Capital Stack Series: Equity and JV with Scott Singer

Foreign.

Welcome back, everyone. We have with us Scott Singer, our co head of debt equity for Avis and Young. Scott thanks again for doing this, James.

Always fun.

And we are here. This is the Capital Stack miniseries and this is your next installment. So if you haven't seen the first couple we've done, definitely go back and check it out. Incredible education, not just for those of you. Maybe you're in school, maybe you're learning, maybe you're looking to do your first deal. But we're going to start talking about some pretty sophisticated topics too. So I think Scott always has a great way of taking very complex topics and breaking things down. And so today we're going to be talking about equity and jv, which is probably interesting to pretty much anyone out there looking to invest. And certainly whether you're the investor, developer, sponsor or hey, if you're the equity out there too, you're going to want to understand kind of how these types of deals are structured. So Scott, to start off, maybe let's just identify what are the top types of equity. So we're talking institutions, funds. Just give us a flavor of what's out there today.

Sure. Happily, there's a broad range and I would say starting at the smallest, it would be individual investors. And then so individual investors who have substantial holdings are generally referred to now as family offices that are both single family offices and multifamily offices. In that context, multifamily is not referring to the property type, but rather to an aggregation of several very wealthy families who invest together or through the same office. Let's say then there are funds, there are institutions which would be so a fund might be Wall street related, whereas an institution would be more like an insurance company or a pension fund. And then at the largest level, there are the sovereign wealth funds that are related to governments. Now there's a lot of mixing and matching between the two. For example, institutions, I'll use Prudential as an example. Prudential, when I started in the business was really just an insurance company. And when you went to Prudential for money, it was Prudential's general account. Well, Prudential and many of the other insurance companies and even some pension funds have evolved into investment managers. Now they use the benefit of their name. They do have general account money from the institution, but they are also managing money for other investors, often other insurance companies, pension funds, but also now governments and individuals within the single family office space or the family office space. Other terms that are used are high net worths, ultra high net worths as the capital has grown around the world, it's been necessary to make those distinctions. They're not absolute rules as to who is a high net worth versus who is ultra high net worth. You know it when you see it.

Got it. But the baseline here, because you also hear friends and family thrown around a lot, especially when someone's looking to do the first deal, you know, pass the hat, that, that kind of thing. We're still talking about accredited investors though, right? Because I, I know on this show as well, we've talked about crowdfunding, we've talked about, you know, there's, there's episodes that you can go back and refer to, but we're, we're talking about accredited investors. And I, I don't know how much you do to kind of bet those sources before presenting. I think you're probably more on the institutional side anyways, as opposed to making individual introductions.

Yeah, we, we don't do syndications and we don't raise money for, for funds. When we receive an assignment, it is to generally to find a single investor who will write the check for all of the equity that's needed by the developer for the deal. Now sometimes do two families invest together or two institutions invest together? Yes. When you talk about a friends and family investment, that is generally checks of at the very low end, 50,000 up to, let's say $2 million that are aggregated by a developer to often that is to provide a portion of the GP capital. So we're going to get into GP versus LP and what that means. But that is a different animal.

Okay, so let's talk about the capital stack. Let's talk about where equity fits into that. So we're talking, I mean, you already alluded to it, but lp, Pref Equity, cogp. Why don't you kind of walk us through the capital stack?

Sure. So it's funny, I have a graphic when I teach at Cornell and some other.

I think we've got one in the book too that you might have provided for us. Thank you.

