JF1598: How to Structure GP & LP Compensation Part 2 of 2 | Syndication School with Theo Hicks
One slightly important part your apartment syndication career is how you will be getting paid, as well as how you will be paying your investors. Today Theo will cover how to pay the Limited Partners in your apartment syndication deals. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series – a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.
Each week we air a podcast series about a specific aspect of the apartment syndication investment strategy, and for the majority of this series we offer a document or a spreadsheet or some sort of resource for you to download for free. All of these free documents, as well as previously recorded Syndication School series can be found at syndicationschool.com.
This is going to be part two of a two-part series entitled “How to structure the GP and LP compensation.” If you haven’t already, I recommend going back and listening to part one of the series, where we discussed the different parts of the general partnership, and the responsibilities and ownership percentages of each of those parts.
If you don’t wanna listen to that, just to summarize, the five parts are going to be 1) the person who fronts the due diligence costs, 2) the person responsible for acquisition management, so everything from finding the deal through closing on the deal. Then you’re going to have the sponsor, the loan guarantor, key principal – that’s the person who can qualify for financing, and therefore signs on the loan. Part four is going to be the person responsible for investor relations, so everything from raising the capital to the ongoing communication with investors after the deal is closed. And then fifth is going to be the person responsible for asset management. The percentages for those are 5% for the person fronting due diligence costs, 20% to the acquisition manager, 5%-20% for the sponsor, 35% for the person responsible for investor relations, and then 20%-35% for the asset manager.
As I mentioned in part one, these are general ranges for the ownership percentages, and it’s going to vary from deal to deal and syndication team to syndication team, and it’s all negotiable. For more detail on those, check out part one.
In this part we’re going to discuss the other side of the coin, which is the structure of the LP or the passive investor compensation. So we’re gonna talk about first the two types of investors, and then we’re going to walk through the investor decision tree, which will also be a free document for you to download, so you can go through that exercise yourself. So let’s just jump right in.
There are really going to be two types of passive investors, and they’re gonna be lumped into two different types of groups. One is going to be an equity investor, and two is going to be a debt investor. So from an equity investor’s perspective, it’s going to be the most profitable, because the equity investor participates in the upside in the deal. So they’re gonna receive their money back until the sale of the apartment. However, they’re going to be — in return for their capital being used to fund the project, they’re gonna be offered an ongoing return, as well as a proportion of the profits at sale. So this cashflow is going to come out of the profits remaining after the GP pays all operating expenses, as well as the debt service, and sometimes the asset management fee.
I know for Joe’s company, and what we’re also going to do – we’re going to put the asset management fee in second position to this ongoing return, because that promotes alignment of interests; we don’t get paid until after the passive investors get paid… But ultimately, that’s up to you. You can take your asset management fee first, and then pay out the return, or you can do what we do and pay out the return first, and then collect your asset management fee.
This ongoing return for equity investors is commonly referred to as the preferred return. The preferred return is not a guarantee, but is an offer to the investors, saying “Hey, you give us this capital, up to a certain percentage of the first cashflow will go to you before we ourselves get paid.” This percentage of the remaining cashflow can be anywhere from 2% to 12% of the equity investment paid out annually. What part of the range you’re at is gonna be based off of the experience of the general partnership and your team. So if you’re first starting out, the preferred return offered might be a little bit higher, because there’s gonna be more risks with a newer syndication team, whereas someone who’s done 10-20 deals could offer a little bit lower preferred return, because the investors will have more confidence in the GP’s ability to hit that number. It’s also gonna be based off of the risks of the project, and the investment strategy.
For example, the preferred return on a distressed investment strategy might be 12%, but since it’s distressed, you’re not gonna be able to hit that 12% right away, because occupancy is at 60%, and half of those people that are already there aren’t paying rent, so you’re gonna have to reposition the project for a few years… So that preferred return will likely accrue and will be paid out in one lump sum, most likely at closing, or once cashflow is able to support that preferred return.
