Just Whose Partnership Is This Anyway?
by James M. Vodola
If you purchased an interest in a real estate limited partnership during the Eighties, it appears that your time has finally come. Prices of commercial real estate are soaring, fueled by property hungry REITS and low interest rates, creating the best seller's market seen in a dozen years. Now is the opportune moment for you to get out of what has probably been, at best, a mediocre investment.
Limited partnerships are the least efficient form of ownership from a limited partner's standpoint. The high cost of maintaining a small public entity, combined with profit sharing arrangements and fee structures that may work to the detriment of limited partners, severely dilute returns from increasingly valuable real estate.
Some general partners have recognized the selling opportunity and are fulfilling their responsibilities through the orderly liquidation of the real estate portfolios they manage and distribution of sale proceeds to the limited partners.
But, there are many general partners who, rather than maximizing returns for limited partners, are devising exit and takeover strategies designed solely to further their own profits and organizational growth. These strategies are at the direct expense of the limited partners to whom they owe the highest trust.
Two of the primary motives for this conflict are the back-end or subordinated nature of the general partners' interests in the partnerships and the desire of the general partners to grow their organizations.
Most limited partnership agreements provided that until the limited partners received all of their original investment plus a cumulative, percentage return, the general partner received no equity distribution. Since almost all partnerships have not performed as anticipated, general partner interests are usually worthless. As for selling the partnership's assets, to do so would cause the general partner to forfeit the management and other lucrative fees upon which it has come to rely to sustain its empire
These dissonant interests have inspired several investor hostile strategies. Generally, one of the most harmful of these strategies is the insider tender offer.
The "Tender Offer" is, in our opinion, the worst form of general partner exploitation because the limited partners are held virtual hostages to their investments. The sale of units by limited partners is an extremely difficult and unregulated process that usually results in a substantial loss. A substantial portion of the loss is known as a "Liquidity Discount." This discount can be as much as sixty percent of the real unit value and is a function of several factors including the difficulty in evaluating and selling limited partnership units and the limited partners' uncertainty as to when the partnership will be liquidated. The obvious solution to the liquidity problem is the sale of the partnership's assets and distribution of proceeds, but many general partners have adopted the strategy of not selling the real estate, perpetuating their own income stream, and suppressing distributions to the limited partners. The result of this strategy is investor frustration with an investment that produces no material returns.
Exploiting the liquidity dilemma, a problem that sometimes appears to have been deliberately created, many general partners have made offers to purchase the units of their limited partners for prices substantially less than what could be distributed if the properties were sold on the open market. This strategy concentrates partnership units purchased cheaply in the hands of the general partners while holding the non-tendering limited partners hostage as their percentage ownership of the partnership declines.
Offers from general partners to purchase your units, accumulation of cash in the partnership's accounts, suspension of distributions, paying down of mortgages and failure to sell properties are some signals that your general partner is reluctant to end your partnership.
The "Roll-up" is another strategy that in many cases can benefit the general partner disproportionately to its economic interest. Simply stated, a roll-up is the combination of several individual partnerships under the control of the same general partner into a larger, ideally, publicly traded entity. The entity of choice into which real estate partnerships are consolidated is usually the REIT. When soliciting the consent of the limited partners to implement these consolidations, general partners often cite liquidity as the primary benefit. Units of the individual partnerships are valued and exchanged for units in the new entity based upon the valuations. The general partner, frequently without independent verification, often prepares the valuations. To support the concept of the new, rolled-up entity, an investment banking firm is often retained to furnish a fairness opinion. These opinions are often predicated on the general partner's unverified valuations and supported by complex economic models based on projections of future property performance. On the basis of these models these firms then state that "the roll-up is fair to the limited partners from a financial point of view." This proclamation of fairness does not necessarily mean that the roll-up value is equal to or greater than the proceeds you would receive if the real estate in your partnership was sold and the proceeds of sale distributed to you for reinvestment.
Also, usually not clearly explained in the proxy statement, the written materials describing the transaction, is how the general partner, whose share of ownership of the partnerships is often no more than one percent, winds up owning a material portion of the new entity. This ownership windfall insures the general partner the right to manage this new, substantial company, indefinitely. This new arrangement frees it from the covenants of the original partnership agreement and bestows a new and lucrative package of compensation from the new entity.
The general partner pays nothing for this substantial economic benefit, and, typically, paid little or nothing for its general partner interest in the original partnership(s).
Tender offers and roll-ups are only two of many general partner originated strategies that might not represent the best interests of the limited partners. If you are solicited to sell your units or vote on any type of major transaction, I recommend that you consult your investment advisor.
In the meantime, if your general partner has not been selling or at least suggested its intention to sell partnership assets you should be asking why.
James M. Vodola is the founder and President of Partners Advisory Services Corp., (Pascorp) a real estate consulting firm specializing in Limited Partnerships and REITS and a Certified Public Accountant with over twenty years of real estate industry experience. Pascorp has acted as the real estate expert in litigation that has resulted in the payment of hundreds of millions of dollars to investors in real estate Limited Partnerships. He is also a Professor of Real Estate Appraisal at the Newman Real Estate Institute at Baruch College in New York City.
Reprinted from the Partnership & Reit Litigation Newsletter, Autumn Issue, 1998.