I've never come across this (all exits I've seen have effectively transferred the asset to a new owner entirely) but have heard of it happening; has anyone been involved in a transaction like this where the LP wanted out/Sponsor stayed with the deal or vice-versa? Or better yet, where the ownership structure involves multiple parties and partial interests are sold at various intervals? Would love to better understand the finance behind how an analyst/associate would run the valuation on something complex like this.
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Yes working on something like that now, what do you need to know
What does the process entail from an underwriting perspective? Does the initial waterfall split even come into play or does the partner auction off it's interest at a predefined premium to their initial equal contribution (and an HFF or Eastdil brokers the partial interest)? I would assume if the deal is one of the LP's fund investments, they have a predefined multiple or leveraged IRR they have to hit. How do you value the LP's interest if you are mid-deal and haven't fully executed the strategy?
We just finished looking at a scenario just like this where we had a build-to-core multifamily asset that was owned in one of our value-add funds. We were the LP and provided operational oversight, property management, and the lion's share of the equity. The developer of the asset triggered a buy-sell via the JV agreement, andwe still wanted to own the asset. The issue we kept running into was how do we recap this asset without triggering a major conflict of interest, maxing out pricing and returns for our fund investors vs. making the recap scenario make sense for the new equity. At the end of the day, we decided to skip the recap and will be widely marketing the deal in January. That being said, if pricing does not come back at the levels that our broker BOVs indicated, then we will explore the recap again as one of our core vehicles could price the asset with its capital, also helps to avoid triggering a tax reassessment.
Know that doesn't really answer your question, but I thought it might be worth sharing.
I've worked on a deal where we replaced the LP investor while the GP/Sponsor stayed in the deal. We treated it as a redemption and removed the LP's at a premium to their original contribution. The original documents were only slightly modified. We knew/trusted both groups so we didn't feel the need to re-document the deal from scratch.
Sure, been involved in a range of situations like this. Can you give a few details? Will walk you through the finance.
We have a premature promote buyout where we cash out the developer 18 months after stabilization, as opposed to asset sale, since we plan on holding the assets for the long term. Of course, holding the assets for ten years markedly reduces the deal IRR and thus the developer's promote, not to mention the developer wouldn't want to wait that long to be compensated.
We treat the process similar to a refinancing, where we project the hypothetical sale value by capping the F12 NOI at that point in time and paying off the debt. Alternatively, we could seek an appraisal and then net out the debt. Given that value, we run it through the promote waterfall and see where they stand. At that point we cash out their promote but they still hang around and collect their pro rata distributions afterwards. Said differently, they don't completely exit; they get their promote cashed out (i.e. the amount of proceeds that the waterfall indicates that is above their hurdle, but they aren't cashed out of their 1% stake). By only cashing out the promote they are still economically incentivized to best manage the project.
All that being said, they are a minority owner and so even if we bought them out completely it wouldn't draw into question any issues of asset valuation from a tax perspective, which is what I would be most interest in learning more about. I would imagine that is where these sorts scenarios become much more difficult -- not from a modeling standpoint but rather from a negotiations stand point.
For example, if you owned an industrial platform and capitalized it with a sovereign wealth fund taking 49% and your fund taking 51%. SWFs are focused on cash on cash returns and holding assets for the long term; so if you wanted to sell your majority ownership five years into the deal and the economy had rallied during that period so you were looking at trading out of the asset at a significantly higher valuation than what you acquired it for, that SWF would get its go-forward CoC returns significantly impacted by the step up in tax basis. At least I would imagine this is the way this type of scenario would play out.
"By only cashing out the promote they are still economically incentivized to best manage the project."
Disagree with this. Once the developer cashes out their promote (assuming they contributed 5-10% of the equity, had a healthy promote structure, and performed on-par), chances are they have no capital in the deal (only rolled over profit), causing misalignment of interests. Do they still have cash to lose in the deal? Sure. Will they be as incentivized to perform? Nope. Have seen this many times over.
Hmm... I suppose my rebuttal to this would be (a) I would imagine for most any local or regional developer that several million dollars is a significant amount of money (assuming they capitalize 1-10% of the equity on a $50M+ development), so to this end I would argue that even if they get cashed out several million dollars in the form of the promote they're going to want to manage the process well to get back their investment but also realize the strong cash on cash returns that will be coming their way if they simply play nice and manage most of the boots-on-the-ground matters; (b) we don't pay acquisition fees for this exact reason (don't want someone capitalizing a large portion of their GP equity with "free money") and the development management fees aren't anything too egregious where the developer is hopefully truly barely covering their own costs plus some; (c) this promote cash out would be 18-24 months post stabilization so we would consider this past the point where C/O has been obtained and the buildings has 90-95% of its space leased and generating revenue (free rent has burned off) -- in this scenario if someone wanted to piss away their equity and future remaining upside then by all means we wouldn't be in too much of a bind to have another group come in an assume daily management of operations like a Greystar or other large real estate company that has a large real estate operations subdivision.
Also, within the particular context of our large mixed use development, one of the reasons we would allow the developer to initiate an early promote buyout would be to fund the required GP equity on the next building development (imagine a $1.0-$1.5bn development with 10+ buildings comprised of resi and office with only 2-4 buildings under development at a time). Now at this point, you're right that there would be some element from their perspective of "rolled over proceeds" but at the same time those proceeds would continue to be tied up and their management incentives only further ingrained/perpetuated.
Sorry to hear you guys have been hosed in this regard before though. To learn from your experience, though, I'd love to know if you see some gaping holes in my methodology.
We are working on a mixed use multifamily over retail development here in LA (ground up construction). Our business plan is to go condo over retail, however, there is a tract map on the site. So, upon construction completion, if the market tanks and there is no condo market, then we have flexibility to "ride out the storm" and hold for a while.
As mentioned before, time kills IRR, which kills developer promote. So given this, I underwrote the deal that once we hit stabilization on the rental, we would value the building by taking a forward 12 month NOI divided by the exit cap to impute value (as mentioned above). From this you can calculate the "implied promote" in the deal. If the GP wanted to stay in, what we would do is convert the promote into equity stake, and then take the whole promote out of the equation and now the GP is a true equity member in the deal going forward, and everyone gets cash flow pro rata based on this new equity stake.
I think in practice, depending on how "nice" all partners play, I think it would probably come down to an appraisal, or each partner get an appraisal and some sort of "baseball" approach, and you meet in the middle on value. From there, members decide if they are in or if they are out, and the ones that are going to stay in must be willing to buy out the other partners at said price.
EDIT. Realized my scenario is really similar to one already mentioned. Only difference is in my scenario, the GP doesn't cash out their promote, they convert it into equity and then just stay in the deal with their new equity % based on the promote they would have gotten relative to what all other members would have gotten on the sale. Ig. if the sale yielded $2m promote, $8m LP investors, promote would now have 20% ownership going forward, LPs would have 80%.
Not sure if you guys use the same terminology but we call this crystallizing the promote in a deal.
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