I was chatting with an operator recently who has been very successful over the last 20 years.
His team has amassed $500M in assets under management, much of that coming from repeat investors. He said that until a certain level of trust is built, new investors care about these 2 things:
When they will get their money back
How much they will get back
Once the trust is there, he said that his investors don’t want their money back at all. They’d prefer that it stayed invested, cash flowing, compounding, and realizing little tax liability.
Here I go over the two things above:
When you get your money back
How much you get back.
First, understand that all syndications are different. This article outlines what I’ve most commonly seen, but there are 1000 ways to structure returns and ownership in these deals. Plus, projections are always just that: projections. Actual deal performance varies.
Here are some terms to know:
The Capital Stack:
The capital stack refers to the structure of all capital that is required to finance a deal. It outlines who is funding the deal, how much they will be paid back, and when. This includes debt and equity partners.
For example, if you buy a rental property, the capital stack includes the bank loan, which gets paid first, and then the equity that you contribute, which gets paid second. If the debt is not paid first, there is no cash flow on your equity.
Waterfall Structure
A waterfall structure describes how, when, and to whom funds are paid in a syndication deal. If you think about a series of cascading waterfalls, you’d notice that water flows in sequence down each. Once the water exceeds the capacity of one pool, it will flow over the edge and down into the next body of water.
The same goes for a waterfall structure. The water represents the capital as it flows through the capital stack. Capital first goes toward paying the debt, and down the line in the order that is defined in the PPM.
At the equity position, where LP’s invests, is normally a preferred return.
Preferred Return
The preferred return is a common first condition in a limited partner’s return that ensures they get paid first. It is typically represented as a percentage of capital invested that must be paid out to investors annually before the general partners get a share of the profits.
Internal Rate of Return (IRR)
IRR is a common way to evaluate a deal’s returns. For one year, IRR would be the same as the annualized return.
However, since these investments are typically multiple years, this is used to track the investment performance while accounting for the time value of money.
An important detail to understand is the time aspect. It is better to get your money back as quickly as possible because that money can be reinvested somewhere else. This is what IRR is good for.
Return OF Capital vs. Return ON Capital
The two are treated much differently from a tax and returns structure. Return OF capital is not taxed, but Return ON capital is taxed as income.
Cash Flow distributions are usually treated as return ON capital. Capital events, like refinance or property sale, will typically return all capital first, and then provide the remaining profit as a return ON capital.
Example Returns Structure:
8% preferred return
70/30 split above the preferred return
Total equity raised $1M.
Projected 16.8% IRR for limited partners.
The hurdle is the 8% return. In other words, the first $80,000 of cash flow is due to the limited partners. If an investor contributed $100,000 of that total raise, then they are due $8,000 per year. If the deal only yields $60,000 in year one, then the remaining $20,000 carries over into year 2, and the year 2 hurdle is $100,000.
Scenario 1: Deal performs to projections.
Year 1: The deal yields a total of 5% or $50,000 in cash flow that goes entirely to the LPs.
Year 2: Cash flow is 8%, so $80,000 goes entirely to the LPs.
Year 3: The business plan is nearly complete, so the deal is now yielding 11%. Again, the entire $110,000 goes to the LPs since there is 3% owed from year one.
Year 4: The yield is 12%. The first $80,000 goes to the LPs, and the remaining $40,000 is split into $28,000 to the LPs and $12,000 to the GPs.
Year 5: The yield is 8%, due to the LPs. Plus, the property sells, returning the $1M in equity plus $860k in profit. All investor capital is returned, and the profit is split between $600,000 to the LPs and $280,000 to the GPs.
Total returns:
LP: $1M investment returned + $1.028M Gain
GP: $292,000 Gain
This is just one example of many. When seen like this, it makes sense that GPs will sometimes charge yearly fees, as a way to get paid during those first few years without any return.
The important thing is to understand how your specific deal is structured. Always be sure to ask plenty of questions upfront.
You’ll want to make sure that you’re being compensated well for taking the capital risk, but you’ll also want the GP to have the incentive to operate the deal well. The ultimate goal is to make sure that all parties are aligned in their interest.
