JF1969: The Pros And Cons Of The Two Most Common Investment Tiers | Syndication School with Theo Hicks
We’ve talked a lot on how to structure deals with passive investors. This episode will cover a much higher level conversation on deal structure with passive investors. Theo will explain an approach that Joe and Ashcroft have used, having multiple compensation structures in the same deal, allowing investors to choose the best investment for them. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Theo Hicks: Hi, Best Ever listeners, and welcome 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 two syndication school episodes, generally a part of a larger series, but we’re going through a lot of standalone episodes at the moment. And these always focus on a specific aspect of the apartment syndication investment strategy. For a lot of these series and episodes, we offer some document for you to download for free – PowerPoint presentation templates, Excel templates, PDF, how-to guides, things that accompany the topic that we discussed in the episode. And all of these free documents as well as free syndication school series can be found at syndicationschool.com.
In this episode, we are going to be talking about the pros and cons of the two most common investment tiers. So we’ve done a lot of episodes in the past about how to structure the deals with your passive investors. If you want to go into a lot of detail on that, check out those syndication school episodes about how to structure deals with your passive investors. This is going to be a little bit more high-level and talk about something that Joe has done on his deals that’s slightly different than what he was doing when we wrote the book and when I recorded those episodes.
So the reason why this change has [unintelligible 00:03:49.08] typically what happens is, apartment syndicators will offer one type of offering of compensation structure to their passive investors, and most commonly– again, this is not always the case, but the most common structure you’re going to see for value-add syndications is going to be a preferred return, and then possibly some profit split. So 8% preferred return and then 50/50 profit split thereafter, or 8% preferred return, and then 70/30 profit split up to a certain IRR threshold, and then above that IRR threshold, it’s 50/50.
But one issue with just offering one single compensation structure on your deals is that it’s a one-size-fits-all approach; you’re assuming that this structure is going to work for everyone. Whereas in reality, typically in accredited investors, even sophisticated investors will have goals that will fall into two categories. And the one-size-fits-all approach might help one of those types of categories of accredited investors achieve their financial goals, but maybe not necessarily the other.
So one category would be people who are just investing for ongoing cash flow. They don’t care about getting a massive upside at sale, they just want a place to park their money and to beat the market in regards to cash on cash return, and then get their money back at the end of the business plan, say five years later. Whereas other people don’t care as much about ongoing cash flow. They want a place to put their money. They’re not worried about making a return on it on an ongoing basis, but they do want to make a large lump sum, maybe double their money in five years, for example.
So in order to offer investment opportunities, compensation structures that allow Joe to match the investment goals of both of those categories, they have decided to offer a two-tiered investment structure as opposed to just one. So rather than just offering Class A, now they have Class A and Class B.
So in this episode, we’re going to talk about what Class A is, what Class B is, and then compare the two and discuss which one of those classes applies to those two categories of accredited investors.
Class A investors will sit behind the debt in the capital stack. So you’ve got debt, and the next is going to be Class A. So you pay the debt first and then you pay the Class A investors second. The Class A investors are going to be offered a preferred return that is going to be higher than the preferred return offered to Class B investors. So if Class A investors are offered a return of 10% per year, let’s say, then Class B investors will be offered something below 10%. The Class A investors will also have virtually no upside upon selling the deal or any capital event like every financer’s helping them alone, and they also do not participate in the profit splits. So anything above that 10%, they are not getting a 50/50 split of that. But because of tax purposes, so that the Class A investors are taxed the same as the Class B investors, they are provided some upsides – it’s just very little; just enough so that they are classified in the same tax situation as Class B investors. And then for Joe’s deals, the bucket of Class A investors are limited to 15% to 25% of the total equity investment.
Another characteristic is a higher minimum investment. So typically, the minimal investment is 50k for the Class A investors, to $100,000. Now, of course, this is just what Joe does, but any of these numbers can be different; the preferred return to turn can be different, a small upside given the percentage of the total equity could be different, the minimum investment could be different, but typically the minimum investment is going to be higher than Class B. The allocation is going to be less than Class B, and the preferred return is going to be higher than Class B, but the upside is going to be less than Class B. So going to class B — I guess I said what class B is, but more specifically, Class B investors sit behind the Class A, and in front of the general partners in the capital stack. So you’ve got the debt, and then behind that is the Class A. So class A gets paid first after the debt, and then Class B gets paid after Class A, and then behind that would be Joe and the general partners, who I guess are Class C, and they are paid last.
Class B investors are also going to be offered a preferred return, but that preferred return is going to be much lower than the preferred return offered to Class A investors. So the Class A investors are going to be offered a 10% preferred return, the class B investors are going to be offered a 7% preferred term. Both of those are paid out monthly, so it’s gonna be 10% divided by 12, multiplied by your investment for Class A, or 7% divided by 12, multiplied by your investment for Class B. And again, since these Class B investors are sitting behind the Class A investors in the capital stack, the 7% is paid out monthly after the Class A has received their 10%, which is one of the reasons why the Class A investors are limited to 15% and 25%, since that preferred term is going to be higher, and the deal itself most likely is not going to have a 10% return, day one. It’s going to be somewhere in between 7% and 10%.
So you’re gonna want your Class B or Class A to be above and below whatever that return on the deal is, and then we can mess around with the amount that’s allocated to each (15%, 25% whatever) to make sure that you’re able to pay out both, ideally.
