What is the state of syndications today? How can you structure a syndication for protection purposes? What are the major differences between funds versus syndications, and why are funds popular today? Jonathan Tavares, a managing partner at Premier Law Group, shares his insights.
Tell us a little bit about yourself.
We focus on helping our clients raise capital to form syndications and funds, primarily in real estate. I have been with Premier for the last four years. I’ve been involved in the real estate industry for 15 years, so that’s the perspective that I take when talking to clients about setting up their syndications or funds, debt funds, private equity funds, and other arrangements in the real estate space.
What is the state of the market today? What are the IRRs looking like? Are you seeing more or fewer deals come across your desk?
Generally, what we’ve been seeing in the last six to eight months is more of a shift to funds. Traditionally, especially during COVID, many clients were doing a lot of multifamily syndication. That’s been a piece that we focused on for a long time. A lot of our clients are heavily involved in the multifamily space. But with increasing interest rates over 22 and various other factors, property taxes throughout many counties and throughout the country are going up very quickly, as well as insurance and specific markets. We have a lot of clients in various markets in Texas that have just gone crazy, places like Houston or Florida, where insurance rates have skyrocketed. It’s presented some challenges for some of our clients, so we’ve seen a lot more creativity in terms of the types of deals our clients have been putting together. Instead of seeing just a straight deal with a certain percentage of debt somewhere around 70% to 80%, often, there’s a lot of creative financing going on to make up for that debt piece that may not be there or where those percentages of debt to purchase price may be a little bit lower than what a lot of clients were used to before.
You see a lot of preferred equity. We’ve seen clients building out structures where, in essence, they’re providing almost a debt structure to their investors, too, to create a sort of debt piece as well as an equity piece in their raises. We’ve seen a lot of clients create funds and use their funds to come in for part of the debt piece for specific projects as well.
You also asked about preferred returns. For most deals, depending on the asset type, and I’ll specifically exclude development projects, we’re seeing a lot of target IRRs between 15% and 20% in the market.
Let’s review the structure of a deal from syndication’s perspective. Where do all the LLCs go so that everyone is protected as much as they can be?
There are all sorts of different structures that you might use to set up a syndication or a fund. For different reasons, for tax reasons, for asset protection reasons, and generally speaking, when we approach the conversation with clients, there’s a general structure that we’ll start from and make tweaks from there. But a typical syndication structure is going to include a syndication entity, or an investment vehicle, where all the investors pool their capital. That’s typically known as the issuer entity; that’s the entity that’s selling securities. And I probably should back up a little bit and talk about what a security is, because a lot of our clients are raising capital to buy real estate, but sometimes they’re not quite sure how the securities piece fits in.
Why does the SEC care about what I’m doing if I’m raising capital to buy real estate? There is a landmark decision that was decided by the Supreme Court many decades ago, and out of it came this test that’s called the Howie test. Out of that, the SEC analyzes to determine if you were selling securities or not, and essentially boils down to the four main tenets of the Howie test to determine whether something is a security or not:
1) Is an investor investing money? Typically, the answer is yes.
2) Are they expecting a return on profits? And usually the answer is yes.
The next two elements of the test are usually the ones that are analyzed a little bit more closely and determine whether the client is selling securities or not.
3) Whether the efforts are generated by someone other than the person who’s investing, like a promoter, or, in this space, what we call a sponsor. In these deals, a sponsor is a GP raising the capital from investors. The investors are passive in the deal. They’re not doing anything actively towards managing the investment, and in fact, it’s sold to them as a passive investment. And that’s what’s considered the efforts of a third party, the promoter.
4) A common enterprise is if the investors are pooling together capital through the efforts of the GP to buy underlying investments. And at the end of the day, that’s typically going to be real estate for most of our clients.
Those are the two main things that are going to move it over from something active, where you may have a joint venture or other arrangement between partners, to a passive investment for investors. The SEC is going to look at that as securities, so you have a couple of options. Our founder always likes to say that you have three options:
1) You can register your offering. Think of an IPO that’s going to cost seven figures. That’s going to take multiple years, and that’s a huge process for companies that are going public. Most of our clients do not play in that space.
