The Capital Stack & Equity Component
Qandor member and CEO & co-founder of Hilltop Credit Partners, Paul Oberschneider explains how you can use the capital stack and equity component to your best advantage.
For most property developers and investors, buying an asset is done with a combination of equity and debt. At the far end of the spectrum is all equity and at the other end is all debt. How far you go towards one end of the spectrum or the other will determine your returns, in a linear fashion; the higher the risk (i.e., the more debt), the higher the ultimate returns, all things being equal.
In the capital stack, the dearest slice of finance is equity. Equity carries the highest risk and gets wiped out first, ahead of debt, which may be secured against the underlying property and has downside protection, the amount of which will depend on the loan-to-value (LTV) ratio of the loan. So, by its very nature, equity will be a more “expensive” source of financing than debt.
The purpose of this article is not to speculate on what that correct balance of debt or equity might be, as that will depend on many variables, but rather to discuss the composition of the equity component itself.
A Developer, Sponsor, Operating Partner, or General Partner (GP) – whatever you call that person – will need equity in any deal (I will refer to that person as the “Sponsor” or the “GP”). That equity may come out of their own pocket or it may be syndicated amongst a few “friends and family,” who, professionally speaking, would be called Limited Partners (LPs). The GP/LP relationship is often confused with other terminology like joint venture. At the end of the day, it’s the same concept; the GP brings the deal, does all the work, and the LP brings the capital which allows the GP to scale his development business.
A Sponsor’s position on the experience and size scale will determine the types of LP capital he will be able to raise. Newer Sponsors will turn to less sophisticated investors, or family and friends, and more experienced Sponsors will raise capital from professional investors such as family offices and institutions. The structure or composition of the Sponsor contribution will also typically depend on his track record.
Typical textbook Sponsor contributions may range from as little as 5 percent of the equity up to 20 percent, in exchange for a disproportionate share of the development’s profits, also known as a “promote”. Promote structures range from simplistic 50/50 profit splits to more rewards-based calculations based on hurdles or “waterfall returns”. These waterfall returns allow for the Sponsor to gain additional disproportionate profits from a successful deal after the target’s archived.
With debt financing becoming more and more difficult to find in these challenging markets, the demand for equity has grown and has the appetite for junior, or mezzanine debt to replace some of the more expensive equity. The problem with junior debt is that it will carry additional legal costs, set up time, and most often a second charge over the asset, which many senior lenders do not like or care to structure, especially at lower deal sizes. Raising LP equity, structured in the right way, can alleviate some of the headaches.
The thing is, there is no right or wrong way. Structuring your capital stack will fundamentally be driven by your track record, the deal itself and your ability to navigate through the different sorts of capital providers.
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