Syndication Exit Strategy -- "Sell" Asset to Yourself>

[Stephen Resch]

Hello BP Community! Active Duty Army Engineer about to retire after 22 year of service. Pursuing REI fulltime now, about to close our first syndication -- 41-unit Senior apartment complex in Iowa, PP $3.7M, raised $800K.

Need advice on an exit strategy:

Apartment is completely renovated so no traditional value add.  But it does have two vacant acres we plan to develop and build a 36 unit assisted living center by Year 5.

Original exit plan was cash out refi at Year 5, return 75% equity to investors, then sell in Year 10. 

However, we (and many investors) want a full exit a Year 5. However, based on projected income, five years is not enough time to build enough equity to pull out enough cash.
Structure: 8% pref ret, 60% equity
PP: $3.7M
Loan: $3M
Investor Capital: $1M
Year 5 Projected Value: $5M
Year 5 Loan Balance: $2.5M
Year 5 Cash Out Refi Avail: $1.5M (80% LTV @ $5M = $4M)($4M - $2.5M = $1.5M)

Selling at Year 5 will easily meet this mark--but we do not want to sell. Rather, we want to expand this into a "Senior Campus" with the second building .

Question then: In Year 5, can we "sell" the property (i.e. "Senior LLC") to another LLC we own, say it's called "Senior Campus LLC"? Senior Campus LLC will already be set up in Year 2 with a construction loan for the new build. This way, we can realize the full market value gain of the original building and have enough capital to cash out investors.

Understand that "Senior LLC" would be responsible for capital gains tax based on sale price. But we could avoid the 3-5% broker/agent fee since we are selling it ourselves. At an approx $5M value in Year 5, that's not insignificant!

So is this a viable and legal plan or not? Am I missing anything or perhaps there is another alternative? Thanks in advance!

[Allan Smith]

Selling Is expensive, but if not all partners want to be in for the long haul you do owe them the duty of getting their cash back.

here's the problem I always ran into. If we sell to cash out investors, we owe it to them to get full market value. That tends to kill the deal for any investors that want to stick around because full market value tends to have terrible returns. It always seemed best to cash everyone out and find a new good deal.

[Tushar P.]

As an LP, one scam I always look for before investing in any syndication is if the GP wants to exit by selling to themselves (another disguised entity) under market value - this is the easiest way for a GP to wipe out LPs with a loss while still making all the profit themselves. Most common scam I’ve seen is a vertically integrated syndicator using its development arm to start the syndication and then the exit plan is to sell to its own operating arm after stabilization. I guess they are hoping that they can exit at below market price, or grab any down-market moment to exit.

I guess there is no shortage of sucker LPs?

[Stephen Resch]

Yes I suppose that technique could be employed to the detriment of LP. We would sell at market value and place that in the op agreement.  Would be able to maximize LP gains and realize the full value of the property appreciation rather than be limited to 80% on a re fi

So it appears this technique is valid so that answers one of my biggest questions.  

Do anyone else have experience with this o any other exit strategies? Thanks!

[Tushar P.]

Of course no syndicator says they want to scam the LPs by selling to themselves at exit. Exit is always expected at market value as per the documents, but probably they are hoping to grab any down-market moment to exit.

I’m not an expert, so you should ask those who have direct experience as syndicators, like @Brian Adams, @Rick Martin

[Rick Martin]

@Stephen Resch pretty heady stuff here. I believe you can set up an SPE (special purpose entity) to achieve what you are after, but you want to listen to an attorney and not me on the topic. Some of the stories that @Tushar P. shares boggle the mind, and I know these practices exist. Our LP's are such a significant component in our businesses. We should only want to develop long-lasting, mutually fruitful relationships with them. So be fully transparent upfront. Do they want to be cashed out, or do they want to come along for the ride? We just closed on a property where investors wanted to know that we wouldn't cash out too early before maximizing their gains. If we are going to cash out refi, they wanted to make sure that they were going to get a return of their capital and remain in the deal, continuing to collect cash flow. Gotta treat the LP's like the gold they are. So I guess to summarize my 2 cents - be fully transparent, and consult with an attorney about the entity (most definitely don't take legal advice from me). Great stuff!

