All Forum Posts by: Kurt Granroth

A Simpler Way

My formula for determining the "tipping point" was illustrative but impractical, since it was near impossible to learn the Average Investment of each Class A investor and sometimes difficult to even discover the Total # of Investors. Based on suggestions by @Daniel Han and @Arn Cenedella implying or stating that the magic number was just a 10% IRR alone, I went back to my whiteboard and worked through even more scenarios.

This time, I resolved to only use figures stated in nearly every OM distributed - the total amount of Raised Equity and the predicted Distributable Cash. I even used "real" numbers this time, from a couple of OMs and PPMs I have lying around.

In one example, the Raised Equity is roughly $9M and the Distributable Cash ranged from $600k to $770k and the final return with sale of $16M. Oh, and this deal limits Class A to only 15% of the total Raised Equity. Given that, we know that Class A requires ($9M * 15%) * 10% = $135k annually to hit their preferred return. That never changes.

In this scenario, Class B will earn roughly 0.5% less each year as quarterly distributions than a Traditional investor would have without the split. That's not a lot, but it's also not nothing.

But during the sale, Class B will earn 30% more than a Traditional investor would have with the same sale price, since literally 15% of all of the investors hit their 10% cap and then stop earning.

Doing all the math, we see that the actual tipping point is much easier to calculate. As suspected, it is simply a 10% annualized return!

To Sum Up

In practice, being a Class B investor would nearly always mean accepting a lower "income stream" in yearly distributions by some percentage dependent on how many Class A investors there are, since the times when operating income alone is enough to generate a 10%+ return while on-going is... rare. However, if you trust that the sponsor can deliver better than 10% overall (and in the market right now, even "underperforming" deals typically do), then Class B will tend to do even better than Traditional overall.

Are Class A / Class B Splits Wonderful?

It really depends on your risk tolerance. It gooses any return above 10%, but it will depress any return below that. And as @Brian Burke showed, in his typical insightful way, that the way the deal is structured could result in a TOTAL LOSS for Class B in a worst case scenario, while Class A made their full return!

I have two PPMs in front of me that illustrate both sides of this. One PPM says this in the case of any capital event:

That is, during any sale, all investors get their capital back first, with no preference between Class A or Class B. In a worst case scenario, where the sale is for less than the initial price, you are all losing money, but you're all at least losing money at the same rate with no preferential treatment.

The other PPM, on the other hand, says this during a capital event:

Oof. Yep, not only will Class A get their capital back first, but they also will first get their 10% return. So in a Black Swan event, Class A could even get 100% of their promised return on the investment while Class B lost everything!!

With that in mind, a Class A / Class B split can be as "safe" to your initial capital during worst cases as a Traditional route, but depending on how the PPM is written, it can be far riskier!

Is Class A Worth It?

That's obviously a personal decision, but I don't personally think so. 10% is a "debt fund" style return with a huge difference. If you actually hold the debt, then you have more opportunity to recoup your money during some kind of crash. If you are Class A equity, then your risk is the same as the rest of the equity stack and you do stand to lose it all. So you have the same risk factor as Class B but you are giving up any extra return to compensate!

Also, just like Class B, your money is locked in for the duration of the deal. In most "income focused" funds, your funds are semi-liquid where you can withdraw your capital after some lock-up period, typically of 1 year. Class A will have you locked up for 3-5 to maybe 7 or 10 years, depending.

The question, as Daniel asked, is "are there are alternative investments that will reliably yield 10% but without the drawbacks?"

In general, yes, potentially quite a few. Many debt funds will hit 10-12% and the big private REITs can also run in those numbers. I believe the Starwood REIT is returning 10% on average, for instance... and you can join in at any time; exit at any time after a year; and they go back to the 90s without losing any money (you also might not even need to be accredited).

