-on-investment?

As I understand it, paying distributions as ROI (not ROC) makes sense with a pref structure, however, from a sponsor's perspective in a straight-split, what is the benefit to a sponsor to pay distributions as ROI? It seems to me that paying distributions as ROC means there's less (or no) capital to return to investors at the time of sale. Thus, treating the distributions as ROC (not ROI) would undoubtedly provide a larger "pie" of net sales proceeds to then divide among investors and sponsors according to the PPM straight-split agreement, correct?

@Brian Burke provided excellent thoughts on ROC vs ROI in this forum post (https://www.biggerpockets.com/forums/432/topics/215958-what-are-typical-apartment-syndication-returns-for-an-investor). 

Thanks in advance! 

[Brian Burke]

You don't choose what to call distributions, instead, you can choose the ORDER of distributions.  For example, your operating agreement could say, "First, 100% to the investors until the investors have received an amount equal to their capital contributions.  Second, 100% to the investors until the investors have received an 8% return on their unreturned capital contributions.  Third, 70% to the investors and 30% to the Manager."

On the other hand, you could switch the order of the first two, where investors get paid a preferred return first and capital second.  Or you could separate return of capital to only happen on capital events (refinance or sale).  

If your waterfall is calculated on IRR split tiers instead of an annual return, the order is moot because "return of" and "return on" are treated the same, without any distinction, simply by definition.

If you look back at the total dollars distributed after the investment is all over, it really doesn't matter much whether return OF or return ON comes first--except that if return OF is first, preferred return is less because the balance on which the preferred return is calculated is reduced with every distribution.

[Ben Leybovich]

Clearly, sequencing offers a lot of flexibility to tilt the investment to either the partners or the sponsors. For example, if you are offering a pref, it's calculated upon outstanding equity. This means that if you pay out equity first, you are really able to limit the amount of pref you'll be having to pay out - clearly helpful to the sponsor, but not so much to the partners.

[Todd Dexheimer]

You really need to look at how it will affect your investors. If you are always reducing their capital in the deal, then each distribution is less of a return. Structuring it as a return of capital on each distribution may be good for you and may make the returns look better, but the overall performance to your investors is worse. 

[Roni E.]

First off let say an investor put in $100k and in a year times you return $10k that is a distribution as really there was no capital even either refinance or sale. Also, the PPM and operating agreement call out for this classification or as Mr. Burke said the split procedure. Due to a cost seg. or even depreciation that distribution income might not have any tax consequence due to depreciation. Finally and most importantly take GREAT care of your investors as this is a marathon and you want to be happy and to come back again and again. 

[Scott Morongell]

@Trey Wheeler not much left to comment on with all the fantastic responses above. At the end of the day, sponsors want to keep as much of the pie as possible yet still be able to raise capital and offer fair returns. 

@Brian Burke @Ben Leybovich what order do you prefer to do?

[Brian Burke]

Originally posted by @Scott Morongell:

@Brian Burke @Ben Leybovich what order do you prefer to do?

For me, most of the time it is pref first, and return of capital only on capital events (refinance and sale). 

[Ben Leybovich]

Originally posted by @Brian Burke:

Originally posted by @Scott Morongell:

@Brian Burke @Ben Leybovich what order do you prefer to do?

For me, most of the time it is pref first, and return of capital only on capital events (refinance and sale). 

Same.

[David Almeida]

So this is the classic Return ON Capital vs. Return OF Capital discussion. If you go through the exercise in Excel, you'll find that Return ON Capital is usually vastly superior to the Sponsor, and the IRR to the LPs isn't much lower--at least not enough to flag the deal.

Return on Capital, as other have mentioned, is paying a preferred return first and returning investor equity at capital events second. 

The wealthiest private multifamily investors I've seen have used the Return on Capital structure, or they've used Equity Multiple Hurdles. If you're raising money from institutions, however, you'll be using Return of Capital, because they know better and they want to reduce their downside. They have mandates to protect their investors so they want their capital back first.

