Syndicators: Why can't we make distribution calculations simpler?

Question

Many syndicators/sponsors are offering a "waterfall" payout arrangement to their investors, whereby the investor first gets a "preferred return "of 8%, and then 75% of any cash flow left over after the preferred return is paid, plus 75% of the equity upon sale or refinance. An internal rate of return may also be mentioned...after the investor hits the promised IRR (15-23%), the split might change to 50/50. The sponsor gets the other 25% (or 50%), plus a 1-3% acquisition fee, a 1-3% disposal fee, a 1-3% annual asset management fee. If they have a property management arm, then they get 6% for management. If they're a broker, then they get to keep any brokerage fees.

It sounds complicated, because it is. I am invested in 5 passive deals, and each has a little different waterfall and fee structure. And uses different language in the Operating Agreement to explain the distributions. I can't really tell you that I understand all the terms...and I'm in the business! How is this investor friendly at all?

Meanwhile, for the sponsor, the 8% payments commence within 30-60 days of closing on the property...regardless of the property's actual performance. It's like paying interest on a note: No flexibility. If it's a value-add deal, it's quite possible there won't be sufficient cash flow to cover the preferred return for 6, 12, 18 mos. Meaning it becomes like a ponzi scheme: You have to raise enough from investors to pay those investors their promised returns until the property can do it! (I'm surprised the banks even go for it, frankly, as it is like a seller-carry 2nd for 8% interest-only...equivalent to a "no money down" deal.

I would sure rather not have required 8% payments hanging over my head as I concentrate on remodeling and turning around the building.

I heard one syndicator on a Joe Fairless podcast (wish I could find it...are you reading this Joe?) say he does it differently: He takes 20% of the cash flow if there is any, and 20% of the equity on resale or finance. THAT'S ALL.

It's sort of the Hedge Fund model (except those rarely get 20% of the profits...it's ALL in the backend except for an annual management fee.) No preferred return. His investors share in the pain of having no cash flow during the startup months, but they don't have to pay out acquisition or asset management fees. It all seems so clean and simple...so why doesn't anyone else do it?

Happy Super Bowl Day!

Go Team! Beat Opponent!

Jeff Greenberg · Answer

@Marc C. We offer a preferred return in order to give the investor an insurance that they will get their pref prior to us getting any CF.  Many times the first few years are on the lean side and we as the sponsor get nothing. Most investors like this structure.  As @Bryan Hancock mentioned we do get a make up to get back on track with the specified split.

On a reposition deal, all of the cash flow is going back into the property.  The investors are told this upfront and that they may not receive any distribution for 12 -24 months.  There would be a much higher overall cash on case return with the higher risk.

When I determine my structure, I look at several things.  What returns will be of interest to the investor on the low end, as well as the high end.  If we hit an out the park home run, then we should reap more of the benefit while providing a great return the investor.  Protect the investor on the downside and reap more on the upside.  This is the reason for a waterfall.

Ponzi Scheme is a pretty dirty word to those of us providing an honest service to those that want to be passive investors.  This term in no way reflects the fact that we raise enough funds to keep the business running, and build it up so that those same investors can reap a great return.  You may want to look closer at your definition.

@Robert Shaw stated that you should read the PPM.  If you are not happy with the structure you don't invest.  If you are the sponsor, create your own structure that will be fair and of interest to investors.  Disclose disclose disclose.

David Thompson · Answer

Ironically I posted a blog in BP last Friday that have some common aspects around vetting a sponsor and discusses common fee structures.  I'm on syndication teams but deal mostly with the investor base in explaining the payout and fee structures.  I generally don't get much push back mostly just having to explain the industry standards, rationale.  Couple comments:

1) The preferred return clearly favors the investor.  Up to 8% on distributions, cash out refi's or sales, 100% go to the investor.  Nothing guaranteed but clearly is the next best thing.  Additionally, if for some reason we only hit 7% in one year, then the following year the preferred hurdle is now 9%, so there is a catch up provision again favoring the investor.

2) There are many "club" deals where the sponsor is limited based on club rules to 20% split fees. They do keep things simple but I've had more than a few sponsors ready to jump ship and ask me what its like to be independent as they do all this work and feel that they should be rewarded more for doing so.  Unless you have been a sponsor, IMO, if they are getting you those returns, treating you right, be grateful and enjoy it.  Often times the more experienced and better performing syndicators will leave these clubs because they can make more money.  As an investor, I really would not care as long as they are meeting or exceeding my return expectations.

3) Waterfalls - they should be structured for outsized returns.  They are also progressive, so you may see 70/30 split up to say 13% IRR.  After 13% o 18% 65/35.  Beyond 20% it may to to 60/40, etc. Agree it does complicate the explanation and understanding but like a hedge fund, its giving the GP more incentive to hit it out of the park but by doing so, all investors win.

4) Your money blueprint - the psychology of wealth.

I re-read a great book last week by T Harv Eker called the Millionaire Mind and highly recommend it.  I think most folks deep down resent others making money.  What you resent will not benefit you, it actually harms you.  There is a deep internal messed up blueprint in our society about people making money.  It is passed down to us from family, friend, media, movies, etc.  Think "scrooge".  You will not have what you criticize.  I would say 95% of the folks I've met in my life with a lot of money earned it and are very nice, generous folks.  They got wealthy because of the great number of people they helped along the way.  The more you help the more you should get.  That's the universal law of wealth.  Yes, you should understand how fees and structures work but if your mentality is these sponsors are greedy then I highly recommend you read Harv's book and re-examine what you think. It will dramatically change your life IMO if you act on what he talks about.