If you’re doing a turnkey strategy, so you’re buying a property and really doing nothing to it, just cash-flowing, the preferred return could be, say, 5%, because again, you’re not pushing the rents up and adding value to it, but also it’s going to be less risky, because everything’s already done, and it’s gonna continue to cash-flow how much it’s been cash-flowing for the past 3, 4, 5 years. And then for the value-add strategy, the common preferred return is going to be 8%. It’s still a lot less risky than the distressed strategy, because the property is likely already stabilized, and you’re just updating the interiors and maybe upgrading or adding in some new amenities to push those rents up. So it’s less risky than the distressed, but it’s got a little bit more risk than a turnkey strategy, so 8% is the common preferred return.
Now, once that preferred return is hit, typically there’s going to be some sort of profit split. So overall, at the end of the business plan, the profit will be split between the passive investors and the general partnership anywhere between 50/50 and 90/10. I’m pretty sure what Joe does is they offer that 8% preferred return, and then the profits are split 70/30, and then they catch themselves up at the sale, to make sure that they hit that 30% number. But again, it’s really completely up to you.
You could just do a peer profit split instead, so you could say “Once we pay all the operating expenses and debt service and the asset management fee, all remaining profits will be split 70/30. 70% to the LP, 30% to the GP.” Now, the issue with that strategy is that there is a reduction in alignment of interests. With the preferred return, they get paid first, before you get paid, whereas for this peer profit split, you both get paid at the exact same time. And that’s on an ongoing basis.
The equity investor also participates in the upside of the deal. So for the value-add investment strategy, for example, since you are going in and raising rents, you’re gonna create a lot of equity in the deal, so when you go to sell the property you might have added a couple hundred thousand to a couple million dollars to the value of the property. So at sale, after you pay back the loan and all the different closing costs, let’s say you’ve got two million dollars remaining – that will get split between the limited partners and the general partners based off of whatever profit split was agreed to.
So overall, the equity investor gets paid on an ongoing basis in the form of a preferred return or a profit split, and then at sale they will also get paid out based off of the profit split that was set, or whatever agreement was set in the documents at the beginning of the deal.
The most common equity structure for a value-add deal is going to be the 8% preferred return, and then the 50/50 split of profits overall. It’s overall, so it’s not 8% preferred return and then the profits are split; it’s overall 50/50 between the GP and the LP.
Now, the other type of investor is going to be the debt investor. From the debt investor’s perspective, it’s going to be the least profitable… So it’s gonna be less profitable than the equity investor. However, there is much lower risk. After the operating expenses and the debt service is paid, the remaining cashflow must go to distributing a fixed interest rate to the debt investor. So unlike the preferred return, if the GP is unable to pay the fixed interest rate to the debt investor – this is assuming that they’re still able to cover the operating expenses and the debt service, but that remaining cashflow isn’t enough to pay that fixed interest rate, then technically the debt investor can’t take control of the property.
So there’s much lower risk, because the investment is based off of the collateral, so they could take the collateral if they’re not paid their fixed interest rate, whereas for the preferred return, if the investor offers 8% and only can distribute 6%, there’s really not much the passive investor can do except not invest with that person anymore. But if they were a debt investor, they could technically pursue the actual asset itself, and take it over.
Now, since they are debt investor, they’re not equity investors, they do not participate in the upside of the deal. So at sale they are not given a portion of those profits. Instead, they are going to be offered a fixed interest rate for a set amount of time, and then [unintelligible [00:11:50].11] is gonna be a balloon payment, where the GP must return 100% of the investment. So this interest rate is going to be similar to the preferred return. It’s gonna be based off of the GP’s experience, as well as the risk factors associated with the project and the investment strategy.
So if the GP is doing the first or second deal and they’re doing a distressed property, then that fixed interest rate is going to be much higher than a general partnership who’s done 20 deals and are doing a value-add strategy. But overall, since it’s a less risky investment from the debt investor’s perspective, the fixed interest rate is going to be lower than the preferred return would be, all other things being equal.
Now, as I said, there’s gonna be that balloon payment after 1, 2, 3, 4, 5 years, whatever you negotiated with your passive debt investor. So you’re gonna have to give them all their capital back, and this is gonna be done before you actually sell the deal. This would occur most likely with a refinance or a supplemental loan.
