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Multi-Class Vs Dual Tranche Structures
July 27, 2022
There are nearly infinite ways to structure an investment partnership but there are a few common terms and structures which sometimes cause confusion. For this discussion, we are covering multiple investment classes (often Class A and Class B members with different investment minimums) as well as dual tranche structures (also with Class A and Class B memberships) which have a preferred equity / subordination component.
We recently introduced multi-investor class deal structures to entice larger investors to commit $500,000+ in deals to qualify as a Class B member in our operating agreement, which gives investors preferential terms, or “major investor status”. Our typical terms include a $100,000 minimum investment, an 8% cumulative / compounding preferred return, a 30% promote up to a 15% IRR and a 50% promote thereafter. However, for Class B members receiving major investor status, the minimum investment is $500,000, the preferred return is 9%, and there is a 30% promote with no additional promote tiers. This enhanced deal structure provides approximately a 1% higher projected IRR (17% net IRR instead of 16%) and provides superior downside protection through the higher preferred return.
The important point to note about this structure is that Class A and Class B investors are pari passu, which means cash flow and profits are distributed on a pro-rated basis with no priority given to any members. Even though Class B investors are owed a higher preferred return, this in no way impacts the returns of Class A investors. The enhanced Class B economics are funded solely out of the General Partner’s (sponsor) share of the deal. Essentially, the sponsor is foregoing a portion of the promote by providing major investors a better deal.
The dual tranche equity structure on the other hand utilizes a senior/subordinate structure to reallocate risk/returns to various investment members. In this structure, Class A investors are owed a fixed rate of return (typically 9% or 10%) which is paid out before Class B members receive any distributions. Class A members are senior to the Class B equity which provides for a cash flow and value cushion since all the cash flow and sale distributions are first owed to the Class A members. This structure could also be described as preferred equity (Class A) and common equity (Class B). In exchange for being subordinate to Class A members’ preferred distribution and return of capital, Class B members receive all the upside above the fixed rate of return, which enhances returns assuming project level returns exceed the cost of the Class A capital on a net of sponsor fee / promote basis. In exchange for higher projected returns, Class B members accept a greater level of risk because of their subordination to Class A members.
Additionally, since most deals have projected cash flows below the Class A member preferred distribution rate of 9% or 10%, Class B members see lower cash flow distributions than they otherwise would. However, if the deal works out, the returns upon sale are more substantial. This senior/subordinate structure is very different than the pari passu nature of the multi-investment class structure described earlier. It is important to carefully understand the mechanics of the deal structure you are investing in and to pay attention to the nuances of the ways deal structures allocate risk and reward as well as incentivize certain actions by investors and sponsors.