Questions about syndication deals with two equity class shares

Multi-Family and Apartment Investing
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Questions about syndication deals with two equity class shares

John Cho
Member since 2018 · 20 posts · 20 votes

Ive seen a proliferation of deals in the last year with two equity shares consisting of preferred equity and the more typical common equity that is common to more typical syndication deals. The Class A preferred equity is often 1-2% higher in pref than the common equity with no participation on the upside (refinance/sale).  Class B common equity with lower pref than in deals past with more typical waterfall splits.  

Is there a reason why syndicators are going to this model? It seems like a crappy deal for the LP compared to a simpler structure and was wondering if there was something Im missing besides the GP needing to raise money at inflated prices to pencil their deals at an acceptable pro forma IRR.

Here are the cons as i see it

Class A Preferred equity

-taking on equity risk (loss of capital) in a non liqiuid asset locked for 3-7 years with no participation on the upside on refinance or sale. Pref is usually 9-10% but again this is equity behind all the loans in the capital stack. Ive also seen this being deceptively marketed as a being safe or conservative as if it is a 1st lien secured loan to the LLC.

Class B common equity   
-increased risk of capital loss by having another layer above you in the capital stack if the deal goes south and performs sub par. 

-decreased pref compared to deals with just a common equity structure 
   

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Mack BensonPro Member
Rental Property Investor · Woodbury, MN · Member since 2018 · 299 posts · 299 votes
6y

The theory is that cap rates could increase due to a recession which would lead to a decrease in prices. Because of the debt being put on the properties the sponsors may be forced to sell at a less than ideal time and there won't be as much of an upside. The investors investing for a higher pref are hedging their bets that the market may not be as strong at the end of the loan term which could lead to the deal sponsor having to sell rather than refinance. They are choosing to take a higher return during the life of the deal in exchange for taking none of the upside. Offering this can help the deal sponsor give a greater upside to the other share class to increase their IRR.

All of this complicates things and I'd rather keep it simple. As one of my mentors says, "A confused mind says NO."

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  • Darius Ogloza
    Investor · Marin County California · Member since 2018 · 1k+ posts · 2k+ votes
    6y

    Preferred equity with no participation right in any upside sounds a hell of a lot like debt under a different name.  

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  • Darius Ogloza
    Investor · Marin County California · Member since 2018 · 1k+ posts · 2k+ votes
    6y

    I should have said nonrecourse debt.  

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  • Michael Le
    Developer · Houston, TX · Member since 2015 · 1k+ posts · 1k+ votes
    6y
    Originally posted by @Darius Ogloza:

    I should have said nonrecourse debt.  

    Totally agree. And subordinate nonrecourse debt at that.

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  • Mack BensonPro Member
    Rental Property Investor · Woodbury, MN · Member since 2018 · 299 posts · 299 votes
    6y

    The theory is that cap rates could increase due to a recession which would lead to a decrease in prices. Because of the debt being put on the properties the sponsors may be forced to sell at a less than ideal time and there won't be as much of an upside. The investors investing for a higher pref are hedging their bets that the market may not be as strong at the end of the loan term which could lead to the deal sponsor having to sell rather than refinance. They are choosing to take a higher return during the life of the deal in exchange for taking none of the upside. Offering this can help the deal sponsor give a greater upside to the other share class to increase their IRR.

    All of this complicates things and I'd rather keep it simple. As one of my mentors says, "A confused mind says NO."

    1Reply
  • John Cho
    OP
    Member since 2018 · 20 posts · 20 votes
    6y
    Thanks for the explanation but the theory doesn't make much sense to me.  Most pro forma on these deals have a reversion cap rate assuming higher cap rate/lower prices at the end.  If not, that's either a sign the syndicator doesn't know what they are doing or trying to manipulate the return which is pretty much a pass. 

    The debt argument is kind of weak as well. Most deals these days are financed by GSE Fannie/Freddie debt at ridiculously low rates with some IO to allow people to ride out unfavorable economic\local cycles.    I guess a property can be financed with bridge debt or bank loan with unfavorable loan covenants leading to that scenario but that loan product is severely limited these days with unfavorable rates and terms.

    I guess what I'm seeing is the typical value-add deal that was offered the last couple years, with roughly the same IRR returns (class B) and  GSE debt with this dual class structure.   


    Originally posted by @Mack Benson:

    The theory is that cap rates could increase due to a recession which would lead to a decrease in prices. Because of the debt being put on the properties the sponsors may be forced to sell at a less than ideal time and there won't be as much of an upside. The investors investing for a higher pref are hedging their bets that the market may not be as strong at the end of the loan term which could lead to the deal sponsor having to sell rather than refinance. They are choosing to take a higher return during the life of the deal in exchange for taking none of the upside. Offering this can help the deal sponsor give a greater upside to the other share class to increase their IRR.

    All of this complicates things and I'd rather keep it simple. As one of my mentors says, "A confused mind says NO."

    0Reply
  • Mike Dymski
    Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
    6y

    When a property sells below book value, the debt holders get paid first, preferred equity next, and common equity last.  The return potential to the debt and equity investors is structured according to the position (risk) in the capital stack with the debt holders having the lowest return potential and the common equity holders the highest (with preferred equity in between).

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  • Bill F.
    Investor · Boston, MA · Member since 2015 · 1k+ posts · 3k+ votes
    6y

    @John Cho

    In theory different share classes allow investors with different risk profiles to take part in the same syndication, which widens the investor base for the GP, thus making capital raising easier. 

    This makes sense at the institutional level, where some players have bylaws that mandate they place money only in certain parts of the capital stack. 

    At the 'raise $50-100k level' its a marketing ploy for the GPs to sell their deal because lets face it, multiple share classes sound sexy and super professional. Plus it is a way for them to further muddy the waters and obscure their true fees. 

    Or at least that is my, admittedly jaded, opinion... 

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  • Jordan Burnett
    Investor · Alpharetta, GA · Member since 2019 · 78 posts · 74 votes
    6y

    I would also add that adding a Class A share with limited exposure to upside but a preferential place in the capital stack is very attractive for your retired/soon to be retired folks who no longer see fixed income/bonds as an option in this interest rate environment. Given, it is equity and not debt--but there are so few options today.  

    With basically zero yield on bonds, there are many investors out there who would invest with even lower (5-6% pref) with no upside. Trust me, I talk to them frequently...

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  • Todd Dexheimer
    Rental Property Investor · St. Paul, MN · Member since 2016 · 3k+ posts · 3k+ votes
    6y

    There are pro's and con's to everything. This structure allows for flexibility among investors. A 10% pref is a great investment for a lot of investors. They are looking for steady returns and don't care about the upside.

    For other investors, they don't care about the cash flow, but are looking to maximize their upside potential and hit the "home run." A two tiered approach allows syndication companies to hit both desired outcomes for their investors. 

    0Reply
  • Lane Kawaoka
    Rental Property Investor · Honolulu, HAWAII (HI) · Member since 2011 · 4k+ posts · 2k+ votes
    6y

    @John Cho

    Pref equity is really for newer investors or very high net worth (3-5M+). Its seen as less risky but if it were me if I'm going into the deal I want the upside too. Its a good way of giving reliable returns but again no upside. It acts very similar to debt arrangements that many investors are used to when they leave the world of private lending (to flippers) behind and step up to more sophisticated offerings.

    Traditional equity is what I like for now but when my net worth is very high I might just be totally happy with 10% coming in like clock work.

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