Financial Structures of Private Equity Investments
In several earlier blogs, we’ve discussed passive investing in real estate and its advantages for investors who aren’t in a position to spend all their time searching for, and then managing, appropriate investment properties. With a passive role (being a limited member) in a private property buy and hold situation (as opposed to a loan), investors will invest alongside a professional real estate company -- often called a “syndicator,” “operator,” or “sponsor” -- that will spend the time needed to find an attractive property and to perform the related management chores. Since such companies are often aware of the benefits of diversification and may prefer to spread their own capital over several different projects, they will typically invite other investors to provide some (or most) of the capital required for any single opportunity. These investors will then share in some of the project’s benefits (and risks).
There are several possible legal structures in which a syndicated investment group can be organized, but most real estate investment are structured using limited liability companies so that none of the participants -- neither the investing members nor the operator -- will (generally) be financially liable for the venture beyond the value of their investment. The structuring issues then come down to questions of how to divide the financial benefits of the project among the investing members and the sponsor, or “who gets what -- and how much?”
In most private syndications, the sponsor provides a relatively small portion of the capital for the investment, but offers the investment opportunity and the time and expertise to make the investment successful. The investors provide most of the money, but also get to take a relatively “hands-off” approach to the project. How to best split up the rewards? For investors, a partial risk/benefit analysis might include the following:
Property type/class, operational concerns, market conditions
Syndicator can bring expertise that investors can leverage
Sponsor may not devote sufficient efforts to a faltering project
Operators with enough “skin in the game” will work hard toward success
Syndicator may be motivated to move on and thus sell the property too cheaply
Sponsors with a significant share in the upside will try to maximize a sale price
Operator’s interests may not otherwise be fully aligned with those of investors
Structured with proper incentives, project can represent an attractive opportunity
The negotiations involved in resolving these issues vary with each transaction, depending on the anticipated risks and benefits involved in the particular project. The primary structuring questions in real estate syndications are usually:
- How much capital will the parties provide?
- Will there be a “preferred return” before sharing any additional profits?
- How will those remaining profits be split?
- Will the sponsor be entitled to a management fee or other payments?
- Who will get any available tax benefits?
Over time, there have emerged some general patterns for real estate equity deal structures. Although each transaction is different, typical structures might look like the following:
- Provide the vast majority of the capital (usually 80-95%)
- Receive a “preferred return” on their investment (often 5-10%)
- Receive a share of the remaining cash flow and profits (typically 50-80%)
- Receive the bulk of the tax benefits, such as depreciation and interest deductions
- Provides a small portion of the capital (usually 5-20%)
- Receives the same preferred return as investors on its own invested capital
- Receives a “promote” share of the remaining cash flow and profits
- May receive fees relating to property acquisition, loan financing and management
- Receives some share of the tax benefits
The sponsor will be managing the project and may not want to invest much of its own capital as a result; but investors should generally look for sponsors that contribute at least 5% of the equity capital for the project. A structure where the sponsor has sufficient “skin in the game” acts to better align the interests of the sponsor and the investors.
Persons putting cash into a project also generally receive some “preference” in the return of that money before any “sweat equity” gets compensated. The preferred return, often in the 5-10% range, means that the investors will receive that amount before the sponsor gets paid any “promote” share of distributable cash flow. The preferred return is not a guaranteed dividend, however; sometimes the preferred return is not paid out because the property cash flows don’t allow it (for example, where the property is still under development). In such cases, the preferred return typically continues to accrue, and any unpaid amounts are ultimately recouped by the investor when the property is sold.
Operators will generally demand some form of management fee, and oftentimes receive fees for arranging loan financings and for each of the acquisition and sale of the property. Sponsors argue that these tasks are uniquely intensive in time and effort, and that they therefor deserve some compensation for their performance regardless of the investment’s ultimate success.
The division of remaining distributable cash varies greatly among deals, although the investors will nearly always be entitled to the lion’s share of the deal profits. The sponsor’s share of profits will depend on a number of factors, including the degree of difficulty of arranging the opportunity, how intensive the management of the property is expected to be, and whether the sponsor already brings a successful track record to investors.
Syndicated real estate investment opportunities can be structured in many different ways; the above summary merely reflects some of the more common methods that investors and operators use to work together. It is important in any case that real estate investments be made under a structure that helps to keep an operator’s interests and investors’ interests aligned. Keeping the financing and operating interests allied is important to the success of real estate projects as well as business ventures generally.