Who benefits from a Preferred Return based on Unreturned Capital?

[Kurt Granroth]

Most private placement deals I see have a LP/Sponsor waterfall that incorporates a Preferred Return, whereby the LP gets a stated rate of return before the Sponsor gets any money.

The Preferred Return can be based either on the Initial Capital Contribution or it can be based on the Unreturned / Unrecovered Capital. In the former case, the per annum distributions paid out is the same if there is a refinance or other Return of Capital event prior to sale. In the latter case, the per annum distributions will be reduced if there is any Return of Capital event.

Let's look at some numbers to explore this difference.

Say I invest $100,000 in a deal with a 7% Preferred Return after which there is a 70/30 split between LPs and Sponsors. In this case, the deal lasts for five years; a refinance at the beginning of Year 3 returns all capital to LPs; and it sells for 50% profit at the end of Year 5. It also doesn't generate Distributable Cash until Year 3 and does so at 9% for the next three years. By having the refinance/Return of Capital event in the same year as the first Distributable Cash, it should make no difference if this is European or American style waterfall.

Let's look at this from two perspectives. In the first, the Preferred Return is based on Initial Capital Contribution. In the second, the Preferred Return is based on the Unreturned Capital Contribution.

7% x Initial Capital
LP
Year 1: $7,000 (7% Preferred Rate)
Year 2: $7,000 (7% Preferred Rate)
Year 3: $108,400 (Initial Capital + 7% Preferred Rate + 70% Share of 2%)
Year 4: $8,400 (7% Preferred Rate + 70% Share of 2%)
Year 5: $43,400 (70% Share of Sale + 7% Preferred Rate + 70% Share of 2%)
Total: $174,200 (1.74x, 14.8% CoC)

Sponsor
Year 1: $0
Year 2: $0
Year 3: $600 (30% Share of 2%)
Year 4: $600 (30% Share of 2%)
Year 5: $15,600 (30% Share of Sale + 30% Share of 2%)
Total: $16,800

7% x Unreturned Capital
LP
Year 1: $7,000 (7% Preferred Rate)
Year 2: $7,000 (7% Preferred Rate)
Year 3: $106,300 (Initial Capital + 70% Share of 9%)
Year 4: $6,300 (70% Share of 9%)
Year 5: $41,300 (70% Share of Sale + 70% Share of 9%)
Total: $167,900 (1.68x, 13.6% CoC)

Sponsor
Year 1: $0
Year 2: $0
Year 3: $2,700 (30% Share of 9%)
Year 4: $2,700 (30% Share of 9%)
Year 5: $17,700 (30% Share of Sale + 30% Share of 9%)
Total: $23,100

If these calculations are all roughly accurate, then basing the Preferred Return on Unreturned Capital has a clear upside for the Sponsor at the tune of 38% more cash over the five years. All that cash comes from the LP, who makes $6,300 less.

It certainly seems like this is 100% skewed in favor of the Sponsor at the expense of the LP, based on my understanding. Am I missing something, though? Why shouldn't I, as an LP, treat Unreturned Capital Preferred Returns as a notable red mark against the deal?

[Brian Burke]

Great analysis, @Kurt Granroth, however you are in fact missing a few nuances--but those details make quite a bit of difference.

1. It's highly unlikely that any year 2 refinance would yield a 100% return of capital so this scenario is a highly unlikely one, however using it for the purpose of discussion does make it simpler.  I point this out only so that LP's don't think that this would be a normal example.

2. If a refinance were to occur that returned a significant portion of equity, the additional interest expense would be a drag on the cash flow, so in all likelihood the distributable cash would be significantly less than in your example post-refi.

Bearing in mind points 1 and 2, in a real-world example the additional promote cash to the sponsor would be a significantly smaller delta than your math here suggests.  But yes, there would still be a higher promote to the sponsor so your point is still a valid one.  Which leads me to point 3.

3.  Using the "initial capital" approach creates an unintended consequence.

The idea of a preferred return is to add to the alignment of interest matrix.  Giving investors priority over distributions motivates the sponsor to perform.  However, no matter what anyone says it is impossible to align the interests of the sponsor and the investor.  There will always be factors that influence the sponsors decisions that do not align with the investor's concerns.  Ultimately sponsors will do what benefits investors, but what benefits THEM will naturally influence their decisions, regardless of them telling you it won't.

So the unintended consequence--under the "initial capital" approach, there is no motivation for the sponsor to do the refinance at all.  They would receive no additional promote, and they take on additional risk by way of a larger loan to which they are on the hook for carve-out guarantees, and they have to keep a larger cash reserve themselves to satisfy the lender's covenants of the larger loan.  So what you are asking them to do is perform a service and tie up their own resources for no compensation, however small that compensation might be.

The investor suffers the consequences, too.  There are three reasons why you as an LP want the sponsor to do the refinance and return some cash.  1. To juice your return.  2.  To lower your risk (you can only lose what you have in the deal, and after a refi, you have less in the deal to lose).  3.  To give you cash back to re-invest in something else and earn a second return while the deal is still at work producing the first return.

If the sponsor doesn't refinance, because there's nothing in it for them, you don't get as high of a return (IRR and CoC--indeed your multiple is less but you can make that up on the investment where that returned cash is placed). You don't reduce your risk. And, you can't take the funds and invest it in the sponsor's next deal and earn your pref on it there.

Bottom line:  The pref is intended to align the sponsor's interest with yours.  Calculating that pref on "unreturned capital" is intended to align your interest with the sponsor's.