[Evan Loader]

Originally posted by @Tushar P.:

Of course no syndicator says they want to scam the LPs by selling to themselves at exit. Exit is always expected at market value as per the documents, but probably they are hoping to grab any down-market moment to exit.

I’m not an expert, so you should ask those who have direct experience as syndicators

How often is this really going on? I would think if a syndication sponsor engaged in this sort of disguised-entity buyer strategy, they would gain a bad reputation pretty quickly among the LP community.  Their investor base would disintegrate pretty rapidly. 

Also, how does one ensure that doesn't happen aside from the sponsor's reputation. @Brian Burke have any insight on this? 

[Tushar P.]

@Evan Loader I have put the scam here in plain English so you are able to comprehend it. Do you think you will be able to see it when the sponsor words it as a “unique optimization sourced via vertical integration to preserve capital and maximize returns for the investors”? I’m sure many LPs don’t even know they are being scammed, and they may never know even after the deal exits, and they may keep reinvesting with the same sponsor. The only person to blame here is the LP, who can’t see through the scam.

By the way, your name sounded familiar, and then I realized you are the guy who asked for help/guidance on tax filing:

https://www.biggerpockets.com/...

Many tax experts responded (@Michael Plaks et al) to help you and even answered your follow up questions. And then everyone repeatedly asked you for your feedback on what you did. But you didn’t respond at al. I would suggest go and post your responses there, unless you just want to get info/help from others but do not want to help others at all.

[Tushar P.]

@Rick Martin I’m guessing you are talking about some of the experiences that I briefly mentioned in this post:

https://www.biggerpockets.com/...

I have many more to share - it keeps adding up with each deal I look at. For example, the sponsor has a gmp agreement with the development contractor, but there is a fine print in the distribution waterfall that the sponsor will first recover any costs above gmp before LPs get any money back. Wtf does that even mean? For such things, I don’t even bother to clarify, irrespective of how good the deal looks on paper.

There were suggestions that I should read books to understand the syndication business. But I haven’t heard of any books written by an investor, so I think my scam scanning abilities may get diluted if I read any books. My fresh pair of eyes are serving me fine so far, but I may reach out if I feel something doesn’t look right or looks too good to be true.

[Evan Loader]

@Tushar P. I will return to that K-1 thread and update it with what I’ve done. Thanks.

[Evan Loader]

@Tushar P. I am curious, have you been an LP in syndications for long? Ever seen a deal go full cycle? Did the scenarios you warn of actually happen to you or people you know? Or is this a general concern of yours?

I ask because if a sponsor is engaging in such behavior their reputation to raise future capital is then put at risk. Especially if they don’t meet the performance projections of the PPM. If a sponsor is selling to an entity they have a financial interest in yet meets or exceeds the performance projections of the PPM, that wouldn’t bother me. It would bother me if they under performed and sold to an entity they had an interest in to take my potential share of profit as an LP. They wouldn’t get my capital again in future deals.

But it doesn’t seem like a sustainable business model of a sponsor to purposely deceive your LPs in such a manner. Word is bound to get out if a syndication sponsor engaged in this behavior. A fly by night operation, or only planning to do a deal or two, yeah I see the risk. But sponsors with a long history of performance as per the PPM I don’t see the high risk. If they meet the numbers they meet the numbers.

[Brian Burke]

Originally posted by @Evan Loader:

Also, how does one ensure that doesn't happen aside from the sponsor's reputation. @Brian Burke have any insight on this? 

The practice that the OP is describing is called a "Recapitalization."  It's done all of the time in the institutional world, and it's done quite often among the larger and more established syndication shops.  There's nothing wrong with the practice as long as the sponsor is disclosing what they are doing and they are recapitalizing at a basis that provides substantially similar economics to the investor as would an arms-length sale.