That could be, it's very helpful. And it's basically what is the capital stack? Because that can be a very confusing term. So the capital stack is the money in a deal, all the money and within. And there are various ways to break it down, but one basic way is debt versus equity. Debt is the money that you borrow and you have to pay back on a certain period of time. And equity is essentially the ownership. So within equity, one structure that really isn't equity has a terrible name. It's called preferred equity. So preferred equity is generally now a debt or debt like structure. So I'm going to put that off to the side. And when we're talking about equity today, we're talking about money that will receive more if the property is more profitable and less if the property is less profitable with no guarantees and no preference over, let's say, the other money that's in there. So going back to what are the types of equity, basic distinction is LP money versus GP money. GP money is the group that is running the deal and LP money is more passive. All of these distinctions blend into each other as we actually get into transactions. COGP money is money that is somewhat of a hybrid. It is generally coming from an investor who is not an operator of the property, but who is getting some of the benefits of being an operator of property, which include fees and promotes the code. GP structure is a way for developers to satisfy the needs of LP investors who want a minimum amount of cash to come from the operator of the property, even when those operators don't have sufficient funds or aren't choosing to use the full amount of money to invest on their own. And so COGP investment can be a very lucrative and very beneficial place to be for a money investor who's going to get some of the benefit of the sweat of the, of the operator partner.

Yeah, some of the terminology that you sometimes hear thrown around is there 9010 investors so simply saying, okay, well as an LP we'll bring 90% of the equity, maybe we'll do 95%. So that's kind of the distinction there. I mean, typically a gp, if they're going to go out and raise capital, I mean, how much skin would they typically have in the game?

So typical is it changes over time. And at the end of the day there is no typical. So there are certain LP investors who want to put, once they are comfortable with the transaction and with an operator partner want to put as much of their money to work as possible. And so those are the types of investors who will get into 95.5structures. And often 95.5 is not what is used in the first transaction between an operator and a money partner. There are other investors who take the opposite approach and say the more cash the operator is putting in, the more comfortable they are. And so there are certain, there are certain investors who prefer 75, 25 structure where the GP the operator is putting in 25% of the cash. 8020 is a common, is a common ratio, certainly for first transactions as you get into sizable transactions. 20% of the equity in a deal can be a lot of money. So it's very much individual preference. When we go out with a transaction we have an understanding. First we need to know how much the GP operator partner is able to put in, is willing to put in, wants to put in and then depending on what amount is needed that informs which investors we go to for the money. It tells us whether we need to find a co GP partner. It tells us within the universe of investors, which happily right now is very large, which subset are most likely to be attracted to the deal.

Let's talk a little bit about major decision making rights because you said the GP is usually the one doing the day to day has the business plan. The LP generally speaking are more passive, but not always. Sometimes you have very vocal LPs who's calling the shots in this? I mean if you have an LP who's put up 95% of the equity, I think they probably want to have a say in you know, major leases, maybe when to refinance, sell.

It's why this is so one of the reasons why raising equity and completing the transactions is so much more difficult than than a debt transaction. Because yes, I've described LP money as passive. And yet you're right. No one puts 95% of the money into a deal and says do whatever you want with it. And so the negotiation of major what constitutes a major decision and what are the voting rights for a major and other decisions is among the most time consuming part of structuring equity deals. There are certain major decisions that are somewhat obvious. So the decision to sell the asset is always a major decision. Often the decision whether to refinance an asset and on what terms is a major decision. In commercial transaction the leases over a certain size would be major decisions. In a condo development, changing the prices of the sales of a unit may be a major decision because that can have a big impact on and there may be conflicts of interest between the LP and the GP in a transaction. So those are major ones. There, there are and there are others.

And what about. And I've seen in some. I wouldn't say this is necessarily typical but in some cases LPs are even putting down deposit money on a contract they are signing guarantees. Is that part of the conversation as well?

It is part of the conversation but the basic concept of an LP investor would be someone whose risk is limited to whether the the operator performs as they were expected to, meaning that they get. They complete the project, whatever that means, whether it's ground up development or renovation or otherwise, and they are essentially along for the ride. When a money partner is asked to provide or sharing guarantees, that is an elevation of the relationship that will tend to push it towards in name or in actuality being a code GP investment. And so LP investors who provide guarantees generally want something in addition to the return they'll get on the deal. That can be a sharing in fees, that can be a sharing in promotes, that may be a preference on getting their money back, but that is a change in the relationship. So it again shows the challenge of using each of these terms. We often refer to the LPs and the deal as the terms are used in ways that create confusion. Not intentionally or typically not intentionally, but, but that really, that really do. I mean it. Even the concept of LP and GP comes from an old. The old structure of partnerships where the general partner took all the risk and called all the shots and the limited partners had essentially no rights, no deals, no new deals are structured as general partnerships anymore. Virtually all deals are owned by an llc. And so what you really have are members and managing members. And yet we still use these old terms, LP and GP all the time.

