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Dual-Tranche Syndication Structure
January 19, 2020
In the world of finance and investment, as returns on deals get thinner, professionals are forced to become creative and “engineer” higher returns. Unfortunately, financial engineering has gotten a bad rap due to events like the 2008 Financial Crisis, which had complicated derivatives products at the core of it. Nonetheless, it is always important to find ways to optimize investments, including the capital structure.
A recent trend in multifamily syndication is to offer investors a dual-tranche equity structure, a preferred equity piece and subordinate common equity. The preferred equity tranche is senior to the common equity and earns a fixed rate of return (typically 10%). Essentially, the preferred equity position trades upside from potentially higher cash flows or profits on sale for a more secure and stable, current yield. The common equity is subordinate to the preferred equity, meaning it can only receive cash flows after the pref equity’s fixed return is paid. Wrapped around this equity structure is the general partnership’s promote (performance-based compensation paid from cash flows and profits upon sale). This means the common equity may still have a preferred return which must be paid before the general partnership earns its promote. Since the preferred equity investors do not participate in the profits upon sale, the common equity receives all of the profits upon sale, thereby increasing their returns in almost all scenarios. This senior-subordinate structure optimizes the capital stack by lowering the project-level cost of capital by more closely aligning risk to returns. By this, I mean the preferred equity investors are happy to accept a lower return in exchange for being in a lower risk position in the capital stack. Furthermore, this type of leverage is very favorable because it typically does not have default remedies or a maturity date and can be cheaper than mezzanine financing because tax benefits usually flow to the preferred equity investors. In my opinion, the dual-tranche structure makes sense to implement across almost all syndications.
At first blush, this structure may look like an attempt on the GPs part to increase their promote. However, a deeper look is necessary to unpack the ramifications of implementing this syndication structure. GPs especially should understand the effects this structure has on his or her total compensation. The initial assumption of most sponsors is that since the preferred equity acts as leverage and increases the common equity returns, that it must also increase their returns as well. However, this is often not true. Given the low level of cash flows typically found in deals at this late stage in the cycle, this structure actually reduces sponsor compensation. The irony of this is that sponsors are looking to implement this structure precisely for deals that underwrite to lower returns and can use the dual-tranche structure to advertise higher returns (which are achieved from the leverage provided by the preferred equity). However, to better comprehend how the returns are affected, the concept of positive leverage must be fully understood. Positive leverage is the concept that yield increases if it is levered by a lower cost of capital. Positive leverage is essentially the premise on which the entire commercial real estate business is created. The goal is to buy property which has an unlevered yield (cap rate) that is higher than the interest rate of the mortgage. For example, if you buy a property with a 5% cap rate and finance the acquisition with a 75% LTV mortgage which costs 4%, you have achieved positive leverage and will see your return go from 5% (cap rate/unlevered yield) to 8% (cash on cash/levered yield). As you can see, even a modest spread of 100 basis points results in a dramatic increase in cash on cash returns. This same principle holds true for all parts of the capital stack. For example, if the project’s cash on cash return is 12% but the preferred equity investors only receive a 10% fixed return, the cash on cash for the common equity will increase to 14%. However, as everyone knows, leverage cuts both ways. If the project’s cash on cash is only 8% yet the preferred equity still gets paid 10%, the cash on cash will be dramatically reduced to only 6% (both scenarios assume the preferred equity and common equity are each 50% of the total equity). This is the power of positive (or negative) leverage. However, this example only points out leverage’s impact on the cash on cash returns but does not touch upon the total returns achieved after sale – which is where the real money is made for the common equity in this scenario. Rather than the sale profits being shared by both the common and preferred equity partners, the common equity receives all of the profits and pays the same promote to the general partner. By utilizing this structure, the common equity could essentially double the profits it would otherwise earn upon sale. And since total returns (IRR) is almost always greater than 10% (cost of the pref), the leverage of the preferred equity is accretive to total returns.
The typical consequences (assuming negative leverage – project level returns are lower than the cost of the preferred equity) of the dual-tranche structure for the common equity is that it receives a lower cash on cash return than it otherwise would but receives a disproportionately larger profit upon sale and thus makes up for the lower cash flows with a higher IRR. This higher IRR makes GPs happy since they are better able to sell the returns of their deal to their common equity investors as well as appease their yield-focused investors through the secure, preferred equity position. However, the monetary implications for the GP itself may not be quite as favorable.
