Return of capital strikes again

Happy Sunday!

Don't budge on return of capital was one of the first articles I wrote on this newsletter - September 2023, back when the subscriber count was far less than 10,000! Thank you for being a part of my journey.

After nearly 2 years of advising LPs full time since then, I felt the need to revisit the topic for a few reasons. It’s a good idea to read the last article before you continue, particularly if you’re new to the topic, its terms, or importance.

Today we’ll cover:

• updated list of articles related to this very important principle

• how my views on the importance of return of capital has changed in 2 years

• cash flow vs capital event splits and implications to return of capital

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• Latest **article: Why multiple IRR hurdles is an overkill - **why simple alignment beats fancy structures

1) Updated list of articles related to this very important principle:

• Return of capital is a legal clause that forces the first “profit” dollars to be sent to the LP rather than being split between the GP and LP. A typical waterfall upon a sale of a property looks like this:

• first 8% preferred return (typically accrued as opposed to cash) to LP

• then full return of capital to LP (i.e. if you invested $100,000 you have to get it back prior to hitting the next step of the waterfall)

• lastly, a split between the GP (typically ~20%) and LP (~80%)

• note that some waterfalls have multiple hurdles, which I actually wrote about last week

• Return of capital is part of a waterfall, which I consider to be a single variable (of 3) within the Alignment of Interests pillar of LP investments. Here are the 3 Pillars of LP investments:

• Execution - track record and counterparty risk

• Alignment of Interests - coinvest, waterfall, and fees

• Property - valuation and business plan

• The reason why return of capital is important is that nobody should be investing in real estate deals for vc-like returns, and therefore downside protection is really important

• More on why I like to think of real estate returns as being capped in probability, thereby making real estate investment diligence particularly important to limit downside

• More on the long term impact of losing capital here (hint: it takes way longer than you think to recoup losses)

• More on the easiest ways to lose money in real estate

With that out of the way, let’s get into so updated thoughts:

2) How my views on the importance of return of capital has changed in 2 years

As much as I’d like to say that I’ve found many cases of “circumstances where this is acceptable” from my article below, I think the opposite is actually true.

I’ve seen a large number of cases where return of capital wasn’t part of the legal documents, to the point where I included this as part of the 6 reasons to put down a deck article. To be candid, I’m not sure how many of these are actually intentional - sometimes documents are being drafted by attorneys who don’t know any better and other times the GP is guiding the attorney based on another non-market structure they found elsewhere.

Regardless, the simple question an LP is asking when requesting this to be a part of the documentation (to be clear - I think the LP shouldn’t even need to ask for it and it should already be there) is “since I’m the majority of the capital today do you agree that I should be made whole before you start making profit?” This seems like a reasonable thing to ask.

A lack of a return of capital clause should be a non-starter for an LP. The cases where this gets more complicated, perhaps, are where the GP isn’t collecting any fees during the entire deal (and therefore needs to profit earlier somehow to fund operations) or has an extremely large coinvest (in which case the LP wasn’t the majority of the cash in the beginning).

To summarize: it’s really easy to focus on the upside (as you should by the way), but ensure you understand what’s happening if things don’t go according to plan. Fundamentally, an LP:GP relationship is one of Capital:Work - and if that’s the case, how can the GP make an argument that in case of downside (i.e. the “work” part of the partnership didn’t work out as planned) the capital doesn’t deserve to be paid prior to the GP making profits?

3) Cash flow vs capital event splits and implications to return of capital

This is another nuance I’d like to touch on.

Many deals will have two waterfalls - one during the life of the investment (i.e. what to do remaining cash at the end of the month/quarter) and another upon a capital event (what to do with profits at the time of a refinance or a sale).

Many GPs will make the argument that if the cash flow is coming, they should receive a part of it too … and some will not make this cash flow split subject to meeting preferred return metrics.

To shorten the conclusion on my opinion, I’ll just say that if the cash flow split is (a) reasonable (I’d guide to 80/20 there) and (b) BEYOND the preferred return (typically 7-8% nowadays) then I think such a structure is fine. If the deal is performing at that level, you likely don’t mind sharing some of the upside - but you still need to be cognizant of the fact that you’re sharing in profits prior to you getting your return of capital back and weigh that accordingly.

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