So Scott, with this all in mind, how do you decide what's best for a sponsor? So a sponsor brings you a live deal. You know, Scott, what, what should I, how should I put the capital stack together? I mean, I guess the first question might be, okay, well, what I do with the debt? Do I want to bring in some mes, Do I want to lever that up? I mean, how are you advising a sponsor on, on the best path?

First we listen, right? And that, and that really is important. So we want to hear first of all, what does a, what does a sponsor have in mind? What do they think is best for them and what are their goals? And in some cases, the sponsor knows exactly what they want. They may have secured everything except for one piece of a transaction. And it's very clear to everyone what should be done. More commonly we are brought in where there's most of the capital stack needs to be raised and there are options. So then listening to the risk profile of the sponsor, the relationship that they have, the proportion of the total cash needed that they are able and willing to provide, and the strength of their balance sheet for guarantees is generally the determining factor in how we take the next step. A sponsor who has a very small balance sheet is going to need a code GP partner. A sponsor who has a giant balance sheet then has options. So that's how it, and how does.

Track record play into this? And maybe I'll give kind of a more specific situation. Maybe it's a sponsor who worked for, you know, 10 years at a big shop, so they've been involved in a lot of transactions, so you can look at that track record. But maybe this is a new venture for them. So is that new sponsor going to have to kind of start from the ground up with the, you know, the friends and family and then kind of work up to the institutions, or can they leverage a track record? Maybe if they, if it was done at a prior firm.

It's a very challenging career move to make. And the answer to your question is very dependent on the state of the world at the time. So when we're in an easier money environment and investors are eager to get their money out, then there's more benefit of the doubt given when we're in a challenging environment, as we were, let's say, in 2023 and 2024, it's very hard to make that move. And so often when someone moves from being an employee and a very active employee who plays a meaningful role to going out on their own, if they leave on good terms, then often some of the seed investment and maybe even some of the original guarantee can come from the original sponsor. And we know multiple examples of people who have been in that, in that fortunate role. Other times that's not possible. And so it is often determined again by what is the liquidity and balance sheet of that individual. If it's not sufficient to provide the guarantees, and they need to find someone who knows and trusts them implicitly to come in and be both the seed investor and the provider of guaranteed capital. It is virtually impossible to find for an unknown party in the current environment, someone to provide guarantees on their behalf.

So let's now talk a little bit about the promote and maybe we should have started with this. Everybody loves talking about the promote, and it's one of the exciting things about investing in real estate. So clearly if you're the sole investor, you don't take on a debt at all. You're just getting whatever the property level returns are, you know, but then, you know, you finance and hopefully that finance is accretive to your cash flow. So then you're making a spread there. But now we're talking about promoting equity investors. Okay. So I don't know how much we want to get into talking about waterfalls and preferred returns and all that works. But again, the goal is, and I would think that if the general partner is putting forth, they've Brought the opportunity, they're doing the day to day, they're putting in that, you know, sweat equity, so to speak. What's in it for them?

Well, so the promote. So again, these are terms that we're throwing around. But, but I like to start at the most basic. So the, the promote implies that a partner and one of the partners in the deal, one of the members in the deal is getting a disproportionate share of the returns. Okay. So a deal that doesn't have a promote is called a Parry Pursue deal. So Parry Pursue means that each investor in the project is getting their proportionate share. They're putting in their proportionate share of the money and they're getting out the proportion share of the returns. The promote is a situation where the generally the general partner, the developer, the GP is getting more than their proportionate share of the returns. And investors think of that as a reward for accomplishing certain things normally. Now in most deals the promote structure kicks in after the investor has received a target return.

And so the equity back or depends.

Yes, because this is generally done on an IRR basis. So generally the capital will come out, will come out first. But again there are no absolutes.