In the institutional space there's little room for fraud because the outgoing institutional LP has analysts and is sophisticated enough to detect any nefarious intent, plus they probably also have some major decision rights.  In the syndication space with unsophisticated individual investors, or even sophisticated individual investors who do not have decision rights (which is the case most of the time), the recapitalization practice is ripe for fraud by unscrupulous sponsors or even well-meaning sponsors who just don't know, or make an effort to know, the true value of the property in an arms-length sale.  Less-experienced sponsors could intentionally or unintentionally screw this up and ultimately make a bad name for themselves, leaving them with a short career.  Maybe they should avoid the practice just to avoid the potential black mark.  Investor's best defense is to invest with well-established sponsors who have a reputation to protect.

For experienced sponsors who treat their investors fairly, the practice not only makes sense, it's commonly deployed. The use case is typically where a sponsor has two different kinds of investors. One type wants to maximize returns--this usually means "buy, fix, and sell" to maximize property value in a short time, and deliver the highest IRR. The other type of investor is a "lower cost of capital." In other words, they aren't seeking the highest return. They are looking for longer hold times, less risk, and steady cash flow, and are willing to accept a lower IRR (or don't even care about IRR at all) than the first type of investor.

So the strategy is to acquire the property with investor type A, fix it up, raise rents, pump the value, and exit...but instead of exiting to a third-party, they recap with investor type B and hold the property for years or even decades.  Everyone gets what they want.

When you hear of sponsors out there with 10,000 units and more, they probably didn't reach that size doing 3-5 year holds.  They would have to acquire dozens of properties per year if that was the case.  Instead, they got there by using investor A to acquire their portfolio and recapping to investor B to grow their portfolio.  I know of large sponsors who have NEVER sold a property to a third-party.  Are they crooks?  Not at all.  Are their investors satisfied?  Yes, both investor type A and B.  They wouldn't have reached the scale that they have if that weren't the case.

[Brian Burke]

Originally posted by @Evan Loader: 

Also, how does one ensure that doesn't happen aside from the sponsor's reputation. @Brian Burke have any insight on this? 

I should add to my answer above because I failed to address one of the most important concepts:  Incentive.

There is an insinuation here that recapitalizing at a below-market basis is inherently advantageous to the sponsor, and thus the sponsor has some incentive to “shortchange” the original investors.

So how does one insure that this doesn’t happen?  An important question is, “where is the new money coming from?”

If the sponsor is saying they are using only debt to accomplish this exit, that would be a big red flag flying high in the wind at the top of the mast. There’s no way that debt would get to 100% of market value so the basis would have to be far below market value to accomplish this, and the sponsor’s incentive would be to keep the deal for themselves without putting any money in.  That’s a misalignment with the investor’s interests.

If the sponsor is putting in their own money, this is a red flag flying at half mast.  They would subsequently own the property for their own account which creates the same misalignment as above.  But at least in this case the sponsor is putting in cash that will bring in more capital than debt alone could ever provide.

The question is whether it’s enough cash to bring the basis up to fair-market value. The sponsor in this case should seriously consider presenting at least two broker’s price opinions, and maybe even a paid appraisal, and even consider soliciting a vote from the investors even if the operating agreement doesn’t require it.

But if the sponsor is getting the money from a new set of investors, or from an institutional partner or family office, there is little incentive to shortchange the original investors. In fact, under most structures, quite the opposite. Transferring to “newco” at a below-market basis transfers this extra equity to the new venture, not to the sponsor. Because the new venture is a stabilized asset, no longer a value-add, the sponsor’s profit split is likely to be lower than it was in the first venture. For example, the original investors might be a 70/30 because the value-add business plan is labor-intensive, but the new structure is 80/20 because the business plan is just stabilized operations. If the sponsor transfers to newco at a below-market basis they shoot themselves in the foot because they’ll only get 20% of it instead of 30%.

The sponsor would also delay their payment—instead of getting the extra value paid out now, the can gets kicked down the road, perhaps to the end of a ten-year hold.  If there are any acquisition and disposition fees, those would be lower if the basis were lower. So if the sponsor is sophisticated enough to understand the mechanics of these recaps they’ll know that there’s no incentive to deliver inferior economics to their original investors.

Investors should understand where the new money is coming from so they can understand what is incentivizing the sponsor and whether that incentive aligns, or misaligns, the sponsor with the original investors. 

[Tushar P.]

