Don't budge on return of capital

We recently discussed the three pillars of LP (Limited Partner) investing:

• Execution - track record and counterparty risk

• Read the article here.

• Alignment of Interests - coinvest, waterfall, and fees

• Read the article here, preferably before continuing.

• Property - valuation and business plan

• Coming soon!

Before moving on to Property, I wanted to touch on return of capital since it was a big topic in last week’s Alignment of Interests article (I recommend reading this before continuing, or at least read the “2) Waterfall” section)

First, some definitions in case you’re tuning in for the first time:

• General Partner - the person or fund making day to day decisions. They found the deal and are raising capital from you, the Limited Partner

• Limited Partner - typically silent investor contributing capital only

Why is return of capital important:

At the outset, a GP/LP relationship is one that is off-balance, since the LP typically contributes ~90%+ of necessary equity capital (and therefore has more to lose!)

To offset this, there are two main tools that are used to "realign" incentives at the outset:

• Coinvest & Preferred Returns - I discussed both of these extensively in last week’s post.

• Return of capital - LPs get their capital back before GP is taking their profit share

Return of capital isn’t talked about enough, in my opinion, and is often overlooked by LPs or even their attorneys.

I believe this is true because return of capital matters less during good times .. and we’ve had a nice run up over the last decade. The returns were so good that the return of capital clause barely moved the needle.

During bad times, however, return of capital is extremely important and as an LP protecting your downside is paramount - especially in an investment that has fairly limited upside like real estate (2x isn’t unlimited, so you have to limit the probability of capital loss). I will write about this specific topic more in the future.

For now, back to return of capital.

At this point, I have seen numerous cases where the GP is making substantial amounts of money while the LP hasn't been paid back (i.e. still has capital at risk). There are certainly circumstances where this is acceptable, but in the vast majority of cases this isn't market (to put it lightly).

Let’s run through an example so that we can all understand why this is such an important topic.

Let's say an LP funds the entirety of a $10mm transaction (no debt, no coinvest, no fees for the sake of simplicity) and agrees to a 70/30 split with no return of capital.

If the building was sold for $10mm (ignoring GP disposition fee and transactional expenses) the day after their purchase, the LP would lose 30% of their investment, since the waterfall would simply be that 70% of the proceeds go to the LP … and in this case, they would get 70% of their $10mm and record a $3mm loss. Ouch!

I like to call this legalized robbery, but I’ve seen it occur in documents even though I would call this a very extreme case.

There are "side" cases here, and as an LP you need to look out for them, vigilantly.

For example, you’ll notice that above there was no preferred return (“pref”). In our example, that wouldn’t have mattered since the pref only accrued for one day before the sale.

Having the pref clock “tick” for a full year would have accrued a 7% (assuming this was the agreed upon number) return to the LP before the 70/30 split. Assuming the deal accrued a 7% return for a year and sold a year later for the same $10mm, you’d first send $700k to LPs, and then distribute the remaining $9.3mm using the 70/30 split. This means that total return to LPs would be the pref ($700k) plus the return of capital ($9.3mm * 70% = $6.51mm), or a grand total of $7.21mm. **Notice that this is better than the original $7mm payout above, but there’s still a $2.79mm loss out of the $10mm invested! **So, the pref alone won’t save you.

Another unique return of capital nuance that you might run into is profit sharing on cash flow, as opposed to capital events (refinances and sale) - this is a complicated topic, but generally speaking if a GP is taking solid management fees and is incentivized by their promote, there’s rarely a reason to share in profits. This is certainly true before your capital is returned…

In summary, whenever you’re looking at waterfalls on a deal, be sure to understand the downside. If you don’t pay attention, you might end up in a scenario where you’re not just paying the GP a disposition fee on a losing investment (this payment is senior to - i.e. it comes before - your distribution), but you might even be giving them a percentage of the proceeds while you, LP, recognize a loss on your investment!

Don’t budge on return of capital!

Next, we’ll move to the last of the three pillars - Property.

Whenever you’re ready, I could help you in 3 ways:

• Limited Partners:

• Future positions - you’re considering investing and need an independent opinion

• Existing positions - there’s a lack of communication, you’re concerned about fraud, or perhaps you got a capital call request and not sure how to proceed

• LP Course - if you’re interested in reviewing investment memos to get practice vetting deals, you can reach out by replying to this email. I am finishing a cohort next week and have a few more spots available for the next one.

• General Partners:

• Deck review - I’ll look over your marketing materials from the perspective of an LP and provide feedback to streamline and professionalize your process

• Investment review - I’ll provide independent feedback on an opportunity you’re pursuing

• **General Consulting **- modeling, strategic advisory, underwriting training, and much more.

If you’d like to chat, you can click here to set up an initial consultation.