Don’t Fear Year 15
By John W. Gahan III
14 min read
Working Your Way Through the Maze: A Scenario
Life was good, or it should have been, for Gerry General, the general partner of a partnership that owned Good Life Lofts, a 150 unit low-income housing tax credit (LIHTC) property, located in Rising Rents, USA. But Gerry was a “glass half-empty” guy. As he tried to relax aboard his 34 foot Tartan sailboat, becalmed on the waters of Lake Erie, the future of Good Life Lofts weighed on his mind.
The property metrics were burned into his brain – an estimated value between $15M – $16M, $4.5M of secured debt, pre-payable in 2016 with a $250K penalty, and modest annual cash flow. The tax credit compliance period ended in 2018. Randomly, he recalled a recent NH&RA conference and a panel addressing opportunities for LIHTC properties with value.
“Values have never been higher; interest rates are low, for everybody but me,” he lamented. “My property has value and I want some of that.”
Gerry loved the idea of cashing in his proverbial chips and retiring but he felt conflicted. The parent in him wanted to help out his children by generating more cash flow at the property or giving them the opportunity to become owners/developers themselves.
Questions swirled in Gerry’s mind. Do I sell or do I refinance? If I sell, do I just go with the highest bidder or should I have my kids buy me out? Should I stay in the tax credit business and do a rehab? Do I want to be tied into another fifteen years as a general partner, with guarantees, risks, etc.? Unfortunately, the answers to Gerry’s questions were not simple. Curious about his options, Gerry called his accountant, Ned Numbers.
“Read the partnership agreement,” Ned suggested. “You need to start by knowing what rights you have.”
As Gerry waded through the agreement, each page left him feeling confused. He was certain of one thing: When he originally negotiated the investment with his limited partner, Insatiable Investor, they had agreed that the GP would receive 80% of any sale or refinancing proceeds.
Gerry’s next call was to his lawyers, Careful Counsel LLC. “Hello! This is Gerry General. Cara Court represented me years ago. Can I speak to her please?” Gerry asked the receptionist.
“Oh, I’m sorry, Mr. General,” the receptionist responded. .”Ms. Court retired a few years ago. I’ll connect you with Larry Lawyer. He’s our most senior lawyer in the affordable housing group now. He is out of the office, playing in a charity golf event, but I will give you his voicemail.”
Gerry left Larry a detailed message and summarized. “I might sell or I may just refinance. I was hoping you could help me figure this out.”
Good News/Bad News
After reading the partnership agreement, Larry Lawyer returned Gerry’s call. “Gerry, I have some good news and some bad news.” Larry began. “Let’s start with the bad. You can’t do anything with this property without Insatiable Investor’s consent. You can’t sell except at a price that they approve and you need their okay to refinance. That consent is at their discretion.
“Just as bad, while it is a great time to be a seller, selling and splitting the proceeds may not be as favorable as you think. If Insatiable has a positive capital account, Insatiable gets repaid that before you receive anything. It’s likely this will radically change the ultimate back-end splits.”
“What’s the good news?” Gerry asked nervously.
Larry responded, “Nothing is imminent. You have time to examine your options and negotiate. The folks at Insatiable are generally pretty reasonable and believe in long-term relationships. Adam Aggressive is the person at Insatiable in charge of dispositions. I suggest you start by talking to him. Just so you know, most investors prefer to negotiate without attorneys. They want to deal directly with their principal. I will get involved if need be.”
Gerry and Adam Aggressive don’t agree on much
When he reached Adam, Gerry explained that he was thinking about either staying in the tax credit program or just selling. “Either way, I’d like my kids to own the property. And, of course, as a last resort, I could always just refinance my mortgage and do nothing.”
Adam told Gerry he would review the partnership agreement and the latest financials and call him back. Two weeks later, he called.
“Hi Gerry, we ran the numbers on Good Life Lofts,” Adam said. “If you sold it for the high end of the value range, at $16 million, after you paid off Friendly Finance and the usual transaction fees, plus a broker, you would get almost $6 million and we would get $5.4 million.”
Taken aback by the unexpectedly low number, Gerry quickly corrected him. “Whoa, Adam, either you misspoke or you miscalculated. I get 80% of the net proceeds from a sale. That should be closer to $9 million to me!”
“I can see why you might think that, Gerry,” Adam said. “But, in a sale, the 80/20 split only occurs after we get back our positive capital account. According to the last K-1, Insatiable is nearly $4 million positive.”
