When a real estate deal goes bad as many are doing now, should limited partners have the right of first refusal to invest rescue capital on the same terms as anything the sponsor can bring in to save the deal?
My podcast guest today, attorney Mark Roderick, calls it ‘pre-emptive rights’ and, as you will hear, he explains it can make the best of a bad situation.
But what does that look like in reality?
Here’s the script:
Email #1: From Sponsor to Limited Partners (Investors):
Subject Line: We’re stopping distributions and need more money from you
Sorry investors, we screwed up because we [select from the following]
- Didn’t manage the property aggressively enough to account for a downturn.
- Underwrote debt levels to eternally low interest rates on variable rate terms and now can’t afford the doubling of our debt costs.
- Our original loan is maturing, the value of the property has gone down, debt costs have skyrocketed, rent growth is not what we assumed in our proforma, and the bank will only lend us 60% of our original loan amount.
- Cap rates are now nearing 6% not the 4% we projected.
- Thought this time was different.
In sum, we need you to pony up more equity so we can avoid losing the property to the bank.
Email #2: From Sponsor to Rescue Capital fund (pref equity, mezz debt, whatever)
Subject Line: Have we got a deal for you!
Our offering docs allow us to bring in additional capital under any terms. Our bank will only lend us 60% of the original loan amount so we need to shore up the difference. Can you help us.
Email #3: From Rescue Fund to Sponsor
Subject Line: We’re in!
Sure. We’ll come in with the 40% you need. We want second position behind the bank (ahead of your existing LPs) and if you miss proforma targets or fail to pay us on time, we’’ll remove you as GP and wipe out your LPs’ equity.
Email #4: From Sponsor to Investors
Subject Line: Great news! We’ve found some rescue capital.
You get first right of refusal on the terms we just got to protect your investment.
Terms are that your new capital will come in ahead of your old [or dilute it out completely], and if we screw up again, you get to remove us as GP.
Please accept these terms or someone else gets them.
Oh, and by the way, the Rescue Capital wants all or nothing so we need unanimous agreement from all Investors or we go with the Rescue Capital.
Is this an ‘offer’ or a ‘threat’?
Or is the dialogue different somehow?
At the end of the day, does having pre-emptive rights (right of first refusal) really mean anything?