@Evan Loader if you clicked the link on my previous message, you will notice that I started dumping money into syndications only 1.5 yrs ago, while the first time I thought of real estate investing was 2 years ago. These are just my observations. I should not call them scams, as I guess these are not illegal activities. And everything is fine if the deal proceeds according to the plan. But who is going to left holding the bag when the deal goes south?

I see these practices to be increasing the risk for the LP so that the sponsor has practically zero risk. Will the LPs be ok with the projected return if they understood the risk, or will they expect higher returns? For me, sometimes the projected return is not commensurate with the risk, while there are other (non real estate) investments with similar higher risk that have much higher potential returns.

@Brian Burke thanks for the excellent explanation. I wonder about the LPs who made investments several years ago with the exit around 2020. Even an official appraisal would probably show the value to be depressed, and while the sponsor didn’t cause the pandemic, they made sure they had zero risk if something like that happened. Perhaps combine the recapitalization strategy with the fact that they collected more in fees than what they contributed to the deal. So for me, it’s a risk vs return issue. Looks like investor A is taking disproportionately higher risk for substantially lower returns, for the benefit of the sponsor and investor B. But I realize there are professional sponsors who would try to find creative solutions even during the pandemic to ensure it’s a win-win for all.

[Michael Plaks]

My hat's off to @Brian Burke: such deep wisdom and so eloquently articulated! 

I'm normally commenting only on the Tax & Legal forum which is my specialty as an REI tax accountant. I was dragged here by @Tushar P.'s tag, so let me comment on the ethical concerns he mentioned.

I've been in this business for over 25 years, and I have seen what he described and worse. I once had a sponsor booking a consultation with me specifically to explore ways to screw over his investors. To my disbelief, he did not even try to conceal his intentions from me and did not see any reason to. 

@Evan Loader - you would think that such crap damages one's reputation and hampers his future "opportunities." Sadly, this is not the case. I see way too many of crooked syndicators continue to operate in their unethical ways for a very long time. Some of them are relatively prominent, and yet even the negative word of mouth does not stop them. There's no shortage of inexperienced LP wannabes who are easily seduced by slick presentations.

[Brian Burke]

Originally posted by @Tushar P.:

@Brian Burke thanks for the excellent explanation. I wonder about the LPs who made investments several years ago with the exit around 2020. Even an official appraisal would probably show the value to be depressed, and while the sponsor didn’t cause the pandemic, they made sure they had zero risk if something like that happened. Perhaps combine the recapitalization strategy with the fact that they collected more in fees than what they contributed to the deal. So for me, it’s a risk vs return issue. Looks like investor A is taking disproportionately higher risk for substantially lower returns, for the benefit of the sponsor and investor B. But I realize there are professional sponsors who would try to find creative solutions even during the pandemic to ensure it’s a win-win for all.

Oh, make no mistake—anyone who made investments “several years ago with an exit around 2020” is  laughing all the way to the bank.  Unless the investment was in hotels, office, or retail, or was in San Francisco or NYC, their investments did just fine.  For the most part, values didn’t drop as a result of the pandemic except in the sectors and markets I just mentioned, with a few exceptions.

I’m going off-topic a bit, but to address your comment about risk increasing when sponsors collect more in fees than they invest in a deal—this correlation is a common misconception.  There is no evidence that sponsor investment increases alignment of interest nor decreases risk.  But there is evidence that the opposite could be true.  Sponsor co-investment can creat a misalignment of interest and increase risk to LPs under some circumstances. I’m not saying sponsor co-investment is bad, just pointing out that it isn’t the bright-line test of alignment that many people believe it to be.

[Stephen Resch]

thanks everyone for you candid feedback.  we have experience investing in RE but this is our first syndication. As an Army vet and West Point grad, honor and integrity and of the utmost importance and I bring this to our new business ventures in RE syndication.  

@Tushar P thanks for your responses and tagging of others to really open up this into a constructive discussion about strategies and operational considerations.

@Rick Martin yes, will be discussing the SPE with our RE attorney and ensure the language is drafted up correctly and in a manner that is easy to  understand and transparent to all investors. totally agree the LPs are so important--we treat ours like family, like the partners they are side-by-side with us in the venture. 

