Interest rates have gone up, real estate valuations have gone down, banks have disappeared, and investors have become more cautious. Many real estate sponsors, faced with looming loan repayments, wonder how they’re going to raise more equity.
They might be surprised when they check the Operating Agreement. Too often, Operating Agreements prohibit the sponsor from raising more equity without the consent of a majority of the LPs or even a single large investor. And getting that consent might not be easy or even possible, for several reasons:
- Existing investors might not agree that new money is needed.
- Existing investors might be unrealistic about market conditions, thinking the new equity can have the same terms as the existing equity.
- Existing investors hate being diluted.
- Existing investors might prefer to contribute the new money themselves on terms the sponsor believes are exorbitant.
- A large investor might be angling to buy the property for itself at a fire sale price.
When times are good and the Operating Agreement is signed those possibilities seem far-fetched. Then you get to an April 2023.
Knowing that an April 2023 is always on the horizon, sponsors should negotiate hard at the outset for the right to raise more equity. They won’t always get it because people who write very large checks usually get what they want (that’s why we call it “capitalism”). But in my experience, too many sponsors give away the right too easily or don’t even think about it.
If the sponsor has the right to raise more equity, how do we protect the original investors? What’s to stop the sponsor from raising equity from her own family or friends on terms very favorable to them and very unfavorable to existing investors, even if the equity isn’t needed?
The answer is “preemptive rights.” If the sponsor wants to raise more equity, she must offer the new equity to existing investors first. Only if they don’t buy it may she offer it to anyone else.
Preemptive rights aren’t perfect. The main flaw is that Investor Jordan, who had money to invest when the deal was launched, has fallen on harder times and doesn’t have money to participate in the new round. Or Mr. Jordan does have the money to participate but is no longer accredited and therefore can’t participate.
Even with the flaws, preemptive rights generally allow for the equitable resolution of a difficult situation, much better than the alternatives most of the time.
You can see my form here. Let me know if you think it can be improved.
NOTE: Sponsors might also consider “capital call” provisions, i.e., provisions allowing them to demand more money from investors if needed. In my opinion, however, they typically do more harm than good, driving away investors at the outset while not providing enough cash when it’s needed. And in practical terms, a large investor who would balk at allowing the sponsor to raise more equity certainly won’t agree to an unlimited capital call.
Questions? Let me know.