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Alignment of Interest is Broken
January 19, 2020
Introduction: Classic Promote Structure
Investment fee structures nearly always tout “aligned interests” between sponsor and investors. Sponsors will explain how their particular deal structure is best suited to align their interests with investor returns. However, not all “alignments” of interest are created equal and even the traditional private equity structure (acquisition fee, asset management fee, preferred return, and promote) has incentives which can put LPs and GPs at odds.
First, a review of the typical structure: most multifamily deals have an acquisition fee of 1–2% of the purchase price or total capitalization (be sure to understand which amount percentage fees are based on). There is usually an ongoing asset management fee of 1–2% of the property’s effective gross income (beware asset management fees assessed on total invested capital, which could be more than twice as expensive). Finally, sponsored investments will have a promote or carried interest structure which allows the sponsor to receive a percentage of the investment’s profits, typically subordinate to a preferred return of 6 to 10%.
Breakdown of Traditional Promote Structure:
If the GP successfully executes a value-add business plan, there will be a large paper promote realizable only at sale. In today’s yield-starved environment, little ongoing cashflow remains for the GP above typical preferred distributions to LPs, so GPs make little on an investment until a sale unlocks the capital gains. Furthermore, many investors fear a looming recession and so prefer deals with 10-year, fixed-rate debt – often saddled with yield maintenance or defeasance. These punitive prepayment penalties can make it uneconomic to sell a property sooner than 1–2 years before loan maturity. Thus, traditional promote structures will always place long-term investors seeking steady yield at odds with sponsors, who make much more from capital gains achieved at sale. The effect is not only that sponsors want a sale to realize their gains. GPs’ relative share of proceeds rises with IRR; since the bulk of sale premium is achieved by the initial value-add, sponsors receive the greatest share of total proceeds when the investment is sold sooner. Longer hold periods spread the initial value creation over longer time periods resulting in lower IRR and lower GP share of proceeds.
Solutions could be to lower preferred returns so that the sponsor achieves meaningful cashflow while holding an investment; or a promote crystallization: a mutually agreed upon valuation that reallocates equity share upfront, bringing the GP’s share of equity in line with the share of proceeds it would realize at sale – but without exiting the investment – eliminating the preferred return / promote structure). I will take a deep dive into crystallizations in an upcoming article.
Theoretically, preferred return protects LPs from underperformance or business failure, relative to the GP. However, a few incentive issues arise from the preferred return. Since LPs get paid first, GPs make relatively little from moderate returns; they gain disproportionately from outperformance. Thus, preferred return hurdles can encourage sponsors to take more risk to try to achieve higher returns.
A Preferred return, or “pref”, is usually based on levered cash flow; more debt => higher cash flows => higher promote for the sponsor. This means that debt-averse investors may struggle to find deals which are leveraged to their liking, or find themselves in deals where supplemental financing added two to five years after acquisition leads to significant return of capital. Investors should check the PPM/operating agreements to see if the sponsor is allowed to encumber the property with additional debt post-acquisition. Personally, I am a fan of additional financing and love deals which have strong enough returns to support maximum leverage.
Lastly, the preferred return highly encourages the GP to distribute out all free cash flow to the partnership rather than reinvest it back into the property. This can be very frustrating for a total return investor like me (I previously discussed the benefits of reinvesting cash flows into capex here): briefly, rather than raising an additional million dollars for budgeted improvements, an investor could instead take all cash flow generated by the property and use it to fund the renovations. This lowers the investment’s effective basis and increases total returns. However, this tactic doesn’t fit in a preferred return structure – the sponsor would get so behind on the pref that they would never make any money. I have however heard from a few sponsors who use this method when investing their own money.
Speaking of getting behind on the pref – investors should understand how their preferred return is calculated. The best case is the preferred return is cumulative and compounding. This means that missed pref payments accrue and additional interest (at the pref rate) is added to the accrued balance. Investors should read the fine print to see whether this is the case or not on deals which they are considering.
Alternative Promote Structures: Better for Investors?
With the difficulties surrounding the preferred return structure, it may be no surprise that a handful of sponsors cite these difficulties to justify eliminating preferred return in exchange for a lower sponsor promote and zero asset management fees. This is pitched as a simpler structure and better alignment of interests, but in my opinion, is a simple marketing ploy – resulting in worse economics for investors and much worse risk-adjusted return profile. Here is a quick comparison of a traditional structure versus a “no pref, lower promote” structure.
