Analyzing Syndication Deal - Return on Capital?

[Danny L.]

Hello all,

I'm currently looking at a potential MF syndication deal. I started investing in syndication this year and have been learning through books, online, and various podcasts. One of the things I came across was determining if the deal was based on Return on Capital or Return of Capital.

Looking at the PPM for this deal, I couldn't figure out which method they were using. I searched the document for either phrase and came up with nothing.

The closest section I've found is this:

(i) Net Distributable Cash shall be distributed quarterly on the following basis:
a. First, to Class A Members, a 9% Preferred Return,
b. Second, pari passu to Class B Members, a 7% Preferred Return, to Class C Members, an 8% Preferred
Return, to Class D Members, a 9% Preferred Return, and to Class E Members, a 10% Preferred Return,
in each case in proportion to each Member’s respective Preferred Return Balances until each such
Member’s Preferred Return Balance is reduced to zero;

My guess is "until each such Member’s Preferred Return Balance is reduced to zero" would indicate distributions are based on Return of Capital.

I'll appreciate if someone with experience on this topic can confirm if my interpretation is correct.

Thank you.

[Brian Burke]

@Danny L., glad you are enjoying the book!

This appears to be a case where distributions are return ON capital first. It isn’t the best drafting, but one clue is where it says “Distributions of the Preferred Return do not reduce a Member’s Capital Account.”  That isn’t true, distributions always reduce a member’s capital account, but I think what they meant to say here is that distributions don’t reduce a member’s capital balance.

Another clue is that the preferred return is calculated using annualized return, not IRR. In the case of an IRR hurdle, all capital must be returned in order to hit it. That doesn't change much from a practical perspective until the percentage is exceeded—it just delays going to the next tier until capital is returned, that's all.

Another clue is that if preferred return is based on an annualized return, the waterfall language would have to say something like, "first, to the Class B Member to the extent of their unreturned capital," if the first distributions were to be return OF capital. This one doesn't say that—it says first to preferred return, and we now know the preferred return is not IRR.

You might also want to look up the definition of “Capital Return” because it’s mentioned in the definition of Preferred Return, just to see if that alters anything.