In this article, you will learn more about the (1) meanings,(2) main difference of the terms “recapitalization” and “acquisition”, (3) when they should be used and (4) how you could improve it to use on your future transactions.
When a sponsor opens the way to investors, the property they want could just recently been purchased (or under contract), or the sponsor will have already bought it using a different financial structure than the one suggested.
Its main distinction is between purchase and what is known as a recapitalization (or “recap”) of the real estate.
The property in an acquisition is new to both the sponsor and the investor.
To summarize, the sponsor already owns the property and aims to replace the present capital structure with a new one through additional debt (most likely) and new investor financing.
Investors should be aware of the subtleties associated with this type of financing before choosing to participate in a real estate recapitalization (or “recap”) rather than a straightforward acquisition.
Improved Recapitalization
Recaps typically fall into one of two categories.
One is where the sponsor will increase their base during the recap.
That would be the case if they had purchased the asset a few years prior and wished to sell, say, 20% of the partnership that owned it.
They will set the price based on an additional value in this case.
This type of recap is frequently observed, where a sponsor closes a deal using their stock and then quickly recapitalizes the venture without ramping up the basis.
With investor funds, this process is known as “backfilling.”
In certain situations, a sponsor may accept an acquisition or finance fee based on the amount of stock obtained, but would not otherwise profit from the deal.
Recaps happen when a sponsor is scaling up the basis, and are often avoided by skilled investors because they may result in a valuation risk if an asset isn’t valued by the market.
It raises concerns about the methodology used to arrive at the recapped value and how it compares to the actual worth of the asset.
Even though the assessed value and the actual market value of the asset are equal, if a sponsor makes money off of a recap, there may be a conflict of interest.
Let’s look at an example where a sponsor wants to acquire an asset and requires $3 million in equity to complete the deal.
In the case of a no-step-up, the sponsor would provide $3 million of their stock to speed up the closure and then start syndicating that money to investors as soon as the closing was complete.
Alignment of Interest
A sponsor could have paid $10 MM for a property five years ago, and today it is worth $20 MM, under the step-up scenario.
In this scenario, the sponsor may obtain funds by selling a 20% stake in the partnership that owns the property, keeping a portion of the proceeds.
In fact, given that they could have sold out and pocketed a profit, they might lead up having negative equity in the home.
In rare circumstances, a sponsor could create a brand-new company to recapitalize the structure.
Concerning the example, the sponsor may raise $5 million in equity, where they may also ‘donate’ $1MM.
Due to the step-up, the sponsor is technically cashing out because they are not adding any new funds to the recapitalized agreement; instead, they are realizing $5MM from the sale of their initial ownership position and leaving $1MM of that gain in the project.
Naturally, having a sponsor recapitalize a property has benefits. The sponsor is probably highly familiar with the buildings, and the risks of missing something during the due diligence process are reduced.
To maintain a healthy alignment of interests, firms must make sure that the sponsor has a meaningful co-investment in the recap, that they bring fresh money to the table that is net of all fees and is not made up only of paper gains from property appreciation.
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