@Evan Loader thanks for adding to the discussion and brining in Brian Burke! Interested to check out your K1 Tax thread as well!

@Brian Burke all I can say is "wow, sir!" Such as wealth of education and context you provided here! I did not have the words for the strategy and now know it is a "recapitalization". I will update the title to this thread. Admittedly, it does sound strange to state it as "sell to yourself" and certainly raises the antenna of a potential scam. Our plan is to do exactly what you described:

"There's nothing wrong with the practice as long as the sponsor is disclosing what they are doing and they are recapitalizing at a basis that provides substantially similar economics to the investor as would an arms-length sale."

We purchased a 41-unit Independent Senior living apartment complex on four acres, two acres are open. this will be for active independent seniors 55+  Plan is to begin building a 36-unit on the back two acres for use as "Assisted Living", thereby creating an integrated "Senior Living Campus" to offer next level if care options, etc. The new construction will be under a Special Purpose Entity funded with debt, new capital raise and tax credits.  Will likely bring in additional General Partners as well so it's not going to be the same group as the original syndication. At the 5 year mark, we anticipate the new building coming online and timed with the recapitalization of the first project. This will provide both type A and B investors solid options--all can cash out at year 5 with higher gains that if we just did a refi, and then the long term investors would be given additional incentives to redeploy capital into the new SPE. 

Will definitely gather several BPOs and an appraisal at Year 5. Figured too that by selling to the SPE we can avoid the ~5% commission and fees associated with an arms length sale. At a projected $5M value that is not insignificant. As the GPs, we would not be taking a fee either at the recap. 

I just retired from active duty Army after 22 years and plan on building our business full time now and grow to be a large sponsor with 10,000+ units. Alignment of interests with all parties esp the investors is paramount. We are focused on building meaningful relationships that will last . As a West Point grad, I am also part of the Service Academy Business Network (SABM) which has an investing group called LocalVest. Have already made solid connections with many and have our first deal posted there if anyone is interested checking it out--would to hear feedback pos or neg, it all helps!

Plan on checking out your other content and learning more about syndications. Look forward to getting more involved on these forums and provide value to others as well. Thanks!

[John Sayers]

Originally posted by @Brian Burke:

Originally posted by @Tushar P.:
...

I’m going off-topic a bit, but to address your comment about risk increasing when sponsors collect more in fees than they invest in a deal—this correlation is a common misconception.  There is no evidence that sponsor investment increases alignment of interest nor decreases risk.  But there is evidence that the opposite could be true.  Sponsor co-investment can creat a misalignment of interest and increase risk to LPs under some circumstances. I’m not saying sponsor co-investment is bad, just pointing out that it isn’t the bright-line test of alignment that many people believe it to be.

 I've seen various sides of the debate on "alignment' but yet to see non-anecdotal input from either side to support their POV as being any better than the opposite view. Always seems a stalemate of opinions. Realistically all sides seem to have holes in their POV if there are to be thought of absolute or even superior. Seems neither side clearly holds up as best, so a balance of both concepts "seems" the best compromise. It would be nice to see a live or recorded discussion/debate of such alignment POVs and the participants also be not 100% GP/syndicator on the panel.  Are any of those out there that anyone has seen that might be interesting to review? Any SEC or FTC case analysis ever published?

[Brian Burke]

@John Sayers yeah it’s typically a passionate topic from both perspectives. I have yet to hear a theory on how co-investment increases alignment and/or decreases risk that I can’t debunk...but again, not saying co-investment is a bad thing.  I’m just saying it isn’t the end-all be-all that some make it out to be.  I’ve heard some investors who will invest in a deal only because of a sponsor co-investment and ignore other risk factors, and also seen investors reject a solid deal due to lack of one.  Both decisions could be wrong.

