Deal Structuring Series - Equity

The way a deal is structured will dictate everything from the transaction payment terms to how the post-close entity or operation is funded, organized and run. Different stakeholders will focus on certain terms of the deal structure more than others, because it’s that certain aspect of the deal where they realize their return. In all deals, structuring should be such that maximum value is realized for each stakeholder, including the seller, the buyer and it’s shareholders, the lender(s), etc.

For the purposes of this 3-part series, I’m going to assume you are familiar with financial concepts such as equity, debt, internal rate of return (IRR), net operating income (NOI), and cap rate, as well as organizational concepts like general and limited partners (GP, LP). I’ll place some information about [some of] these in the comments below in the event you need a quick refresher. I’m also only talking about structuring commercial real estate deals. While the concepts may be the same, strategies can be very different with other alternative asset deals.

Verrazzano Narrows Bridge, New York

At Georgia Tech I studied structural engineering, and I loved bridge design. The bridge above is the Verrazzano Narrows in New York. It connects Brooklyn to Staten Island. The Verrazzano was always one of my favorites due to its simplicity of design while still being one of the longest in the world. It’s truly a beautiful site. There are a lot of different kinds of bridges out there. Like deals, they are designed to be the best combination of form, function, and value given the parameters. In my deals I value simplicity over complexity, clarity of risk over persuasion, and value production across the board.

Recall from the article on the Capital Stack, there’s the debt component, the equity component, and the differentiation between types of each that make up the invested capital in the stack. This capital is used to purchase the asset, fund the capital improvements, and cash flow the operations. In parts 2 and 3 of this series, I’ll dive into debt and fees.

Equity

The individuals and entities that own equity in a deal collectively own 100% of the asset. From a financial perspective, the asset serves to produce cash flow on behalf of the equity. The different types of equity, the ownership split, and any performance hurdles are important to understanding how that cash flow is distributed among the equity entities. The sponsor, or GP, partners with investors, or LP’s, to pool equity capital and management talent in order to purchase, own, and realize returns. The LPs are passive investors, and the GP is the active investor. The LPs benefit from the GP performing most or all of the work to identify, acquire, and operate the asset, and the GP benefits from passive investment capital from the LPs who capitalize most of the transaction.

Special Purpose Entity (SPE) Equity Promote Structure

It’s common for the GP to contribute 10% of the total equity raise, although that number can change as the deal size increases or if the GP is cash flush. For this 10% contribution, the GP will get a disproportionate share of the profits. Remember, the passive LPs rely on the active GP to source and underwrite the deal, finance the deal with debt and equity, develop a strategy to harvest value from the asset, negotiate purchase and loan agreements, complete due diligence, close the transaction, execute the operating strategy, manage the asset, and conduct cash distributions during service. Additionally, the asset must be disposed of after the hold period. In exchange for the active ownership duties performed, the GP earns a greater share of profits than the pro-rata equity participation.

Preferred Return

The LP contributes the lion’s share of the equity capital. In exchange for the financial risk taken, a preferred return is given to all equity, usually 7-8%. This preferred return, or “pref”, is a set return on capital whereby the GP return is subordinate to the LP or treated as common equity (known as pari-passu or side by side). Once the pref hurdle is reached, the splits are calculated differently. This is where the disproportionate share of the returns are realized by the GP, known as a promote or carried interest. The promote contributions are placed into a separate entity known as the Promote Entity, which keeps the promote distributions clearly delineated. After the pref hurdle and up to a 15% IRR, the split might be 80% to all equity and 20% to the Promote Entity. In this performance range the GP realizes a 20% promote. Above a 15% IRR, the split might be 60% to all equity and 40% to the Promote Entity. In this performance range the GP realizes an additional 20% promote.

Example Waterfall:

• A 7% preferred return pro-rata to all equity, then

• A pro-rata return of capital to all equity, then

• A split of 80% to all equity pro-rata and 20% to the Promote above the 7% pref hurdle to a 15% IRR, then

• A split of 60% to all equity pro-rata and 40% to the Promote above a 15% IRR hurdle

Another common deal structure is the co-investment structure, which is similar to the promote structure, but the GP is the Class B member. This eliminates the promote entity but still enables performance hurdles. Performance hurdles align the interest of the GP and its investor LPs. LPs should be cautious around any deal structures that don’t pay the GP’s promote last.

It’s important to understand the equity deal structure. A good sponsor will have the structure clearly outlined in the Offering Memorandum and will over-communicate these points in discussions about who gets paid what and when.

In the next installment of the series, we’ll discuss quite possibly the most important aspect of the deal….debt.