Now, from your perspective, having debt investors is going to be the most profitable for you, because if you think about it, if you have a debt investor with a three-year term and you pay them 8% for three years while you implement your value-add business plan and you create a ton of equity, to the point where you’re able to distribute all of their capital back and then you have 100% ownership of the property. Now, the drawback is you have to add enough value to distribute all of those returns back, which means that if they are funding 30% of the down payment, then you’re gonna have to add 30% value to the property in order to pay them back. So when you’re underwriting the deal you’ve gotta make sure that that’s what you’re projecting, is that 30% increase.
Another option would be to do a combination of the two. When I was talking to a bunch of attorneys and lenders, and they were explaining to me what they typically see, they’ll see a large chunk of the money raise will be a debt investor; so there’ll be maybe one or two people who are bringing the majority of the capital, and then they offer them a fixed interest rate for a certain amount of years, and then that’s it. Then to cover the remaining 10% to 40%-50% of the equity raise, they bring on 20% different equity investors who invest 50k each, and maybe they’re family or friends who are not necessarily worried about a large ongoing return, but they wanna see that money double in five years.
That way, you’ve got your equity investors, who are participating in the upside of the deal, as well as you’re getting the ongoing return, but then you’ve got your debt investors who only funded 50%-70% of the actual investment, so now rather than having to add 30% value to the deal, you only need to add 20% value to the deal in order to pay them back. You’ll, again, own the majority of the property, and all you have to do is worry about paying those 10%-30% of the equity investors their ongoing return, and then paying them their upside at the sale.
So overall, the best partnership structure that you create is gonna be based off of, technically, what you want to do, but also what your passive investors want to do. If you start having passive investor conversations and they seem more interested in a low-risk investment vehicle to park their money in for a few years, or receiving a lower fixed interest rate that simply beats inflation, then you could potentially structure your deals with debt investors.
But if you start talking to investors and they’re more interested in something that offers a higher ongoing return that’s not necessarily guaranteed, but they’re interested in a higher return, as well as the potential for that large lump sum profit at sale, then you’re gonna have to structure your deals as equity investors. So you can either 1) make decisions yourself and only find investors that wanna be debt investors or equity investors, or you can base it off of the conversations you’re having with investors, and kind of what’s going on in the market at that time, what your competitors are doing.
Then of course, again, I said you could diversify. From the passive investors’ perspective, maybe in a couple of deals they’ll invest as debt investors, and in a couple of deals they’ll invest as equity investors… [unintelligible [00:16:06].10] you can bring on debt and equity investors.
But of course, make sure you consult with your attorney first to make sure, if you’re doing a combination of these two, that you’re doing the right security offering type, and things like that, and just make sure you’re doing everything by the book.
As I mentioned, we’re going to go over a structure decision tree that you can go through step by step in order to create the specific compensation structure with your limited partners, because you’re gonna wanna know what the compensation structure is going to be pretty early on. I didn’t mention that you can kind of feel it out with your investors, but if you remember back in a previous series about how to find passive investors, we went through the 49 common questions that the investors are going to ask you, and one of the most obvious questions they’re gonna ask you is how much money they get paid and how the deal is structured… So you need to have an answer for them, you can’t just tell them “How much money do you wanna make?” That’s gonna be unprofessional. You need to have at least a general structure in mind in order to run that by them, so they can make a decision on whether or not they want to invest with that structure.
The best way to do so is going to be to go through a decision tree, which as I mentioned, we will offer as a free document that you can download at SyndicationSchool.com, or in the show notes of this episode. So you’ll run through a series of questions, and then based on your answer, you’ll go down one side of the tree or the other side of the tree.
The first question is “Do you have equity investors or debt investors?” Circle one – are you gonna bring on equity investors or debt investors? If you’re bringing on equity investors, then will you offer a preferred return, yes or no? If yes to the preferred return, what will the preferred return be? That could be, as I mentioned, between 2% and 12%. There’s a blank for you to fill in, and then it says “The preferred return percentage is ____%.” For example, the preferred return is 8%. If you go ahead and fill that out, that’s gonna be one part of your compensation structure.
