Balancing Equity and Control: The Role of Major Decision Rights in Real Estate Syndications
There are many ways to structure real estate deals. Some deals are done solo by an individual investor, others with multiple active partners, and some with many passive limited partner (LP) investors. In scenarios where multiple parties contribute equity to a deal, a typical arrangement involves the contributions of a blend of both active and passive participants. [1] Notably, as the quantity of individual equity investors increases, there tends to be a disproportional rise in passive involvement.
For a typical real estate syndication, one of the appeals for LPs is the passiveness of the investment. In many cases, the LP investors may be busy professionals who do not have the time, nor the industry-specific expertise, to manage and deal with such investments. As a result, they prefer to write a check as a passive LP, rather than actively participate in a deal. [2]
However, it is important to note that not all LP equity investors, or rather their equity contributions, are created equal. For instance, one investor may contribute 1% of the total equity needed for a deal, whereas another investor in that same deal might be the source of 50% of the overall equity raise. In cases where an investor underwrites a substantial portion of the overall equity (or simply a substantial portion of equity), their inclination towards passivity is often tempered by the magnitude of their investment – making a wholly passive role seem much less appealing. However, while a sponsor might understand such inhibitions, they may be wary of accepting an investor who can become overly involved in a deal’s day-to-day management – or a “backseat driver.”
A potential solution comes with the implementation of “major decision rights.” [3] This mechanism can help strike a balance by allowing a significant equity investor control over certain material and consequential investment decisions that can substantially impact their large equity position, while still preserving the role of day-to-day management with the general partner (GP). [4] These major decision rights typically encompass critical areas, such as property sales, refinancing, or the execution of lease agreements with key tenants. [5]
Even in real estate syndication involving GP co-investment, it is commonplace for the overwhelming majority of equity to originate from LPs. The fundamental agreement in such deals is often fairly straightforward: the GP, also often referred to as the “sponsor,” assumes responsibility for underwriting, sourcing, and managing of the deal's operations. [6] By contrast, the LPs furnish the requisite equity funding essential for closing on the deal. The extent of each LP’s specific contribution will vary based on a deal's specific requirements, but it's not uncommon for a few, or sometimes even a single LP, to provide a significant portion of a deal's equity. [7]
While the efficacy of such a capital raising strategy – one heavily weighted towards a few LPs – is a subject of debate, that is not the topic of this writing. [8] Instead, our focus is on the rights that a passive LP investor might attempt to achieve in such cases to protect their equity investment.
Such rights are often called “major decision rights.” Their naming correctly suggests that the subject matters covered are generally not the day-to-day elements of running a deal. Rather, major decision rights are generally drafted to give the subject LP investor(s) rights surrounding material and consequential or “major decisions.” These rights can include the requirement of such LP investor’s consent to matters such as: [9]
In conclusion, real estate investment is marked by different roles and responsibilities, particularly between a GP and LPs within syndications. While the GPs typically navigate day-to-day management and have most decision-making rights, LPs, especially those contributing significant equity, may seek to safeguard their investments through structures such as major decision rights - ensuring that they have a say in critical decisions without disrupting a deal through day-to-day involvement.
This article is a brief overview of a topic which contains substantially more nuance. The information in this article is for general informational purposes only and is not legal advice, a legal opinion, tax advice, accounting advice, or investment advice. You should seek the advice of legal counsel, tax representation, accounting representation, and any other such representation as necessary when acting in any capacity and shall hold the author harmless from your failure to do so or in the use of any of the information contained herein for any and all purposes. The author does not guarantee or provide warranties regarding the correctness of the information provided herein. You may not copy, reproduce, distribute, publish, display, perform, modify, transmit, or in any way exploit this content, nor may you distribute any part of this content over any network, sell or offer it for sale, or use such content to construct any kind of database without prior written permission?from the author.
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[1] In many cases the sponsor (the active participant in a deal) will also contribute equity to the deal. Though, the sponsor’s share of profits will typically be disproportionate to the level of such contribution due to the sponsor’s benefiting from the deal’s promote structure.
[2] There may also be securities law implications for active vs. passive participation within a syndication – something which is beyond the scope of this writing.
[3] Major decision rights are typically incorporated into real estate deals through the deal’s operating agreement, a crucial document that outlines the governance and operational guidelines of the investment.
[4] In this article, when we refer to "equity contributions," we are referring to common equity (as opposed to, for example, "preferred equity"). Furthermore, this is not to suggest that day-to-day management decisions don’t substantially impact an investment – they certainly can.
[5] What is considered a major decision will, of course, change deal-to-deal. For instance, as we note later on (within Footnote #10), for a large multifamily complex with hundreds of units, a tenant lease will generally not be included. However, for a retail strip center with only five tenants, leasing may be included – particularly as it relates to anchor tenant leases.
[6] Of course, there are numerous other responsibilities which a GP typically undertakes outside of day-to-day management and those listed in this article. For instance, a GP will generally also be responsible for arranging the original debt financing of the property and arranging for its sale – when the time comes.
[7] What is considered a “significant portion” of a deal’s equity raise is up for interpretation. However, there are cases where that line might be more clear. For instance, in the case where an LP contributes over half of the total equity raise. ?
[8] On one hand, consolidating capital from a few well-capitalized investors can streamline the capital raising process significantly. In such scenarios, for example, the sponsor benefits from having fewer stakeholders to engage with. However, the flip side of this equation reveals the increased leverage these large check writers possess. Their substantial investment can be a linchpin for the deal's viability and their withdrawal could jeopardize the entire deal due to a shortfall in equity. Consequently, these investors often find themselves in a stronger position to negotiate not just specific rights and provisions within the deal’s structure, but also more favorable financial terms. For instance, they may insist on greater preferred returns and larger portions of profit splits. Conversely, when a deal is made up of numerous smaller LP investors, each generally lacks the individual influence to push the sponsor for enhanced terms. This dynamic underpins a rationale behind smaller investors pooling their resources through a money manager who establishes a fund to invest in real estate. Such collective funds enable these investors to mimic the influence of a large check writer, offering substantial capital in exchange for greater bargaining power. However, this comes at the cost of the fund manager's fees (typically, they won't offer such a service for free), making it a calculated decision each LP must weigh.
[9] Major decision rights for a specific deal will typically be outlined within the operating agreement.
[10] The relevance of certain major decision rights can vary depending on the property type involved. For example, the right to enter into or amend leases is typically more crucial in properties with a limited number of tenants, where each lease significantly impacts financial performance. By contrast, this right might be less pertinent in large multifamily complexes.
[11] The definition of what constitutes a “major” decision can also hinge on the financial scope of such decision. In the context of capital improvements, a specific monetary threshold might be set to delineate major expenditures (which, by extension, might also be considered “major decisions”). For instance, any capital expenditure exceeding $50,000 might be classified as “major.”