Syndication: BAM Captical

[Gino Hillincci]

Another question:

I was looking at BAM Capital, they were raising money last month. In a video, I heard the GP saying that "in this fund, we are purchasing some property from a previous fund" (paraphrase).  That was curious to me.

I took a call with BAM, and asked some questions about that... there is something about that practice I don't like.

My understanding is that BAM could use the capital from this current fund to improve those properties from the previous fund.  So the previous fund "created value," and can sell (back to BAM), exit, create upside for investors in the previous fund.  And the current fund could take new money, and further improve that same property, creating additional value in rents and on exit.  BAM said that by buying their own property (from themselves), they can be certain about the rents, market, etc.  Again, I am paraphrasing.

I won't invest in the current fund, because of this "selling to themselves" component.  If the first fund was doing what it should have done, there shouldn't be a lot of upside left in that property.

My concern is that BAM is "propping up" the first fund, buying the property at a level that makes that previous fund look successful (even if the current fund has to compensate for that price).  Why create this complication? Why not sell to a 3rd party, proving the value on the open market? This makes me cautious.  By selling to themselves, they could hide some flaw from the earlier fund, pass "low performance" to the current fund.  The current fund should be looking for deals that have a lot of investor upside, and if that is true, the previous fund didn't get it done, or if that's not true, and the current fund is essentially a recapitalization (without calling it that). Either the first fund underperformed (and is looking to clean that up), or the second fund is buying something with less upside than it could otherwise... that is my read.

Is this all normal/healthy? It doesn't feel right.

I don't know why they would do that? It would be so much cleaner not to buy their own buildings.

I am trying to get educated here. This is my read. I am curious what more experienced investors would say? And where you might send me to learn more as I look at places to invest.

Thank you.

[Brian Burke]

I know nothing about the group or deal you’re referring to so I can’t speak to this particular instance, but speaking solely in generalities, this is a fairly common practice.  You don’t often see it with smaller groups or with smaller properties, but larger groups do this frequently and it’s even more common as asset sizes get larger.  There is even a name for it: recapitalization.

But just because it’s common doesn’t mean it’s OK, and it doesn’t mean it’s a suitable investment for you.  It doesn’t mean it isn’t, either.  You have to dig deeper.  Investing in a recap requires more thought, more due diligence, and more questions.

The main question:  why?  There are many reasons for doing a recap, but the most common reasons center around capital structure.  Let’s say a group buys a heavy value-add, meaning it requires a lot of heavy lifting but they can get a big pop in the rents, and the value, quite quickly.  They raise money from investors with a high risk tolerance who are expecting high returns and a quick exit (what I call “hot equity”).  For example, maybe they tell investors it will be a 2 or 3 year hold with returns in the high teens or low 20’s.  Such business plans are high risk and not suitable for everyone.

Now, after the heavy lifting is done, the property shifts to more of a market-based play, where the velocity of the market will drive the value, and perhaps there is still some meat left on the bone from the value add plan (for example, they renovated 2/3 of the units during the 2-year plan, leaving upside on the remaining third).  This plan is lower risk, will play out over a longer time, and will likely throw off lower returns.  The original investors didn’t sign up for that, so simply holding isn’t the right thing to do.  Fresh investors, perhaps ones with a lower risk tolerance than the original set, could recap the deal and hold it for some longer period, say, 5 to 10 years, for example.  They might be happy with returns in the low teens.

The challenge with recaps is ensuring that it is a win for all parties.  Assuming the recap is at market price, the outgoing investors could win because they can get a quicker exit and perhaps save some transaction costs.  Incoming investors could win by getting certainty that the deal will close, plus get off the ground running because of continuity of management.  And maybe even get a slight price discount if there is a broker commission savings that could be shared with the outgoing investors.

As an investor (on either side of these deals), your concern is fairness.  How do you know that the sponsor isn’t recapping at an above or below market price?  The truth is you don’t, because there was never exposure to the market coupled with buyer competition and arms-length negotiation.  Even an appraisal, or multiple appraisals, won’t establish the true value, as those valuations are simply the opinion of the appraiser(s). 

Bottom line is it’s important to understand why the sponsor is recapping the deal. And then due diligence and Q&A to ensure that the transaction value is fair. 

And I can add this:  recaps are far more common in the institutional capital space, where the players all do this for a living and are used to it and know how to navigate it.  It’s more challenging to get these done in the private capital space because individual investors, who aren’t entrenched in this business every day, have the same feelings and apprehensions that you do, making it harder for the sponsor to raise the capital for the recap.