“This can’t be possible,” Gerry said impatiently. “Are you sure you are looking at the right agreement? When I brought you this deal, I insisted on an 80/20 back-end split. Your investors would get the ten years of tax credits and I planned on getting the long-term appreciation. Ask Oscar Oversell and Clive Closeit in your shop about this; we did several deals together. They know the business deal we struck. I have a long history with your company and would love to do more, but not if this is how you treat your friends.”
Adam responded, “Sorry Gerry, but Oscar and Clive were laid off in the downturn of 2008. Our company was sold to a group of investors. New owners, new ball game. My job is to maximize proceeds for our investors. And, by the way, Gerry, you did this deal for the huge developer fee, not for residuals. We both got lucky that this deal has value. Gerry, you can check this out with your accountant and lawyer, but what I said is how it works in a sale.”
With his voice rising, Gerry pushed back.” What if I just decide not to sell and I refinance my mortgage instead? I know I get 80% of those proceeds.”
Adam followed with yet another roadblock, “You would get 80% of refinancing proceeds. But you need our consent to do that. Frankly, we would prefer that you just sell on the open market. It’s easier for us. Our investors can get out at a price determined by the market. I don’t get interrogated by our investment committee. Getting approvals to anything but a market sale takes time and the investment committee will tear me apart if I present a deal that doesn’t make sense.”
Adam continued, “If you don’t want to sell, you do have another option though. You can buy us out.”
“At what price?” Gerry asked angrily.
“The same price; just as if you had sold and divided the proceeds,” Adam explained. “And, remember, as the Special Limited Partner, eventually Insatiable has the right to ask that you market the property for sale. If that doesn’t result in a sale, we can sell the property on behalf of the partnership.”
“What if I don’t want to sell?” Gerry asked angrily.
“You have to buy us out as if you had.” Adam replied gleefully. “And one last thing, we would love to do more deals with you but we have to keep things separate. I can’t be seen as selling out one group of investors to benefit a different group.”
An unhappy, disillusioned Gerry parted, by ending the call. “Honestly, Adam, I couldn’t be more disappointed. I thought we were partners. I’m calling my lawyer. He’ll straighten this out for me.”
Gerry then recounted his conversation with Adam in an exasperated voicemail to Larry. “Call me as soon as you can!”
Gerry and Larry Evaluate the Situation
After listening to Gerry’s hysterical rant, Larry invited Gerry to talk through the options in a calmer setting. Together, they calculated splits from a sale. Adam was correct. A sale, even at $15M, would result in Gerry receiving less than 45% of the net proceeds, a far cry from what Gerry anticipated.
Gerry insisted, “But what Adam says is not what the deal was supposed to be. Larry, you have to fix this. I didn’t do this deal to make the folks at Insatiable rich.”
“Gerry,” Larry offered. “Refinancing might generate sufficient proceeds to buy Insatiable’s interest now. You can decide later what your long-term strategy is. I think that is worth looking at. Let me talk with Insatiable’s lawyer and see where I get.”
Debating the Contract Language
Larry again reviewed the Good Life Lofts partnership agreement. He compared the language in the Good Life Lofts agreement to the text found in other agreements he’d closed over the years, some signed before and some after the Good Life Lofts agreement was executed.
While the exact language varied from investor to investor and even within the same investor portfolio, Larry noticed an evolution. At some point, agreements for Insatiable’s deals started to include a reference to a sale pursuant to the “qualified contract” provision of the Tax Code. Next, the “qualified contract” sale language was augmented by the insertion of the phrase “and/or to take such other action permitted or required by the Code…to effect a sale…” This text appeared in the Good Life Lofts agreement. Insatiable’s most recent agreements no longer contained those words. Instead, the agreements explicitly gave Insatiable a right to force a sale a year or two after the compliance period ended.
Why, Larry wondered to himself, had Insatiable changed its language if – as they were suggesting now – the language already allowed them to force Gerry to sell?
Larry answered his own question in a voicemail message to Insatiable Investor’s lawyer, Allison Attorney. “I read this partnership differently than Adam did,” Larry explained. “Clearly your client has changed this provision multiple times over the years. I think you knew the language in the Good Life Lofts partnership agreement was not clear so you improved it. I don’t think Insatiable can force Gerry to sell. And, even if you can force a sale, that’s years away and a lot could happen between now and then. Let’s talk and I can share my analysis with you.”
Coincidentally, as Larry was calling Allison, she was calling him, having heard from Adam. Allison left a message, focusing on the refinancing.