Oddly enough, in this particular situation, IRRs are the same but cash flows in the “no pref” are almost 100 basis points lower. Furthermore, investors are at a substantially higher risk of underperformance in the latter structure because they are not protected by a preferred return. For example, here are the returns for the same deal with vacancy stressed from 7% to 12%.
In this case, both IRRs were at 14.1% and are hit but the traditional structure held up better to the stress test because the preferred return was caught up by profits from sale. Without a preferred return, investors have full exposure to the ups and downs of the investment’s performance. In conclusion, a cumulative and compounding preferred return is almost always optimal for investor economics and is a great alignment of interest when employed properly.
We are not, however, in the clear yet – a nefarious and return-dilutive strategy exists whereby the sponsor “over-raises” enough equity from investors prior to closing to pay any shortfalls in the preferred return. This is fantastic marketing because the sponsor can still include a pref in their structure yet know they can reach into the cookie jar for their promote at will because they have the power to always stay current on their pref. As an aside, this makes sponsors like us who don’t play this game look extremely bad when we don’t meet our pref in the first year or two. Investor: “Why can’t you pay my pref when the sponsor down the street just paid a 4 cap and is paying out 8%?” Magic. … Or – they are using yourmoney to pay your return so they can earn their promote sooner. This strategy is the opposite of reinvesting cash flows to be more capital efficient and lower your basis. Instead, pre-raising the pref increases the total amount of equity required to make the investment which dilutes total returns and sale profits across a larger equity slice. Worse still, this has no effect on the sponsor’s sale compensation – the sponsor earns a fixed percentage of the sale profits regardless of how much equity there is to split it with. “Over-raising” or “pre-raising the pref” not only lowers investors returns, it also eliminates the preferred return’s power as an alignment of interest, rendering it useless.
Additional ancillary or hidden fees don’t necessarily bring interests into or out of alignment, but are important to recognize and reflect the sponsor’s approach to business. The largest and most-overlooked fee is the loan guarantee fee, which can sometimes be lost in the laundry list of fees associated with financing. There are often numerous parties receiving fees so it is worth understanding who exactly gets what exactly. Sponsors sometimes assess a guarantee fee on the loan balance for signing on the loan – I would argue this is justified for recourse debt with below-market terms such as a low interest rate. It would be well worth it for an investor to pay a 1% loan guarantee fee to a sponsor who signs a recourse loan with an interest rate that is 50 bps below market.
However, assessing a guarantee fee on a non-recourse loan is a naked fee grab – a sign of a sponsor seeking to maximize the upfront fees they receive. Other “hidden fees” include expenses charged to the property that really ought to be covered by the asset management fee or borne by the sponsor. Asset management fees are paid to “keep the lights on”. However, some sponsors charge travel costs to the property and I’ve even been told by a sponsor that he bills his properties his hourly rate for being on site. All this begs the question – if this is happening in plain sight, what is being charged/manipulated behind the scenes? I hate to say it, but investors in these deals are being fleeced. I encourage investors to ask sponsors which costs are and are not covered by the asset management fee.
Lastly, I would like to touch on creative structures. We analyzed the “no pref” structure – pitched as more investor-friendly but shown to be more expensive with a worse risk profile. Sadly, most creative structures are more of the same. Sponsors will typically diverge from the traditional structure because they believe it will pay better. We are always analyzing unique structures in the market and working to devise new structures that are a win/wins for the GP and LP, such as not taking an acquisition fee, preferred equity, dual-tranche syndication, and promote crystallization.
So, what solution is there when so many structures fail to deliver favorable post-fee economics or properly align interests? The truest alignment of interest is GP co-investment. Cash (co-invested) is king. The best structure is one that includes the sponsor investing significant cash (relative to their net worth), net of all upfront fees and on the same terms as LPs. This is very rare and can be difficult, especially for newer sponsors who may not have the luxury of investing much at all. When substantial co-invest isn’t feasible, investors should ensure that newer sponsors are long-term oriented and are invested in their reputations. Investment by family members of the sponsor should also carry similar weight.
In conclusion, investors should underwrite every deal they consider, fully understand the nuances of proposed deal structures, and be aware of GP co-investment and hidden fees. For passive investors seeking guidance in navigating the multifamily syndication market, visit www.greenoaks-capital.com/advisory to learn how we can help you achieve your investment goals. We offer passive investors full and transparent underwriting and analysis of an investment, giving you the confidence to make an informed decision. Alternatively, you can invest with us at www.lonestarcapgroup.com, where we strive to put investors first with our actions, not our words.