Syndication Sponsor Shenanigans

[Andrew Sol]

My Dad is currently invested in a few syndicated multifamily deals, and one of them is stabilized and ready to market. 

Instead of selling it, the sponsor has decided to "recapitalize the property with new equity and debt amount".  Basically, he's doing a cash-out refi, distributing the proceeds, and plans to "exit" the investors from the deal (calling it a recapitalization). The Operating Agreement is silent on this process and says nothing about exiting upon refinancing, only upon dissolution of the fund after the assets are liquidated.

The sponsor is keeping the remaining 20% equity (after the refi) for himself. The annualized COC return on the deal is over 20%, so no complaints there. But if it were a sale, or true recapitalization, the investment proceeds would double that.

Does the sponsor have any justification or precedent in doing this, if it's not described in the OA?  He believes he does, but gives no details.  He's asked for a signed “assignment of membership interest” form, before distributing the proceeds from the refi.  Most of the investors, I believe, are Mom and Pop types, and don't know any better than to give back their interest.

I don't want to burn bridges with the sponsor, but I'm not willing to give up the significant $ that the OA entitles me to.  Any helpful thoughts or insights?  Is it time to contact an attorney? 

[Brian Burke]

@Andrew Sol you need to carefully review the operating agreement, and if this provision obviously stands out to you in the agreement, yes, they can do it.

If it doesn't stand out to you, you should have an attorney review the operating agreement.  Sometimes these types of things can be written in a way where it is confusing so just because you don't see it doesn't mean it isn't masked in there in some way.

A sponsor can only unilaterally exit the investors if the operating agreement allows for it.  If it isn't in there, they can still do it, but only with the approval of the investors.  And I can think of very little reason why the investors would, or should, approve of such a move.

Now it is perfectly acceptable for a sponsor to take out cash from a refinance and distribute that surplus cash to the investors as a return of capital.  But after such return of capital, whether a partial return or a complete return, the investor should remain in the deal with the same ownership percentage.  Their preferred return would stop accruing (because preferred return is typically calculated on unreturned capital) but the waterfall rules on distributions would be otherwise unaffected.

There is another scenario where a sponsor might want to exit the investors by returning their capital plus profits.  This is a very difficult maneuver to execute because there are so many conflicts of interest.  But it can be done.  If I were a sponsor attempting such a move I would want to have at least one appraisal, perhaps two, and calculate the investor's economics under a conventional sale and try to duplicate those results as closely as possible. And then execute the move only with the approval of the investors after carefully outlining how we got to the numbers.  It's not something I've ever done, typically when it is time to sell, we sell. 

So my advice is to be sure you understand exactly what the sponsor is trying to do, and review the OA carefully and with the assistance of counsel if necessary.