I could see the signs of concern in her eyes when she asked worrisome: “Does it mean I will get bought out at refi?” This is a question I frequently receive from investors and pertains to the impact of refinance on one’s passive investment. In today’s snippet, I will demystify exactly that.
Cash
In a prior article I discussed the different waterfall structures and how the distributions flow through that. So what happens if the sponsor determines that they want to do a cash out refinance?
The refinance proceeds will typically follows the waterfall structure established at the onset (and documented in the PPM). Usually the sponsor would first pay any catch up distributions accrued from the preferred return due but not yet paid, then they would pay down the principal investment of the LP (or a large share thereof), and lastly any excess profit would be split as per the LP-GP ownership share (for example in a 30%-70% GP-LP split, the LPs will capture 70% of such excess proceeds and the GPs the remaining 30%). Thus, ultimately the LPs will be taken care of first. Note: If the principal repayment ranks lower in the waterfall, then the profit split will precede it.
The LP investment principal pay down or pay off does not dilute the ownership share. Instead it simply returns the principal and accumulated returns due but not yet paid back faster. The LP can then choose to reinvest such principal in other deals.
Post pay out, any preferred return would be based on the new capital account / principal balance. If such balance is zero, i.e. if the principal was fully returned to the investor, a pref would not accrue. Instead, the waterfall will follow the established profit split (e.g. 70% LP and 30% GP in the hypothetical example above). Some deal structures will change the profit split once a certain IRR hurdle is met. Therefore, if such cash out refinance meets that IRR hurdle (typically that means the principal is paid back), the profit split will change according to the new schedule established in the PPM at the onset of the deal (e.g. the split may change from 70% LP and 30% GP to 50% LP and 50% GP). This type of structure keeps the GP motivated to outperform projections and return principal back to the investors sooner.
What happens if the sponsor performs a cash in refinance? Unless principal is returned back to the investor, nothing will change – they will continue to receive or accrue the preferred return with profit split remaining intact. Any catch up distributions along with the gain from sale will be paid out at exit, if the deal performs. A sponsor may choose to perform a cash in refinance, if they are in need of additional capital. That is good way to source such capital utilizing the built in equity of the deal vs. doing a cash call from investors.
Tax
There will be no tax due on the cash out or cash in refinance proceeds because the source of such proceeds is debt. In a cash out refinance scenario where principal was returned to the investors, the capital account for K1 purposes will be reduced by the distribution amount.
I hope today’s snippet was helpful in demystifying the impact of refinance on the investment and removes any prior fear or concerns of such event.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.