What happens to my LP ownership interest in the case of a refinance? It is a question I get asked a lot, so let's get some answers. There is some trepidation or skepticism amongst LPs (limited partners). They fear getting paid back means getting bought out, thereby diluting their shares. Getting bought out equates to a very high-risk loan without any reward for the limited partner and a short-lived career by the syndicator(I would think). My question is: Does this happen?
A Syndicator Needs to Create a Win-Win Situation
A syndicator needs to perform well for the investor, to maintain a long, fruitful relationship for both. One deal (or even five) does not make a syndicator. It boils down to "What have you done for me lately?" If an investor is getting a return OF his capital and not a return ON his capital, then that relationship won't last.
To survive, syndicators need to earn a profit and create a win-win scenario for both the GPs and LPs. A refinance is something that an LP should look forward to and not fear, so let's clear up the confusion by showing an example.
Refinance Scenario:
When a refinance occurs, speaking for our company, the limited partners stay invested in the deal. The total amount they receive from the preferred return distributions does drop because they are now earning their preferred return on the less principal they have in the deal. Their equity split – let's assume a 70/30 split – remains; thus, they still receive 70% of the profits.
Example:
If you invested $100,000 with an 8% preferred return, you'd expect to receive $8000 annually. After a refinance- let's propose a 30% return of capital - you are returned $30,000, so you have $70,000 of your original principal invested in the deal. The preferred return is 8% on the remaining $70,000, or $5,600. You can still earn above the 8% preferred, but whatever remains is split 70/30 with a General Partners.
If you earned $7000 in a year, the first $5600 would be your 8% pref ($5600 ÷ $70,000 = 8%). The remaining $1400 would be your 70% cut/split of the remaining cash flow.
The COC percentage increases since you have less money in the deal:
$7000 ÷ $100,000 (original investment) = 7% COC
$7000 ÷ $70,000 (after 30% return of capital) = 10% COC
Note: This is the same reason COC% "gets juiced" by including a refinance into underwriting. Be cautious of any deal that provides for a refinance into the underwriting, as they are hard to predict (what will the interest rate be at the time of the refinance, and how much capital will be returned?). There are too many unknowns.
Limited Partners Stay in the Deal
Since the refinance doesn't affect the profit splits, you'll still get your 70% split of the profits after a sale. So if there were $10M profit after a sale, $7M would go to the LPs. It is important to remember that you can redeploy the returned $30,000, increasing your velocity of money. Not only are you still in the original deal, but now capital has been freed up to invest in more opportunities.
If your shares are being diluted by getting paid back, it is time to find another deal. I advise asking the sponsor of any syndication how they handle a refinance before you commit to the agreement. Have them explain it in writing if not described in the operating agreement.
Again, it is problematic that people can get away with that, but the stories may be true. The good news is that most operators handle refinancing, as I described in my example. Like with any investment opportunity, some due diligence on your part will yield the truth. Don't fear the refinance; embrace it.
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