Refinancing in a Partnership Structure

In this article, I’d like to cover another “nuts and bolts” topic related to the way refinancing works in a real estate partnership structure. While there are infinite ways to structure a deal, the most typical way is with a preferred return and a promote structure, also known as a waterfall.

An industry standard waterfall includes a cumulative and compounding preferred return which is also subject to a return of capital prior to the promote (performance compensation) kicking in. This priority of distributions remains consistent across cash flow, refinance proceeds, and sale proceeds. However, some structures (not Lone Star’s) adjust the cash flow distribution to allow the sponsor’s promote to kick in on cash flow after the preferred return is met but prior to returning all capital. This is not necessarily fair since the sponsor could earn performance compensation but then underperform or lose capital later without a claw back of their compensation. In any case, this is not a big deal in today’s environment since cash flows are rarely more than preferred returns. Preferred returns range from 6 to 10% depending on the type of deal and investment amount (Lone Star’s preferred return is 8 to 9%).

Consistent with the aforementioned structure, refinance proceeds are first used to pay any accrued preferred return. If the preferred return is already current or there are excess proceeds after making the preferred return current, remaining proceeds are used to pay down investors’ capital accounts. The important distinction here is that investors receive a return of capital which pays down their capital account but does not reduce their ownership percentage in the deal. Based on the industry standard waterfall, investors’ ownership can never be diluted. Even if 100% of capital is returned back to investors, they would still own the same percentage of the deal and continue to receive distributions split at the waterfall rate. For example, if a deal has a 70/30 split above an 8% preferred return (70% for investors / 30% promote) and 100% of capital has been returned via a refinance, then every dollar of cash flow or sale proceeds thereon out would be split 70/30.

However, there are some other structures out there that are unfavorable to investors particularly as it relates to refinancing. For example, some structures consider the payback of investor capital through a refinance as a way for the GP to “buy out” the LPs out of the deal, allowing the sponsor to own a disproportionate share or the whole deal. This essentially means the LPs are treated like debt or preferred equity in that they don’t participate in the full upside of the deal and are subject to being bought out of the deal.

For a value-add investment, this is even more unfair because the LPs are in the deal early on when risk is the highest, while the business plan is being implemented. Once value is created and the deal is stabilized, investors are bought out through the refi, rather than being able to enjoy the upside and stabilized returns created through the riskier part of the deal. Furthermore, there usually is no capital subordination in these structures, which means the LP capital sits in a first-loss position in the capital stack. This means LPs are taking full equity-like risk and receiving debt-like returns because they are able to be bought out by a refinance.

This deal structure is most commonly implemented on deals which have the potential to do a full cash out refinance on, which are the heaviest of lifts meaning they are much riskier than the average value-add deal. In an institutional / standard structure, LPs’ ownership is not diluted by a refinance because they own a fraction of the deal and changing the debt does not change the ownership percentages on the deal. Additionally, a true institutional structure requires all capital to be returned by a refi as well as the preferred return to be met prior to the sponsor being able to participate in any refinance proceeds. This makes the most sense since, even though the cash out refinance may be a result of value creation, a refi is still a return of capital and investors are owed their capital back prior to paying the sponsor a promote since there is still possibility of underperformance in the future.