Avoiding Partnership Waterfall Disputes and Potential Litigation
Real estate is a sophisticated industry with market participants having different investment strategies and cost of capital. From annual cash-on-cash to internal rate of return requirements, general & limited partners are becoming more creative with their operating agreements as it relates to the cash flow from operations and cash flow from capital transactions sections.
“At FTI Consulting, we are seeing more and more disputes and litigation cases where the parties disagree on the language in operating agreements that do not precisely convey the business intent,” observes FTI Consulting Managing Director Mark Dunec, who specializes in real estate valuation and real estate litigation matters. “Unfortunately, these types of disputes can come at a high cost in terms of litigation-related fees.”
Disputes can be avoided when the operating agreements and underwriting financial models are reviewed by a third-party to ensure they are in agreement to the negotiated economics of the deal.
Top Challenges Affecting Clients Today
Below is a sample of disputed issues and suggested solutions to avoid litigation between general & limited partners.
- Compounding Frequency
Due to the intricate math involved in compounding (especially when accommodating the exact date of accrual), the wording around this concept can become fairly complicated. “The consequence of dispute arising from compounding return can be significant especially when the partners hold the asset for a long period of time as the impact of varying compounding frequency increases with time,” says FTI Consulting Managing Director Eun Oh, who specializes in complex financial modeling in FTI’s Real Estate Solutions practice. “A potential drafting error on compounding returns can be easily prevented through a quick review of the distribution and IRR definition sections.”
- Timing of Contribution
In many cases, partners put in money at different times. For example, some partners contribute money before closing of a fund, but others are admitted after the closing of the fund. Different timing of contribution means a different starting point of the IRR clock, where some partners reach the IRR hurdles earlier than others. “In order to clarify potential confusion arising from such timing differences, the operating agreement should include a clause clearly explaining the treatment of such issue,” says Dunec.
- Clawback Provisions
“A clawback computation can become easily complicated especially in a portfolio or a fund where incentive fees are paid on a deal-by-deal basis.” says Oh. “A sophisticated mathematical model is needed to compute clawback in such cases.”
A clawback provision involves a partner returning an incentive fee distribution. There are situations when the sponsor/manager does not have cash readily available to fulfill the clawback obligation. To prevent this situation, sometimes investors demand that part of the incentive fee be kept in escrow until the partnership sells all assets.
- Who pays fees and who does not?
The general partner or its affiliate entity (sponsor or manager) manages the asset and receives incentive fees when the asset achieves returns higher than agreed upon hurdles. As limited partners (or capital providers) would naturally require the general partner to have equity in the deal, the general partner contributes a small amount of capital alongside the limited partner. Sometimes an arrangement is made such that the general partner’s ownership interest is exempt from paying incentive fees. Similarly, a limited partner can also negotiate an arrangement for a fee exemption/reduction, which can be written in the operating agreement or in a side letter.
It is important that the documents precisely reflect the business intent that is agreed upon among the limited partner, general partner and the sponsor/manager, says Dunec.
- Promote Crystallization
Traditionally, the developer receives a promote when the building is sold. As the promote is time-driven, a delay in the sale process can quickly decrease the developers promote even when the project is a success. “In order to address this issue, partners frequently agree that the developer get compensated at stabilization rather than at ultimate sale” says Oh.
Promote Crystallization eliminates the conflict of interest between the general partner and limited partner arising from the promote structure driven by the IRR clock.
The Benefits of Partnering with FTI Consulting
Operating agreements should precisely reflect the business deal (and intent) that has been negotiated. Including a mathematical formula in the operating agreement is helpful and can prevent potential disputes on topics mentioned above. Having a spreadsheet exhibit in the agreement can solidify mutual understanding among partners.
When combined with proper language, a spreadsheet exhibit functions as a vital and informative supplement, says Oh.
Disputes and costly litigation can be avoided when the operating agreements and underwriting financial models are reviewed by a third-party in collaboration with discussions with general and limited partners and their legal counsel to ensure they are in agreement to the negotiated economics of the deal.
Find out more by connecting with the FTI Consulting team today.
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FTI Consulting is an independent global business advisory firm dedicated to helping organizations manage change, mitigate risk and resolve disputes: financial, legal, operational, political & regulatory, reputational and transactional. FTI Consulting professionals, located in all major business centers throughout the world, work closely with clients to anticipate, illuminate and overcome complex business challenges and opportunities. The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals. FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm. ©2022 FTI Consulting, Inc. All rights reserved.