Next is gonna be what is the profit split after the preferred return? It gives you five different profit split examples to choose from: 50/50, 60/40, 70/30, 80/20 or 90/10. Again, that first percentage is for the LP, and that second percentage is for you, the GP.
I haven’t mentioned this yet, but the next question is gonna be “Will you set a hurdle?” What that means is that let’s say you offer the 8% preferred return and you do a 70/30 profit split. Year one, year two, year three, year four, year five you hit that number, and then you go to sell the property, and you do the 70/30 split entirely. Let’s say that results in a 25% internal rate of return to your investors. That’s great, that’s totally something that you can do. But as you gain more experience, or starting out, again, depending on what you wanna do and where your investors are at, you can set a hurdle. So following the same scenario, you offer 8% preferred return year one, year two, year three, year four, year five, and hit the number, and then at sale you distribute your profits based off of a 70/30 split… But let’s say once you distributed three quarters of the profits to the investors, they hit a 20% IRR. Now, you can set 20% IRR as a hurdle, when you initially start the agreement, and then after that hurdle is hit, the profits cannot be split 50/50. That might result in a 21% internal rate of return to your investors, while you are able to make more capital.
So for the question “Will you set a hurdle?” if the answer is no, you can just leave it blank, but if it’s yes, what will that hurdle factor be? In the example that I gave, it was the internal rate of return, which is going to be the most common, but technically I guess you could set it off of a cash-on-cash return as well.
So pick IRR, or cash-on-cash return, or if you wanna do some other hurdle or other factor, by all means, I guess it’s technically possible. You could do an equity multiple, or [unintelligible [00:20:10].05] multiplier, or something like that, although I haven’t seen that before, and then at what percentage will that hurdle come into effect, and what will be the new profit split? So fill in the blank. Once the LP receives x% of whatever factor you use, the profit split is __/__ thereafter.
For example, once the LP receives 13% IRR – so the hurdle is going to be IRR, and the percentage is 13% – then the profit split is going to be 50/50 thereafter. Now, going back to the other side of the decision tree, the question was “Will you offer a preferred return?” and we’ve done yes… What about no? So if the answer is no, you’re not gonna offer a preferred return, that means you’re doing that peer profit split, so now what is the profit split going to be? Of course, again, based on the team’s experience and the risks of the project in your business plan, that could be anywhere between 50/50 and 90/10… And then, you’re gonna have that same question about the hurdle. So are you gonna set a hurdle such that once the return or IRR or cash-on-cash return or whatever reaches a certain number, then that profit split changes?
Again, as an example, once the LP receives 13% IRR, the profit split is 50/50 thereafter. Now, that concludes the equity investor side of the decision tree. Now, what about the debt investor side of the decision tree?
If you circled debt investor, the next question will be “What interest rate will I offer?” So fill in the blank… For example, you offer a 12% interest rate to your debt investor. The next question is “What will be the length of the loan?” aka “When will you return all of the debt investors’ capital?” Fill in the blank. For example, it could be three years.
And then lastly, the question will be “How will I return all the debt investors’ capital?” You have the option of circling Refinance, Supplemental Loan, Buyout, or fill in the blank with some other type of strategy for returning all of their capital.
I highly recommend just using this decision tree to create your LP compensation structure… Again, remembering to keep your investors’ goals in mind, since you’ve already started those conversations, and then also maybe kind of go through the decision tree to run a few different scenarios, just to get the hang of setting these compensation structures.
That concludes this series of how to set the compensation structure for the general partnership and the limited partnership. In this episodes you learned the differences between the debt and the equity investors, as well as ran through the decision tree for actually setting the compensation structure based off of whether you are going to bring on debt investors or equity investors. As I mentioned, we will be giving away the decision tree document for free, so you can download that at SyndicationSchool.com or in the show notes of this episode.
To listen to part one of this series, as well as other Syndication School series about the how-to’s of apartment syndications, and to download that free decision tree document, go to SyndicastionSchool.com.
Thank you for listening, and I will talk to you tomorrow on Follow Along Friday.