The general partner’s participation in the cash flows via their promote will decrease or become nonexistent in the negative leverage scenario since the GP’s promote is usually subordinated by an 8% preferred return offered to the common equity (not to be confused with preferred equity). The default assumption is that the GP should also make it up on the sale, right? Actually, no. The GP’s compensation via the sale remains the same in a traditional syndication or in a dual-tranche syndication. The sponsor earns 20 to 30% of the sale profits as their promote but the sale profits do not change based on the equity’s internal leverage coming from the preferred equity tranche. A sponsor can potentially make up for this by adding an IRR hurdle into the structure (ex: sponsor can increase the promote to 50% after an 18% IRR is delivered to the LP equity, which is more achievable when levered behind the fixed-return preferred equity).
Here is an example of how the dual-tranche syndication structure can affect a sponsor’s compensation in a negative leverage scenario.
Scenario #1: Traditional Syndication
In this first scenario, the sponsor is charging a 2% acquisition fee, 2% asset management fee, is offering an 8% preferred return and has a 30% promote. For this example deal, the LP returns are 13.9% IRR and 8.4% cash on cash over a five-year hold. The returns are a little light so this deal may be a bit harder to sell to investors.
Here is how the total GP compensation breaks down:
Scenario #2: Dual-Tranche Syndication
Now here is the same investment but with a dual-tranche structure instead of a traditional structure. In this scenario, we have a 10% preferred equity tranche which makes up 50% of the equity. The common equity investors pay the same fees and promote to the sponsor as in the traditional syndication (see Scenario #1 above). However, in this scenario, the common equity receives a 17.1% IRR and an average cash on cash return of 7%. The cash on cash went down but the IRR jumped to an impressive 17.1% which is much more attractive than the 13.9% in the first scenario and can certainly be the difference maker for an investor deciding to invest or not. Here is how the GP compensation breaks down in this scenario:
As you can see, even though the LP returns went up for the common equity, the sponsor is projected to make LESS money because they never hit their promote until sale. This is due to the cash on cash being lower due to negative leverage. The 8% preferred return must be made up upon sale which leads to the significantly lower sale promote for the GP. Sponsors should fully analyze and understand how their compensation is affected through the implementation of various capital structures. In this example, the GP is making 22% less in the dual-tranche structure. Sponsors need to ask themselves whether a deal is worth doing just because they are able to structure it in a way which will get their investors to bite. Just because you CAN doesn’t mean you SHOULD. On the flip side, investors should model out the projected returns for LPs and the GP and question why the sponsor is willing to reduce their returns so dramatically, if that is the case. One answer could be that a sponsor could be fee-focused and only care about generating acquisition and asset management fees by getting the deal done rather than optimize the deal to maximize promote compensation. An investor could reasonably ask a sponsor looking to set up this dual-tranche structure to reduce their acquisition fee to 1% (assuming it was originally at 2%) in exchange for increasing the promote or establishing a tier 2 return hurdle. This could reveal whether interests are truly aligned between the sponsor and their LPs.
Additionally, limited partners should understand that higher projected returns in a dual-tranche structure are derived from leverage and thus are a riskier return, all else being equal. This is a senior-subordinate structure which means the common equity will take the first principal loss in an unfavorable sale and could quickly see their cash flows evaporate in difficult times. LPs should scrutinize coverage ratios and breakeven metrics. In my opinion, the leverage employed by the dual-tranche syndication structure is worth the additional risk since the preferred equity typically doesn’t have control rights or default remedies. All in all, this is an optimal structure for cash flow investors and investors seeking higher total returns since each tranche (pref equity and common equity) cater well to each investor type. Investors should also realize that in most scenarios where this structure is being used, the general partners are opting to make less money (whether they realize it or not).
On the bright side, for investments which have project-level, levered cash flows which are higher than the preferred equity tranche’s return (typically 10%), everybody wins. The common equity LPs will see higher projected cash on cash returns than they would in a traditional structure and the GP will make more money from the promote as well. We will absolutely look to employ this structure on deals where we underwrite to this positive leverage scenario and we would even consider the dual-tranche syndication for deals which result in negative leverage because it caters very nicely to two very different types of investors.