But... yeah, I am finding it harder to find the "good" 10%+ income funds than the very many Class A offerings out there. The latter might be much much riskier, but boy is it made easy for you (as long as everything goes peachy-keen)

Class A / Class B

The practice of splitting the LP investor equity group into Class A and Class B (sometimes: "Series A" and "Series B") tranches is already extremely common and seems to becoming almost ubiquitous. Institutional funds have used levels such as Series I and Series D and the like for years, but this particular structure was -- I believe -- introduced by Ashcroft just a few years ago. It has certainly caught on, at least in the BP and adjacent crowd.

This is the concept, for the uninitiated. The LP group is split into a conceptual "income" group and a "growth" group. The Class A "income" group is offered a 10% Preferred Return but in exchange, doesn't participate in the "upside" (meaning a portion of the eventual sale of the property). The return is also typical based off of initial capital rather than unreturned capital, plus extra effort is often given to ensuring that the 10% goal is met, even in year 1. Finally, Class A returns are superior to Class B returns and are typically second only to the debt itself.

Class B "growth" shares are more like a traditional (pre-2018/2019) LP group. The Preferred Rate is going to be 7% or 8% and there is not as much effort to hit those targets in the first years. Class B also doesn't start making any money until Class A's return is met. In exchange, Class B does participate in the upside including a promote waterfall even before a sale when income exceeds the preferred rates, plus a split of the sale proceeds. The idea is that a Class B investor might not make as reliable a yearly income as Class B, but the total returns (and, thus, annualized returns) can be notably higher.

The Problem: High Level

Given all that, I find myself wondering: as a Class B investor, why would I ever want to invest in such a deal knowing that my return is potentially compromised compared to a deal that did not have such a split? My risk hasn't changed at all but my reward may be mathematically notably more likely to be less.

The key to all this is that since Class A is higher in the return stack than Class B, in general that means that the total pool of available proceeds to be distributed is already depleted by a potentially significant amount before Class B even starts to get their cut. A class-less LP group would just take $X profit divided by Y investors. A class-based LP split has ($X profit minus A profit) divided by B investors.

Not Always Bad?

There is a twist to this, though. Since Class A is artificially limited to "only" 10%, a very well performing deal could result in a boosted return for Class B, rather than a weaker return. An example: say there are 100 LP investors all with $100k initial capital splitting $1.5M proceeds, simply. That's a $15k return or 15%. But now let's say that half of the LP investors are Class A and half are Class B. The 50 Class A investors extract their $10k each (10%) for $500k total, first. The remaining 50 Class B investors split the remaining pool of $1M into $20k each, or a 20% return! Same overall proceeds to distribute, but Class B actually had a boosted return in the tiered case. Nice!

But one more example. Say the profit to split in the above scenario is $750k. In a simple case, the LPs each get $7.5k or a 7.5% return -- just above a typical preferred return. In the half/half Class A and Class B split, the Class A investors extract out their $500k (still 10%) leaving only $250k for Class B. When that is distributed, each of the 50 Class B investors is looking at $5k or only 5% -- appreciably less than they would have otherwise earned.

The Tipping Point

What's going on here is that there is a tipping point of proceeds to be distributed where each increasing number of Class A investors acts as an accelerate to Class B returns. It's conceptually similar to how investing on margin will accelerate both earnings and losses, with stock investing. Earnings below the tipping point means that every additional Class A investor accelerates the reduction of Class B proceeds and earnings above the tipping point means that every additional Class A investor will actually accelerate the Class B profit boost.

What is this tipping point? In general, it is:

That is, if the average/mean investment of all Class A investors is $125k and there are 100 total investors split between Class A and Class B, then the tipping point is $1.25M. Knowing that, I could look at the financial projections and if they are reasonable and I see that the projected pool is going to be typically less than that, then I better pass, in favor of a near-guaranteed better deal. If the expectation is above $1.25M, though... well, take my money and sign up as many Class A investors as you possibly can, since each one of them is goosing my return that much more!

Due Diligence?