On opposite ends of the spectrum are Return of Capital and Equity Multiples. To give you an idea of the difference between Return of Capital and Equity Multiple (EMx) Hurdles, I've seen sponsors using EMx hurdles get close to 50% of the total deal-level cash flows after capital events for a 20%+ IRR deal. Whereas the same deal with a typical private equity Return of Capital structure might see the sponsor get low 20s% of the total deal.

[Michael Ealy]

Originally posted by @Brian Burke:

Originally posted by @Scott Morongell:

what order do you prefer to do?

For me, most of the time it is pref first, and return of capital only on capital events (refinance and sale). 

 I agree with this and it's exactly what I do.

Here's a side question: when you do a refinance, my investors still retain their equity % in the deal. I've seen some sponsors "buy out" their LP's shares during a refi. I also invest passively in addition to being an active GP, so since I don't like my equity to be reduced during a refinance, I don't do that with my LPs when I am the GP.

What's your opinion on that?

[Brian Burke]

@Michael Ealy I’m with you.  Absolutely never ever alter your investor’s interest in the deal, even if you’ve returned ALL of their capital they still get the percentage of distributions that they were entitled to day one. The only change is the accrual of pref and and hurdle accruals.  

Investors place their money in a deal at the riskiest point—at the beginning.  It’s unfair and greedy to yank the carpet out from under them at the moment that the ride they paid to take you on has smoothed out.  I never understood why sponsors do that “buy-out” thing—but what I struggle even harder to understand is why investors invest in those deals.  There are better options out there...

[Ben Leybovich]

Originally posted by @Michael Ealy:

Originally posted by @Brian Burke:

Originally posted by @Scott Morongell:

what order do you prefer to do?

For me, most of the time it is pref first, and return of capital only on capital events (refinance and sale). 

 I agree with this and it's exactly what I do.

Here's a side question: when you do a refinance, my investors still retain their equity % in the deal. I've seen some sponsors "buy out" their LP's shares during a refi. I also invest passively in addition to being an active GP, so since I don't like my equity to be reduced during a refinance, I don't do that with my LPs when I am the GP.

What's your opinion on that?

That's just ******. I can't believe people go for that, but many do. I think that's a lack of education, plain and simple. Otherwise, they'd know better... 

[James Kandasamy]

 On the topic of treating Cash flow as Return of Capital.

Specifically on profit split model (not preferred return/waterfall)

Look at this way. The passive investors are not making any profit in the investment during the operational stage. Zero. All their profit is "promised" at the sale/refinance.  This structure is more like a loan with a promise to pay at the end of an investment cycle.  When we look at Risk, the passive investor's money is put at the highest risk portion of the deal which is the sale stage. Everyone knows that the exit cap rate is taken from the air. Why you want to put the invested money on the high-risk portion of the deal. Certainly, the Return of capital benefits the sponsor as the backend split is much larger.  Any passive investors when they really found out what they are investing, will freak out. If you are in the long game, take care of passive investors. At the institutional and sophisticated level investors, everyone does Return On capital as that is a true definition of an Investment. We need to be able to call the cash flow from operation as Cash on Cash return.

[Aaron Smith]

I'm thinking about doing this, any thoughts?

For Monthly Cash Flow Distributions:

First, 100% to the investors until the investors have received an 8% IRR

Second, 70% to the investors and 30% to the Manager until the investors have received a 15% IRR

Third, 50% to the investors and 50% to the manager

For Capital Events (Refinance or Sale):

First, 100% to the investors until the investors have received an amount equal to their capital contributions.

Second, 100% to the investors until the investors have received an 8% IRR

Third, 70% to the investors and 30% to the Manager until the investors have received a 15% IRR

Fourth, 50% to the investors and 50% to the manager

After a Refinance:

On unreturned investor capital for both cash distributions and at subsequent capital events:

Structure shall remain the same.

On returned investor capital, for both cash distributions and subsequent capital events:

First, 40% to the investors and 60% to the Manager

@Joshua Smith