Syndication Structures - Return of Capital

[Trey Wheeler]

Hi BP Community! My question relates to syndication structures with respect to how a sponsor categorizes cash distributions. 

If you have syndicated a MFH deal, have you chosen to categorize the cash distributions (whether a pref or straight-split) as a return-of-capital, or, as a return-on-investment?

As I understand it, paying distributions as ROI (not ROC) makes sense with a pref structure, however, from a sponsor's perspective in a straight-split, what is the benefit to a sponsor to pay distributions as ROI? It seems to me that paying distributions as ROC means there's less (or no) capital to return to investors at the time of sale. Thus, treating the distributions as ROC (not ROI) would undoubtedly provide a larger "pie" of net sales proceeds to then divide among investors and sponsors according to the PPM straight-split agreement, correct?

@Brian Burke provided excellent thoughts on ROC vs ROI in this forum post (https://www.biggerpockets.com/forums/432/topics/215958-what-are-typical-apartment-syndication-returns-for-an-investor). 

Thanks in advance! 

[Brian Burke]

You don't choose what to call distributions, instead, you can choose the ORDER of distributions.  For example, your operating agreement could say, "First, 100% to the investors until the investors have received an amount equal to their capital contributions.  Second, 100% to the investors until the investors have received an 8% return on their unreturned capital contributions.  Third, 70% to the investors and 30% to the Manager."

On the other hand, you could switch the order of the first two, where investors get paid a preferred return first and capital second.  Or you could separate return of capital to only happen on capital events (refinance or sale).  

If your waterfall is calculated on IRR split tiers instead of an annual return, the order is moot because "return of" and "return on" are treated the same, without any distinction, simply by definition.

If you look back at the total dollars distributed after the investment is all over, it really doesn't matter much whether return OF or return ON comes first--except that if return OF is first, preferred return is less because the balance on which the preferred return is calculated is reduced with every distribution.