Hidden above lies the problem -- I need to know all three variables in order to determine if a deal is right for me, and I'm finding it nigh impossible to get those numbers. I want to do my due diligence but without all the necessary data, I need to go in blind.

And so, without the necessary data, I need to make assumptions. My assumptions are that for most deals, the typical proceeds-to-split is going to be less than the tipping point, most of the time, and so I should expect that for any deal with a Class A / Class B split, that I would earn less on that deal than a comparable deal without that split.

Therefore... why, as a Class B style investor, should I ever go with a deal with said split?

What am I missing?

Originally posted by @Nick B.:

E.g. 500 MFAs over 50 states vs. S&P 500. Otherwise, anything can be proven or disproven with this kind of comparison.

 Well, yeah. As I said, it's only one data point -- specifically only 1 of my 6 MF investments and my entire pot is only on year 3 of a 5 year plan. This cannot "prove" anything whatsoever and in any way.

It is a data point, though, and the very first one I have that I can do any kind of comparison with... hence this comparison. I have every confidence that the rest of my investments will out-perform this one.

The question I asked to start this thread was "What beats apartment syndication returns for passive income?" and it's far to consider if index funds in the stock market fit that bill.  I do have precisely one data point in that regard, now, as my very first deal has sold. Now that its cycle has completed, I have final numbers that can be compared to alternate options.

In particular, what if I had used the initial capital to invest in VTSAX, the Vanguard Total Stock Market Index. That is as "passive" as you can get. In the alternate timeline, I simply collect the dividends rather than re-invest them and sell the stock on the same day as the MFA deal closed. Here are the results:

MFA
Multiple: 1.32x
Annualized CoC: 11.24%

VTSAX
Multiple: 1.51x
Annualized CoC: 17.5%

So, yeah, in this specific case, the stock market easily beat the syndication for passive returns.

Yes, I do get that the stock market returns are largely due to the inexplicably bullish 2020, whereas MFAs all tended to do relatively poorly that specific year. This deal was also considered somewhat under-performing which is why it was even sold so early, and so doesn't necessarily (hopefully) reflect the rest of my portfolio. I also still have tax benefits from the MFA including the 1031 where I'm pushing my sale proceeds plus the remaining excess passive losses that should be shielding me in the future. And finally, this is literally just one data point out of what will be many data points, so I really can't read anything meaningful from it.

Still... VTSAX for the commanding win, this time.

Thanks for the explanation, @Brian Burke - that was exactly what I was looking for.

Indeed, my example was unrealistic in several aspects but I did so to try and reduce the number of variables in play and to ensure that my primary question wasn't hidden in the noise.

Your explanation of the psychology behind the difference makes a lot of sense. I've heard something along a similar vein when talking about the promote share split percentages. That is, a 80/20 split would benefit the LP far more than a 60/40 split... but in the latter case, one could argue that the sponsor would be working much harder to maximize profits than it would in the first case. In a "rising tide raises all ships" scenario, it's possible that the LP could still make more money in the latter case even though the actual percentage aren't as good as the former.

Thanks!

Most private placement deals I see have a LP/Sponsor waterfall that incorporates a Preferred Return, whereby the LP gets a stated rate of return before the Sponsor gets any money.

The Preferred Return can be based either on the Initial Capital Contribution or it can be based on the Unreturned / Unrecovered Capital. In the former case, the per annum distributions paid out is the same if there is a refinance or other Return of Capital event prior to sale. In the latter case, the per annum distributions will be reduced if there is any Return of Capital event.

Let's look at some numbers to explore this difference.

Say I invest $100,000 in a deal with a 7% Preferred Return after which there is a 70/30 split between LPs and Sponsors. In this case, the deal lasts for five years; a refinance at the beginning of Year 3 returns all capital to LPs; and it sells for 50% profit at the end of Year 5. It also doesn't generate Distributable Cash until Year 3 and does so at 9% for the next three years. By having the refinance/Return of Capital event in the same year as the first Distributable Cash, it should make no difference if this is European or American style waterfall.

