Syndication BreakdownDeal structures, distribution waterfalls, and the sponsors who run them

Offering DocumentsNil Masferrer Jiménez

The Operating Agreement: Control, Voting and Removal Rights

The memorandum describes the deal. This document is the deal. Where they differ, this one wins, and it is the one most investors have not opened.

The private placement memorandum describes the offering. The operating agreement — or limited partnership agreement, in an LP — is the offering. It is the contract, it governs, and where its terms differ from the memorandum's summary, its terms are what you own.

It is also the document most investors do not open, partly because it arrives last and partly because it is written in a register designed to discourage reading.

Six provisions do most of the work.

1. Distributions

The real waterfall, including the definitions it depends on. Frequently two waterfalls: one for operating cash flow and one for capital proceeds.

The memorandum's one-sentence summary — "8% preferred, 70/30 above it" — is a compression that loses the catch-up, the tier order, and the definitions of Preferred Return, Unreturned Capital Contribution, Available Cash Flow and Capital Proceeds. All four are in this document and all four change the arithmetic.

2. Voting rights

A short list, and its shortness is the point. Typically: sale of substantially all the assets, amendment of the agreement, dissolution, and admission of new members in some structures.

Not on the list: which property manager to use, whether to refinance, when to sell within the manager's discretion, how much to hold in reserve, whether to renovate, and whether to distribute.

Read the thresholds. A vote requiring a majority of the interests is achievable. One requiring a supermajority means that a sponsor holding a meaningful interest, or a group of aligned investors, can block anything.

3. Removal

The provision that matters most when everything else has failed. See GP removal for the detail. Three questions:

  • Is removal permitted for cause only, and how is cause defined? A definition requiring fraud, gross negligence, willful misconduct or a criminal conviction excludes poor performance entirely.
  • What threshold is required? A supermajority of investors who have never met each other is a substantial practical obstacle.
  • What happens to the sponsor's economic interest on removal? Many agreements let a removed sponsor retain its promote.

4. Capital calls

Whether additional capital can be required, what happens if you decline, and on what terms new capital enters. See capital call provisions.

The clause to find is the consequence of non-participation: proportional dilution, punitive dilution at a stated multiple, or conversion of the contributed amount into a priority position ahead of everyone who declined.

5. Transfer restrictions

Why the interest is illiquid. Transfers generally require the manager's consent, which may be withheld at its discretion, and are restricted by securities law because the interest is unregistered. Some agreements add a right of first refusal.

There is no market, and this provision is why.

6. Indemnification and the standard of care

Usually broad. The sponsor is typically indemnified by the partnership for anything short of fraud, gross negligence or willful misconduct — meaning the partnership's own assets, which are your money, fund the sponsor's defense.

Read the standard of care alongside it. Many agreements reduce the manager's duties to the maximum extent permitted by the governing state's statute, which in some states is considerable. A clause disclaiming fiduciary duties is legal in a number of states and worth knowing about.

Amendment provisions, which decide how stable the rest is

One clause governs how much the other clauses are worth: what it takes to amend the agreement.

Three patterns appear. Amendment by member vote, usually a majority or supermajority of interests. Amendment by the manager alone for specified purposes — correcting errors, complying with law, admitting members — which is ordinary and narrow if the list stays narrow. And amendment by the manager alone, more broadly, provided the change does not adversely affect members disproportionately, which is considerably wider than it first reads.

Two things are worth locating. Whether the distribution provisions can be amended without a member vote, and whether new classes of interest can be created without one. A manager who can create a senior class unilaterally can restructure the economics of the deal without asking anyone, which is the mechanism by which rescue capital sometimes arrives.

Where the agreement and the memorandum part company

The most common defect in an offering package is not concealment; it is compression. The memorandum summarizes the waterfall in a sentence, the agreement sets it out in five tiers with four defined terms, and the sentence loses information.

Read them in that order — summary first for orientation, agreement second for authority — and list every difference. Most will be innocent. Each is worth raising, and the quality of the explanation is itself informative, because a sponsor who cannot reconcile their own two documents has not read one of them recently.

Reading it without a lawyer

Having counsel review it is the right answer where the investment is large enough to justify the cost. Where it is not, the document is still readable, because the six provisions above are concentrated in identifiable places.

That last step is the one that pays. Differences between the summary and the agreement are usually innocent compression rather than intent — and the compression always runs in the direction of making the deal sound simpler than it is.

Primary sources

Every factual claim above is traceable to a filing, a rule or an agency publication. These are the ones this article relies on.

  1. SEC, private placements under Rule 506(b)sec.gov
  2. IRS, Publication 541 on partnershipsirs.gov
  3. Legal Information Institute, 26 US Code 704 on a partner's distributive sharelaw.cornell.edu
  4. Investor.gov, private placements explainedinvestor.gov

Questions readers ask

What is the operating agreement in a syndication?

The contract governing a limited liability company: who controls it, how money is distributed, what investors vote on, how interests can be transferred, and when the manager can be removed. In a limited partnership the equivalent document is the limited partnership agreement.

Does the operating agreement override the PPM?

Yes. The memorandum summarizes and the agreement binds. Where a summary compresses the waterfall into a sentence and the agreement sets out five tiers, the five tiers are the deal.

What do limited partners actually get to vote on?

Usually a short list: a sale of substantially all assets, an amendment to the agreement, admission of new members in some cases, and removal of the manager for cause. Operations are not on the list.

Can I negotiate the operating agreement?

Essentially never as an individual investor. The terms are set before the offering circulates and apply to the whole class. The document is a decision input, not a negotiating position.

What are the most important provisions to read?

Distributions, voting thresholds, removal, capital calls, transfer restrictions and indemnification. Six provisions, and they determine almost everything about what happens when a deal goes badly.

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