Right.

And this is, and so different.

Depends on the deal too. Right. If it's a five year hold and it's a value add and, and the return is made on the back end, whether it's a refi or a sale versus if, I mean, I guess there could be investments where look, we're going to hold this forever and it's just. Okay, how are we sharing the cash flow?

Well, and we've invested in, in, in some deals and raised capital for deals that are, that, that are essentially forever investment. And so we've come up with a structure there where there are two different sets of promotes. One is based on the annual cash flow and the other is based on the eventual irr. And that's a way because one of the challenges of long term deals has been how do you give a developer the benefit of having a deal that goes quite well but is not monetized essentially forever. And so I think we've solved that in a way that works for some investors and some developers. But the promotes are also given in exchange for taking risk. So when in a development transaction where there are guarantees that are required, it is generally the gp, not the LP who is taking the guarantee risk. They're doing that on behalf of the entire partnership. So why are they willing to do that? Well, it's not possible. It's not feasible to build projects using construction money without a guarantee. Someone has to provide it. LPs are generally not willing to do so. So a GP with a sufficient balance sheet takes that risk on behalf of the whole partnership. In exchange for that, they want something that the some things are fees along the way and promotes if the deal goes well. So the promote is a necessary structure to incentivize developers to take risks.

Okay. So I want to just to give this some context. So if the typical promote structure might be, okay, you're the lp, I'm going to pay you a preferred return. Okay. And after you we've accomplished that preferred return, then I'm going to get a the promote after that. Right. So thinking about how our sponsors would set something up that that's fair, I would, I would think that it's very specific to the deal. Right. And the risk profile. So if I have you coming into a cash flowing multifamily deal that let's say we're, we're buying at a 6% return and the hope is that the stabilized yield on cost, once we do our improvements, we're going to get it to an 8 or 9%. Right. So you know what would be kind of a preferred return that would seem fair and then after you've accomplished it, what kind of share of the, the upside? I mean, I'm just trying to put some, some context around this.

Well, so now you're, you're using preferred return.

Yeah.

Right. So then that raises the question, am I a preferred equity investment investor, which is really debt, or am I an LP investor? So as a. So one structure that has been more common over the last couple years among investors who were worried especially about the exit cap risk, was to say, James, I love your transaction. I'd love to come into it. It's great that you're making that going in return and that you expect to improve the cash flow. But I don't know what the exit cap rate is going to be and I am really targeting an 11% IRR. So now you will show me that the exit cap rate is going to be about where it is today, or maybe it's even going to go down. And based on that great exit cap rate, we're going to make 15%. But I'm worried that the Fed is going to keep raising interest rates and cap rates are going to be 9 or 10% down the road. And then the IRR is 5 or 6%. I'm not willing to invest for 5 or 6%. So the solution over the last couple years was for you to offer me a preferred equity position. So that means I get all of my return and money back. I get all the money that comes out of the deal until I've received some return that we agree on. And then you start catching up and eventually getting ahead of me if the deal goes well. So that way, if my target return is at least an 8%, I could make my 8% even if the deal only returns, say a 6 or 7. Okay, so why would you do that? Okay. And that, why would the developer do that? Well, one is because it might be the only way to do it, but the other, what are you going to want in return? You're going to want an outsized share of the profits. After I've gotten my preference and you've caught up, then maybe you're sharing, maybe you put in 25% of the money, but you're getting 75% of the upside. Right. The alternative would be a pari pursue structure, a waterfall that starts out pari pursuit, where we say you as a sponsor put in 25%. I as the LP investor put in 75. The first money out, we would split 25 to you and 75 to me. And we're taking the risk together on what's going to happen with the deal. And then how does the promote kick in there? You're not going to ever get 75% of what's left for having put in 25, but you might get a 20% promote over some threshold return that we've agreed on. So.

Right.

Yeah.

Okay. No, you have to run it out.

In a model and everything's complicated.

Yeah, absolutely. So let's, let's lastly talk about fees. So one of my favorite subjects. So what kind of fees can a sponsor charge that are, you know, market. What are the different types of considerations?