2) Find an exemption.
3) It’s an illegal securities offering.
As you might imagine, most of our clients fit into that second category. We play in the exemption world. The SEC offers exemptions to sponsors who are raising capital that allow them to do so without having to register their securities offering. But they have very strict rules that they have to follow.
Let’s go back to the question about a typical entity structure. The issuer of the securities is the entity that’s selling the securities to the investors, which might be an LLC, a limited partnership, or sometimes another investment vehicle. Typically, we will have the client form a fund manager or a syndication manager that’s a legal entity. So that may be another LLC, limited partnership corporation, or other entity to manage that syndication, and that’s usually for liability protection. That entity is calling all the shots, managing the syndication, and deciding what assets the syndication will purchase. It’s going to make decisions about how to operate those things and when to dispose of them. All of those decisions are made by the syndication manager and then, typically, another entity for the sponsors, where they’re going to collect their carried interest or promotion or sweat equity. The investors will invest together in a passive class of membership that will entitle them to a certain percentage of ownership of the company or preferred return, depending on the structure of the syndication.
Who owns what, where does the investor money go, and where does the management piece go?
Your syndication LLC is where the investor money is going to go. That’s the issuer entity that is selling the investments to the investors. All that capital will get pooled into that entity, and that entity will go out and purchase the underlying asset. That’s the flow of money from the investors into the syndication LLC into the underlying asset. From there, that underlying asset will hopefully generate a cash flow or profits, depending on the underlying strategy. It will flow back up to that syndication LLC. Then there will be an operating agreement for that syndication LLC to describe how those profits get distributed between the sponsor, or the GP, and the investors, who are normally called the LPS. That’ll be dictated in that agreement from that syndication LLC. The manager LLC is going to be the entity that decides how to manage and operate that syndication. That will be a separate LLC, and that LLC is generally going to collect management fees.
In a real estate syndication, I may collect an acquisition fee when the property is purchased. I’ll probably collect an asset management fee, around 2%, maybe it’ll be less than 1% or 3%, depending on what type of syndication it is. Also, disposition fees are paid when the property is sold. It’ll collect a percentage of the sale price, or if it’s a refinance and a longer term hold that there may be a certain fee on the refinance, on the new loan amount. That manager LLC will collect those fees in exchange for providing those services to the syndication. If you think about it, if these individual investors were to buy their properties and buy rental real estate or some other asset, that’s all the work that they’re going to have to be doing on their own. They’re going to have to be handling the acquisitions, finding the deals, negotiating them, closing on them, and then being their asset manager, organizing all that, whether it’s renovations and capital expenditures, or managing the property manager. There’s a lot of work that has to be done there.
It’s the same thing in terms of dispositions. The manager has to decide when the ideal time is to sell the property, like an individual investor. In exchange for making those decisions and doing all of that work yourself, you’re giving that up to the manager as an investor. You’re hopefully happily paying those fees to the manager to be able to provide those services while you collect your profits through cash flow and ultimate disposition of the asset at the end of the day.
It’s more than a full-time job, as you can imagine: the due diligence and not all deals go through. There are a lot of expenses related to these deals up until the due diligence period. There’s a lot that goes on behind the scenes. You mentioned that funds are becoming more popular right now. Can we talk about funds versus syndications, and why people are more interested in this market?
There are advantages and disadvantages to each, but I’ll start by talking about how we typically explain the difference between a syndication and a fund. I know people use different terms, and the meanings that we ascribe to those terms do matter. When we refer to a syndication, it’s something that’s project-specific. A GP is raising capital to buy a specific asset that they’ve disclosed, or maybe it’s a group of assets. It’s a portfolio. But the key is that those are defined assets that the investors know what their capital is going towards, in terms of the investment.