Let's look at this from two perspectives. In the first, the Preferred Return is based on Initial Capital Contribution. In the second, the Preferred Return is based on the Unreturned Capital Contribution.

7% x Initial Capital
LP
Year 1: $7,000 (7% Preferred Rate)
Year 2: $7,000 (7% Preferred Rate)
Year 3: $108,400 (Initial Capital + 7% Preferred Rate + 70% Share of 2%)
Year 4: $8,400 (7% Preferred Rate + 70% Share of 2%)
Year 5: $43,400 (70% Share of Sale + 7% Preferred Rate + 70% Share of 2%)
Total: $174,200 (1.74x, 14.8% CoC)

Sponsor
Year 1: $0
Year 2: $0
Year 3: $600 (30% Share of 2%)
Year 4: $600 (30% Share of 2%)
Year 5: $15,600 (30% Share of Sale + 30% Share of 2%)
Total: $16,800

7% x Unreturned Capital
LP
Year 1: $7,000 (7% Preferred Rate)
Year 2: $7,000 (7% Preferred Rate)
Year 3: $106,300 (Initial Capital + 70% Share of 9%)
Year 4: $6,300 (70% Share of 9%)
Year 5: $41,300 (70% Share of Sale + 70% Share of 9%)
Total: $167,900 (1.68x, 13.6% CoC)

Sponsor
Year 1: $0
Year 2: $0
Year 3: $2,700 (30% Share of 9%)
Year 4: $2,700 (30% Share of 9%)
Year 5: $17,700 (30% Share of Sale + 30% Share of 9%)
Total: $23,100

If these calculations are all roughly accurate, then basing the Preferred Return on Unreturned Capital has a clear upside for the Sponsor at the tune of 38% more cash over the five years. All that cash comes from the LP, who makes $6,300 less.

It certainly seems like this is 100% skewed in favor of the Sponsor at the expense of the LP, based on my understanding. Am I missing something, though? Why shouldn't I, as an LP, treat Unreturned Capital Preferred Returns as a notable red mark against the deal?

Okay, it's been three years since I originally posted this and at the time it was all theory and no practice. I now have three years of following this ladder in practice and so it's time for a checkpoint.

Here are my results from the past three years:

Yeah, I'm missing my target by a notable amount. It's a mix of changing market conditions and just practical effects vs theoretical.

In no particular order:

1. The listed "preferred rate" these days is more commonly 7% than 8
2. But even then, that rate is only applicable retroactively after the deal completes. Precisely one of my deals (BAM Multi Fund) hit the preferred rate in the first two years -- most are notably less the first year.
3. Those CoC numbers aren't annualized, which they should be to be accurate since none of the deals happened at the beginning of the year and, in fact, all were initiated between June and October of each year. Still, even annualized, only one deal hit the preferred rate at all.
4. 2020 has $50k less invested than predicted since I was furloughed and we were keeping our cash close to the vest as a "just in case"
5. 2020 didn't do as poorly as I would have expected, though. I mean, they were all low (except one - yep, BAM Multi Fund for the win) but not as low as I thought they'd be.

I am back to work and we have a healthy liquid funds buffer built up so the goal is to invest $150k this year to catch up in the 5 year plan. It'll be very interesting to see when the first sale will be and how it'll impact all this.

Okay, here's some more on what I found out while researching what my K-1 actually means.

Line 20 represents the Section 199A items.  These are brand new for this year -- so much so that quite a few resources online still claim that not enough is known about them.  Newer ones are more clear.

They are used when calculating the Qualified Business Deduction (QBD).  The QBD is also new for this year.  It's a 20% deduction on income earned by a qualified business.  That came into play for me because I have a YouTube channel and earned $2k at it.  That means I have a small business (even pay self-employment taxes) and so I was able to deduct 20% of that $2k.  So the question is if passive investing in a syndication is considered a "qualified business."