Now, if this full 7% can’t be paid out for some reason, then it will accrue over the life of the deal. So if the Class B investor only gets a 5% return year one, then that 2% is going to accrue and it will be paid out at some later date, whether it’s the next year, at a capital event or at the end of the business plan, when the property is sold. So at some point, they’ll make that preferred return, but they’re not necessarily going to get that preferred return on an ongoing basis. So, the probability of the Class A investors receiving their 10% preferred return is much higher than the probability of the Class B investors receiving their full 7% preferred return based off of the capital stack.
Now, in return for this less likely chance of getting on an ongoing basis – they’re going to get it eventually – is that the Class B investors do participate in the upside upon the sale and upon any sort of capital event. So on Joe’s deals, the Class B investors will receive a profit split of 70%. So any of the profits above their preferred returns are split between the Class B investors and the general partners. Class B gets 70% of the profits, general partners get 30% of those profits, Class A does not get any percent of those profits. or very, very minimal, again, for tax purposes.
Once the return to the class B investors has equaled 13% IRR, then the profit split goes to 50/50. Again, keeping in mind that the IRR is not going to be above zero until they receive all their money back, which most likely is not going to happen until sale… So the profits will be split 70/30 up until sale, and then a portion of the sales proceeds will most likely be split 70/30. Then once that threshold is hit, 13% IRR, whatever IRR threshold you decide to use, then it can change to 50/50 or 60/40 or again, or whatever you decide.
The minimum investment for class B is $50,000 for first-time investors and $25,000 for returning investors, so much lower than the investment for the Class A investors. And again, like I explained for Class A, the other syndicators might have a different preferred returns, different profit splits, different thresholds, different minimum investments, again, depending on what they’ve decided to do with their investors. This is just what Joe does as an example, but the general concepts still apply.
So let’s compare the two rules. So Class A investors are in front of Class B investors in the capital stack, so they’re paid first. Additionally, the Class A investors are offered a higher preferred return, so if you’re an investor and you are interested in a stronger ongoing cash flow, then Class A tier is ideal for you, because of the fact that you get paid first and the payment that you receive is the highest of the two classes.
Class B investors are behind the Class A in the capital stack, so they are paid with what is left over after the Class A investors have received their preferred return. If that leftover money is not enough to meet that preferred return member, then that is going to accrue and will most likely be paid out upon disposition or a capital event.
Class B investors are offered the lower preferred term, 10% versus 7%, but they do participate in the upside upon disposition or capital events like a supplemental loan or a refinance. So since they participate in the upside, but also have the drawbacks of not necessarily getting money on an ongoing basis, then the overall return over the life of the deal is actually going to be higher for Class B investors because the fact that they are participating in the upside.
So for Class A it is going to be 10% because they’re always making 10%, whereas for Class B, it could be as low as 7%, but most likely is going to be higher because they are getting some of the profits as well. So what does that mean? That means that class B tier is going to be ideal for accredited investors who want to maximize their returns over the life of the investment, as opposed to getting a strong ongoing return.
So in the beginning we said that the two categories are 1) they invest for ongoing cash flow, so Class A, and 2) they invest for upside, Class B. Well, what happens if I want both? What happens I want to have an ongoing cash flow, but I also want to participate in the upside? Well, for Joe’s deals, in particular – again, this might vary from syndicator to syndicator – but the passive investors can do both. So they can invest $75,000 as a Class A investor and then $25,000 as a Class B investor and participate in both of the upside and the ongoing profit.
From the apartment syndicators perspective, this is gonna be beneficial because you’re able to fulfill the needs of more investors. So if you’re just offering a Class A, or say, a nice preferred return, but no profit split – well, your accredited investors who fall into the category of wanting a strong, ongoing cash flow, but no upside, are going to be interested in your deal. But the ones that aren’t necessarily worried about ongoing cash flow and want to participate in the upside aren’t going to look at your deals, and obviously vice versa as well.
If you’re only offering upside to a lower preferred return, but a nice juicy profit split, then the people who are the accredited investors who want to receive more upside in the deal are going to be interested, but the ones who want a stronger ongoing cash flow are going to go somewhere else.
So you’re able to appease, in a sense, both categories of accredited investors by offering these two different types of investment tiers – a Class A and a Class B. Then even better, is if you allow a single investor to participate in Class A and Class B. And in this case, if you remember, the minimum investment for Class A was $100,000, but in the example that I said, they’re only investing $75,000 because the total investment needs to be $100,000. So if you are participating in Class A, your total investment needs to be a 100k. So you can invest 100k grand into the Class A, or you can invest 75k in the class A, and 25k into class B.
In conclusion, offering these two different tiers – or heck, more than two tiers; three tiers, four tiers, whatever – in your apartment syndications will allow passive investors to select the investment option that meets their financial goals, as opposed to either you fit them or you don’t fit them.
I went through, for Joe’s deals, how they offer the Class A and the Class B. The Class A are for a higher preferred return that is paid out first, but Class A investors do not participate in the upside. Class B investors, on the other hand, are offered a lower preferred a term that is paid out after Class A makes their preferred return, but they do participate in the upside. Therefore, Class A is going to be ideal for accredited investors who are more interested in the ongoing cash flow. And Class B is going to be more for the accredited investors who are more interested in the up side, as well as wanting a higher return over the life of the deal.
So that concludes this episode. To listen to some of the other syndication school series, as well as to download all of the free documents we have available, those are at syndicationschool.com. I’ll be back tomorrow. Until then, have a better day I’ll talk to you soon.