Why invest in a deal with a tiered Class A / Class B split?

[Kurt Granroth]

Class A / Class B

The practice of splitting the LP investor equity group into Class A and Class B (sometimes: "Series A" and "Series B") tranches is already extremely common and seems to becoming almost ubiquitous. Institutional funds have used levels such as Series I and Series D and the like for years, but this particular structure was -- I believe -- introduced by Ashcroft just a few years ago. It has certainly caught on, at least in the BP and adjacent crowd.

This is the concept, for the uninitiated. The LP group is split into a conceptual "income" group and a "growth" group. The Class A "income" group is offered a 10% Preferred Return but in exchange, doesn't participate in the "upside" (meaning a portion of the eventual sale of the property). The return is also typical based off of initial capital rather than unreturned capital, plus extra effort is often given to ensuring that the 10% goal is met, even in year 1. Finally, Class A returns are superior to Class B returns and are typically second only to the debt itself.

Class B "growth" shares are more like a traditional (pre-2018/2019) LP group. The Preferred Rate is going to be 7% or 8% and there is not as much effort to hit those targets in the first years. Class B also doesn't start making any money until Class A's return is met. In exchange, Class B does participate in the upside including a promote waterfall even before a sale when income exceeds the preferred rates, plus a split of the sale proceeds. The idea is that a Class B investor might not make as reliable a yearly income as Class B, but the total returns (and, thus, annualized returns) can be notably higher.

The Problem: High Level

Given all that, I find myself wondering: as a Class B investor, why would I ever want to invest in such a deal knowing that my return is potentially compromised compared to a deal that did not have such a split? My risk hasn't changed at all but my reward may be mathematically notably more likely to be less.

The key to all this is that since Class A is higher in the return stack than Class B, in general that means that the total pool of available proceeds to be distributed is already depleted by a potentially significant amount before Class B even starts to get their cut. A class-less LP group would just take $X profit divided by Y investors. A class-based LP split has ($X profit minus A profit) divided by B investors.

Not Always Bad?

There is a twist to this, though. Since Class A is artificially limited to "only" 10%, a very well performing deal could result in a boosted return for Class B, rather than a weaker return. An example: say there are 100 LP investors all with $100k initial capital splitting $1.5M proceeds, simply. That's a $15k return or 15%. But now let's say that half of the LP investors are Class A and half are Class B. The 50 Class A investors extract their $10k each (10%) for $500k total, first. The remaining 50 Class B investors split the remaining pool of $1M into $20k each, or a 20% return! Same overall proceeds to distribute, but Class B actually had a boosted return in the tiered case. Nice!

But one more example. Say the profit to split in the above scenario is $750k. In a simple case, the LPs each get $7.5k or a 7.5% return -- just above a typical preferred return. In the half/half Class A and Class B split, the Class A investors extract out their $500k (still 10%) leaving only $250k for Class B. When that is distributed, each of the 50 Class B investors is looking at $5k or only 5% -- appreciably less than they would have otherwise earned.

The Tipping Point

What's going on here is that there is a tipping point of proceeds to be distributed where each increasing number of Class A investors acts as an accelerate to Class B returns. It's conceptually similar to how investing on margin will accelerate both earnings and losses, with stock investing. Earnings below the tipping point means that every additional Class A investor accelerates the reduction of Class B proceeds and earnings above the tipping point means that every additional Class A investor will actually accelerate the Class B profit boost.

What is this tipping point? In general, it is:

That is, if the average/mean investment of all Class A investors is $125k and there are 100 total investors split between Class A and Class B, then the tipping point is $1.25M. Knowing that, I could look at the financial projections and if they are reasonable and I see that the projected pool is going to be typically less than that, then I better pass, in favor of a near-guaranteed better deal. If the expectation is above $1.25M, though... well, take my money and sign up as many Class A investors as you possibly can, since each one of them is goosing my return that much more!

Due Diligence?

Hidden above lies the problem -- I need to know all three variables in order to determine if a deal is right for me, and I'm finding it nigh impossible to get those numbers. I want to do my due diligence but without all the necessary data, I need to go in blind.

And so, without the necessary data, I need to make assumptions. My assumptions are that for most deals, the typical proceeds-to-split is going to be less than the tipping point, most of the time, and so I should expect that for any deal with a Class A / Class B split, that I would earn less on that deal than a comparable deal without that split.

Therefore... why, as a Class B style investor, should I ever go with a deal with said split?

What am I missing?