As far as I can tell, the answer is no.  I would need to be far more involved than any passive investor can possibly be in order for me to claim it.  Heck, it looks like even being an active landlord renting out homes that you own is still not active enough to be considered "qualified".

Thus, while it is true that Section 199A is used to calculate the QBD, it simply will never apply to me in this context, so the entirety of Line 20 is informational but pointless to me.

Originally posted by @Charles LeMaire:

Normally as an overview assuming you are passive and this is your first deal, you put it the $50, they distribute say 5% per year for the 5 year hold ($2.5K/year * 5 years = $10K), you are still receiving a return of capital (no taxes on your money).  At the end of the hold they sell it and you double the investment (your share of the sale is $100K).  They send (it often takes several checks to close it down) you the $100K.  Your capital account (basis) was $40, so you get to pay cap gain on $160K (really there were some actual expenses that modify this a bit, but think big picture).  If you are a mover and shaker, you get to pay 20% + the 3.8%.  Smaller fish, 15%.  Maybe you can get away with 0% tax.

 

Thank you for this reply -- I'm still parsing out the ramifications in my mind.

In the above, am I right in that you are referring to the "outside basis" or "tax capital" rather than the ongoing "tax basis"?  If that, then the outside basis is calculated by reducing the initial capital with any distributions, thus my ending outside basis would be $40K in your example.  A sale that doubled my investment would result in $100K returned to me, which would include my initial $50K.  At this point, only $50K is taxable since half is the return of my investment.  But, since $10K was already returned to me, it's really $60K that is taxable since they're sending me $100K and not "$50K more than my initial investment".  The distributions, then, are more "tax deferred" rather than "tax free".

Is that $60K actually taxed as capital gains?  I thought all proceeds from these investments are taxed as income...

Did I read that right?

Originally posted by @Eamonn McElroy:

@Kurt Granroth

Asking CPAs to educate you 3 weeks before a major statutory deadline might be an uphill battle...

You are confused on several things above.  I'd encourage you to google and read about the following:

• Tax capital vs tax basis
• How to calculate tax capital and tax basis
• What happens when losses exceed tax basis
• The passive activity loss rules and how they relate to calculating taxable loss or income annually for passive activities
• The new 20% passthrough deduction and items of QBI

 Yeah, the date doesn't matter a lot to me directly at the moment since this particular K-1 results in no taxes for this year.  It's the long term view that I'm looking for... so if it takes a year to nail down all the details, then that works for me!

Based on your suggestions of further topics to google, here's what I found.

Tax capital is what you start out with and what matters when the property is sold.  I believe it's referred to as "outside capital".  Tax basis, then, is an ongoing amount that affects what is taxed, primarily.  Tax capital and basis start out the same at the beginning.

Tax basis is calculated by starting with the last year's basis ($0 for the first year), then add on any capital added during the year ($50,000 for my first year), then add or subtract any income from Part III Line 2 (-$30,690) and finally subtract any cash distributions or withdrawals (-$1,841).  The result is my tax basis == $17,469.  Not yet 100% certain how to calculate the capital or "outside basis".

A positive tax basis appears to mean that cash distributions are tax free and all of a loss may be used for that year.  The basis cannot be reduced below 0.  Any portion of a cash distribution that would lower the basis below 0 is instead treated as capital or income and is taxed accordingly.  Any portion of a loss that would lower the basis below 0 is not available for use the current year but may be carried over for future years.  That latter bit is subtle.  I'm guessing that it comes into play if you have multiple passive investments?  Like maybe you have one investment with income of $60,000 and another with a loss of $60,000... but the tax basis starts at $30,000 and so subtracting that loss brings it below 0 and thus only $30,000 of the loss may be applied to the $60,000 in profit.  If there is only one passive investment, then it doesn't seem like the "below zero" matters at all for the loss since you're going to carry all of it over regardless?

Don't yet know much about the 20% passthrough and deductions and QBI.