Bryan Hancock · Answer

You should NEVER use the words:

-Guaranteed

-Promised

Or anything like them when you're talking about investments.  Never!

Preferred returns are paid with preference before the sponsor is paid IF (and only if) there is sufficient cash to do so.

Many sponsors use a "make up return" where they get a match on preferred returns.  This keeps the deal in balance and generally is fair IMO.  You may consider doing that if you're worried about the pref and want to get paid the next squirt of capital after you hit your pref.

Joel Owens · Answer

I think it depends on what you are doing with  a syndication.

There are people out there syndicating for paltry returns to the sponsor because they want to quit their job making 50,000 a year and replace it with syndicating etc.

Generally I find 3 types of syndications I see.

1. A property that is already stabilized where the sponsor is nothing more than almost a glorified property manager. With where we are in the market there is not much cap rate compression to be had on those types of properties for equity upside to the sponsor. 4 to 5 years ago at the bottom they might have picked up 200 to 300 basis points in compression selling today. Today if you buy stabilized at XX cap and improve 100 basis points in return over say 2 years after resale costs you do not have much upside as a sponsor. Accredited investors that care more about cash flow distribution upfront love these kinds of deals getting cash from day one. Now the sponsor can build in more fees as mentioned in various ways but yield to the sponsor is still small unless taking a very large fee upfront on the purchase.

2. Value add - Has some cash flow coming in already but needs to be stabilized for full cash flow potential. Accredited some like these for some cash flow some and some equity upside on the back end.

3. Development deals - This is what I focus on. Doing ground up retail development. There is a lot more work for a sponsor than the other 2 types. The investors that like these tend to not care as much about cash flow right away but taking equity upon resale in future years when the tax rates might be more advantageous to them to take income than today. Once the build out is done and the tenant takes CO the pref return starts.

On these development deals I have many other developer friends and they take 40 to 50% of upside all day long every day with a pref of 7 to 8% to investors. The developers tend to stay away from larger investment investors as sometimes they get too greedy on what they want.  I will take large investors but only if the equity to sponsor is right. The size of the development deal matters as well.

If for instance it is a 3 million dollar deal with 1 million of upside after resale cost then at 50% the sponsor gets only 500,000.

If it's say a value add property and not development where the property is 50 million at 50% occupancy and then worth 80 million after stabilized then at say 28 million profit after expenses at 30% to sponsor is 8,400,000. Even though percentage is less the deal is larger. So there are many variables to each project and deal.

The syndicator has to find the right passive investors for their project where the sponsor and the investor both feel great about the deal.

I won't do ANY syndication at a low sponsor fee. I can just keep closing out commercial retail transactions where I am getting paid as the principal broker six figures commission per deal where my clients are buying existing buildings directly to own.

Again if a sponsor trying to quit the j-o-b is desperate to get their first small deal started they might take some really low sponsor fee.

Dahl Brandon · Answer

I was under the impression the Preferred rate doesn't mean guaranteed.  If it's a 10% preferred then the investor gets the first 10% if there is anything to distribute and split after that rate was achieved.  So if they only hit 9% for that period then theres no waterfall to the sponsor.

Abel Sng · Answer

@Marc C. I totally agree with you! However, it will all depend on the sophistication of the investor... We typically structure our deals with an 80/20 split and keep it simple. In my experience, if you can't clearly explain the proposition and returns in less than 5 minutes you've already lost the investor.

Bryan Hancock · Answer

Inadvertent ponzi schemes are more common with funds than they are with one-off syndications and they generally occur because the promoter fails to keep their books in order properly.  Setting limits on what can be raised in the fund and/or time until distributions can be made protects the investors from this happening.  The music will eventually stop if distributions have to be made.

The best protections for this is having a good accountant looking over the books.  Ask about this before you invest.  Measure twice, cut once.

Paul B. · Answer

I know of a sponsor here in Dallas who said he keeps it simple because many of his investors are not in real estate or finance (e.g. doctors) and he doesn't want to have to walk everyone through a complicated scenario. He follows the same structure: 20% of cash flow, and 20% of appreciation. An asset management fee of around 1.5% of revenue is also pretty common. It's the only payment that a sponsor is guaranteed to get, but it is often not significant compared to the other payouts, so his interests are still aligned with that of his investors.

Bruce Petersen · Answer

Preferred is generally not guaranteed.  The sponsor doesn't get any of their "cut" until you, the passive investor, get your 8% preferred return.

If there isn't sufficient cash flow to pay the 8% most deals are structured where that shortfall throughout the project is made up on a capital transaction (loan proceed or sale) first, then the sponsor will start to get their cut on that cap transaction.

Remember that in this scenario the sponsor doesn't get anything until the passive gets their 8%, if no 8% then no piece for the sponsor.

Every deal is different so you must read the docs and understand what you are investing in before giving your money.

Michael Le · Answer

@Marc C., I'm in 7 properties and 6 of them are set up exactly as you said. No waterfall or IRR hurdle structure. Just 80/20, 85/15, etc. Guess you just need to find different sponsors. lol

Syndicators: Why can't we make distribution calculations simpler?

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