Sure. Sponsors charge different fees for different reasons, and LP investors have different responses. So one fee that is commonly charged that some LP investors really don't like is an acquisition fee. And so that is where essentially the LP investor is paying a toll to come into a transaction. Now, there are sort of obvious reasons why an LP investor wouldn't like it, but why would they accept it? Sponsors use acquisition fees to pay the costs of getting into a transaction. So it's very, it can be very expensive and time consuming for sponsors to find transactions and to chase them and to close them. So, and for example, to pay an equity broker a fee, often the acquisition fee is actually used to pay the equity broker. So acquisition fees are one Asset management fees are another. And so an asset management fee can be charged either on the amount of money invested or in a cash flowing deal as an off the top payment out of, let's say the gross receipts that those are generally used by the sponsor to pay their staff and to cover their overhead and to pay some salaries. And, and those are not the places where developers make big money. The big money is made, you know, partly through a sponsor's investment in the deal if the deal goes well, but especially in the promotes.

Yeah, and the fees, what I've heard is to be kept at a reasonable level. You sometimes hear the expression the sponsor should not be feeing out of the deal, meaning are they getting more fees than the actual equity and much larger transactions? Again, it can become more significant.

It is something that many investors look at and there are other fees as well. So often a sponsor will charge a construction cost fee. So in an apartment renovation deal the sponsor is spending time and money and taking risk with when they are renovating the units. So often a sponsor will charge a, you know, make an upcharge on the construction costs. And that's something that I think sophisticated investors are okay with because it is a service that's being provided. It takes the time, it takes oversight. And it's one of the keys to successful equity relationships is, is building trust over time and investing with people who are well vetted and who you see how they perform and, and when you have a comfort that decisions are being made by the sponsor based on, excuse me, what's best for the transaction, then paying those types of fees is okay. There is an inherent potential conflict of interest in a fee that's paid based on cost that is in it's. There is an incentive to elevate the cost. So you have to deal with people who you trust and you have to vet what they're doing and, and watch that.

So Scott, as we wrap up, one final question for you and the role of the debt equity advisor. So you know, if you have a sponsor who already has a stable of investors, LPs, I mean maybe it's not needed. But what would be the case? Why would someone want to bring in an advisor to help structure the capital stack and specifically raise the equity when maybe they have the connections already and could do it themselves?

Yeah, we play different roles for different, for different groups. So there is a segment, you know, newer up and coming groups who really need to be introduced to capital because they don't have the relationships. Then there are established groups who are looking to grow their relationships because investors change their appetites over time or deal flows get larger or property types change and then beyond that, even with the groups who have essentially access to all the capital they need. It's a question of creating competition and using the benefit of all of the transactions that we see to bring to negotiations between, between the parties. Often many of our clients, most of our clients have existing relationships and we get involved in the negotiations with the existing relationships partly as a buffer. And so that when challenging positions are need to be taken or there or there are challenging negotiations, it creates. Buffer is the best word. It creates some ability for those challenging conversations to be had without it negatively affecting the relationship. So it's, it's very different depending on the, the situation in the deal. One of the aspects to all the capital, both debt and equity, is that it changes so quickly and there are so many new sources coming in and there are many sources who have gone out that by virtue of the number of deals that we're working on, we are just at the forefront of where that capital is coming from and what. And what the best terms that can be driven are. While keeping in mind that especially with an equity transaction, it is marriage and getting to a finish line in with relations being strong and with a setup that is really the beginning. The closing of an equity transaction is the beginning of a relationship. It's very different than a debt transaction. So, so we think the role is critical and our clients who keep using us seem to agree.

Wonderful. Scott, this was awesome. Thanks again so much for doing this.

Love doing it.

Thanks and thank you all. For those of you joined, definitely check out james nelson.com that's where you can find the show notes for this podcast. It's where you can also find the prior episodes helpful white papers that we've written on this topic. Again, we built this site for you. So appreciate Again, until next week, thank you.

Thanks very much.