“Gerry can’t refinance unless we consent,” Allison said. “The agreement says that consent is ‘at our sole discretion,’ so Insatiable has the absolute discretion to say ‘no’ to a refinancing.”
After hearing each other’s messages, the lawyers talked live.
Larry asked, “Why would Insatiable object to a refinancing?” A refinancing would clearly be in the best interest of the partnership. Is Insatiable saying ‘no’ to refinancing just so it can try to force Gerry to sell the property and get more money? How do you square that with Insatiable’s fiduciary duty to the partnership.”
Allison tried to lower the temperature. “Larry, Larry – calm down. You know that Insatiable’s first obligation is to its investors. Having said that, I may not agree with you, but I at least see what you’re saying,” Allison said. “We should try to resolve this. Talk with Gerry and send us a proposal in writing. We will try to work with you. We’ve done lots of deals together and most have turned out pretty good for both sides.”
Gerry and Larry Propose a Deal
Gerry and Larry put pen to paper, outlining a proposal. A sale was out of the question as it resulted in Insatiable reaping the lion’s share of proceeds. But a refinancing at $11.0 million, with $5.0 million of costs, would leave $6.0M in net proceeds.
Together, Gerry and Larry called Allison
“Allison – Gerry and Larry here…
“We would like to work through what we are thinking before we send it to you. No sense going through the exercise if we are not likely to get to “yes.” Can we schedule a call with you and Adam?”
Within minutes, Allison replied by sending a calendar invite for a conference call. An hour later, Larry, General, Adam and Allison conferenced.
Larry Lawyer started the conversation, “Listen, Gerry doesn’t have to sell and even if you really think you can force him to, you can’t even start that process for five years. Do you really want to bet on what the market will be then?
“Why not let Gerry refinance, pay off the permanent loan and use the rest of the proceeds to buy your LP interests and put a little money in his pocket. Gerry can decide later what his estate-planning objectives are – maybe he sells, maybe he does another LIHTC deal, maybe, maybe…We part friends, Insatiable comes out well, your investors should be happy.
“We really are not interested in a lot of back and forth negotiating,” Larry asserted. “Allison, you’ve known me for years; it is not my style to drag things out.
“What would you think about $1.5M to buy your interests, closing at the end of the year or earlier if you want, tied in to when the refi closes. Insatiable consents now to a refi and stays out of that process You get all your fees through year’s end and your share of any cash flow this year. We sign all the necessary documents now. You can hold them in escrow. .And how about a $200,000 deposit? And if we can’t do the refi by January 1, 2016, we return all the documents and start all over. Sound fair?”
Adam replied, “We may need to put some parameters on the refinancing. What you suggest is within the ballpark of other deals we’ve done. But, how do we know that once you get our agreement to be bought out, you won’t then sell?”
Larry answered, “You’re consenting to a refinance. If Gerry pays you the $1.5M by year’s end, you are agreeing to be out, regardless. Whatever happens after that happens. Pretty simple!”
Adam asked, “Can you put this all down in writing that I can attach to my memo to the investment committee? There is a committee meeting later this month and if we get on that agenda, with a little luck, we can have an agreement in principle by month’s end.”
To which Larry responded, “Sounds like a plan.”
Getting to “Yes”
Larry drafted the formal proposal and sent it to Allison. Ten days later, Adam reported that the investment committee was concerned that Gerry would do a “mammoth” refi and 20% of net proceeds would be greater than the proposal. So Insatiable offered to do the deal at $2.0M with no strings attached.
Gerry gulped hard, muttered to himself. But his lawyer advised, “Gerry, Gerry, Gerry, just say ‘yes.’ You’ll still own Good Life Lofts. And you will still retain lots of options. What’s not to like?”
And so Gerry General completed the deal.
Gerry’s Fatherly Advice to Gina and Gregory General
We are all set with Good Life Lofts. I have decided I am having too much fun to retire and I have a lot of relationships I value. We are going to stay in business together.
As your dad, let me tell you what I would do differently if I had a “do-over.”
While reading agreements is what I pay lawyers to do, I wish I read everything and asked questions. It is a worthwhile habit to be in. Treating my investors like my business partners (not just my money suppliers) and meeting with them, with open and not infrequent communications, could have saved me a lot of tension and heartache. I should have offered to go to dinner with them. They almost always pay.
Larry taught me that the best time to think about the “exit plan,” is before you actually need one. The “entry” documents should provide for the “exit” you want.
One thing not to change is going to NH&RA conferences. They always add value.