Generally speaking, most funds are going to be blind pool funds. In other words, the GP is setting up a fund and criteria for the types of assets that they plan on purchasing. The investors receive that disclosure, and they receive, if you will, the buy box for the fund. If it’s in the real estate space, maybe it’s the types of real estate assets, the geographical locations, or certain types of real estate strategies that they’re going to pursue. They put that all together in their disclosure documents and their operating agreement, and the investors are betting on the GPs’ ability to execute that business plan. They’re trusting that GP to go out and find deals that fit that criteria and that will generate returns for the investors.
One of the biggest pros of a syndication is that many investors like to see, feel, and touch the dirt, so to speak. A syndication allows them to see that. They can see the underwriting as it relates to a specific property. They can become more comfortable if it’s an asset that they can then go, sort of underwrite on their own to a limited extent, but not to the same extent as the GP. But that gives a certain comfort level to investors versus a blind pool fund, which is a little bit more difficult because investors are betting on the GP to go and find those deals. Some investors don’t feel as comfortable with that. Sometimes, with newer GPS, it can be difficult to raise in a blind pool, or a situation where maybe you’re onboarding new investors, which can be a difficult sell. Sometimes, being able to do syndications and having a track record with clients better suits you to do a fund in the future. We have some clients with great track records, but because of the way that they operate their syndication businesses, it makes a lot more sense for them to syndicate, as opposed to a blind pool fund.
One of the advantages of a blind pool fund is that it gives you the ability not to scramble every time you have a closing. When you do a syndication, clients don’t have much time to do that. Once they have their LOI out there, they get it accepted, and they’re negotiating the PSA. Things can happen very, very quickly. And so they may have a matter of two, three, or four weeks to raise capital. In some cases, it might be a few $100,000. In other cases, it might be a few million dollars. That could be a very stressful time for GPs, especially as they start to hit deadlines in the PSA for refundable versus non-refundable earnest money. And their money goes hard. That can be a challenge, whereas with a blind pool, it allows you not to have to deal with that stress if you can pre-raise for properties and have the money in the bank when it comes time to close.
What is a typical fund set of fees? And also, what if they commit a certain amount to the fund? Is it standard that they just put 10% or 20% of their commitment, and then, when we find the deal, is that when they have to give the entire remainder of their commitment?
What’s pretty standard is a capital cost structure, as you were alluding to, where the investors will typically put down a percentage of their capital commitments. They will likely sign a subscription agreement, for example, agreeing to commit $100,000 to a fund. As the GP has underlying assets to purchase, they may call that capital in portions over time. To bind them to the fund, the sponsor will usually take a 10%, 15%, or maybe 20% deposit on that total commitment. The GP may take $20,000 as a deposit, and then, as they have additional assets to purchase, they may call additional percentages of that capital.
The investor is committing to putting in that capital and agreeing to put in additional capital when called by the GP. There may be clauses where the investor may forfeit a deposit if they fail to put up additional capital to meet their original commitment. GPs will usually do that, so they’re not sitting on a bunch of cash before they have the deal flow to deploy those monies. But it depends on the structure. We also have some clients who will raise all the capital upfront because they have the deal flow. They know that the timing will be pretty short between when they receive those funds and when they deploy them. But it also depends on the type of structure in the fund, whether you have a preferred return, or whether there’s just a profit split from cash flow and distributions, and also net profits from a sale event.
What is a typical fee for the funds, like a management fee? Are there other fees that are typical for funds?
Most of the same fees apply in a syndication versus a fund. The biggest difference is an asset management fee at the fund level. Usually, it’s a smaller amount. It could be a half percent or a percentage point, or one and a half percent. It depends on the size of the fund and the type of work involved in the fund, on the assets under management, or sometimes it’s on the capital that’s deployed. There are a lot of different metrics that fund managers may use. Usually, it’s on assets under management and a typical private equity structure, which is generally 2%. It usually can go up to 2% in a real estate fund. But then your acquisition, disposition, and refinance fees are going to apply at the property level.
Jonathan Tavares
(508) 212-1193
jonathan@plglp.com
www.premierlawgroup.net