I laid out the whole scenario about how it can actually work against the investors as well as how sponsors can completely defeat the supposed benefits in “The Hands-Off Investor”.  I’d love to repeat it here but it took a whole sub-chapter to give up the secrets and explore the nuances.  Too long for here plus would hijack this thread. :)

[Stephen Resch]

@Brian Burke All of our investors asked is we the GPs were investing in the deal which we are at 10% of the total capital raise of $1M. That made them feel more comfortable knowing we had "skin in the game" but I see your point of how that could work for or against. Think it's more important for new sponsors w/o a significant track record of successful syndications as in our case. Will definitely check out and read your book to learn more about this dynamic. Thanks!

[Tushar P.]

Originally posted by @Stephen Resch:

@Brian Burke All of our investors asked is we the GPs were investing in the deal which we are at 10% of the total capital raise of $1M. That made them feel more comfortable knowing we had "skin in the game" but I see your point of how that could work for or against.

Since you seem to get the point, maybe you can explain how you think GP having no skin in the game doesn’t increase LP’s risk. What incentive does the GP have to bring the deal on track if it goes south? And if the GP really believes in their business plan then why not demonstrate that with skin in the game rather than just words. Currently, that’s the first thing I look for in any deal and I discard the deal right away if I see not enough skin in the game by the GP.

I would ask Brian too, but I respect that he doesn’t want to hijack your post.

[Tushar P.]

Originally posted by @Brian Burke:

Originally posted by @Tushar P.:

Oh, make no mistake—anyone who made investments “several years ago with an exit around 2020” is  laughing all the way to the bank.  Unless the investment was in hotels, office, or retail, or was in San Francisco or NYC, their investments did just fine.  For the most part, values didn’t drop as a result of the pandemic except in the sectors and markets I just mentioned, with a few exceptions.

Within commercial real estate, my understanding is that retail, office, and hospitality amount to more than double the size of multifamily. Anyways, I had an option to invest in a hotel to multifamily conversion recently. The appraised value was 20% lower than the cost basis that investor A paid and the “recapitalization” would result in investor B entering the deal at a basis 15% lower than the appraised value. The sponsor seemed keen to keep the “promise” to exit as per the original plan, rather and hold longer (after all they didn’t cause the pandemic). I wonder if investor A was left holding the bag here, and if the sponsor would do the same if they had their own money tied up in the deal. I didn’t invest because I can go for other (non real estate) investments with similar risk profile that have better return potential.

[Stephen Resch]

@tushar p 

@Tushar P. I think it is important for the GPs to invest in the deal and have "skin in the game", especially if there is a limited track record. We invest in all of our deals. My comment ref Brian's point is more geared to a more experienced sponsor/GPs with a strong record of performance.  

From a business perspective, GPs personally investing in a deal is not always in the best interest of the company and syndicate itself as they must maintain certain levels of liquidity to satisfy lender requirements.   Not investing their own funds in a deal does not mean GPs have no "skin in the game", they take on other risks like personally guaranteeing the loan the LPs are insulated from. 

[Brian Burke]

Originally posted by @Tushar P.:

Within commercial real estate, my understanding is that retail, office, and hospitality amount to more than double the size of multifamily. Anyways, I had an option to invest in a hotel to multifamily conversion recently. The appraised value was 20% lower than the cost basis that investor A paid and the “recapitalization” would result in investor B entering the deal at a basis 15% lower than the appraised value. The sponsor seemed keen to keep the “promise” to exit as per the original plan, rather and hold longer (after all they didn’t cause the pandemic). I wonder if investor A was left holding the bag here, and if the sponsor would do the same if they had their own money tied up in the deal. I didn’t invest because I can go for other (non real estate) investments with similar risk profile that have better return potential.

Investor A probably ate it here--but it's impossible to point fingers without knowing what's happening behind the curtain.  Investor A might have had a defined investment period and forced-sale rights, or might have asked the sponsor to exit despite the loss because they had another need for their capital.  No way to know for sure.  It's also impossible to say whether a sponsor investment in that deal would have made any difference.  Sponsors could opt to take a loss on their investment for the same reason as the investors--and hope to make it up on the next round with investor B.  

Also, the opposite could happen.  Let's say that the sponsor did have an investment in the deal, and some life event caused them to have a need to get that capital back.  They might be pressured to sell that property, even at a loss, to deal with their own life event rather than to hold for the benefit of their investors.  The knife cuts in multiple ways.