A primary concern in structuring an equity partnership between an investor and a developer is to minimize the downside risk to the equity investor while providing a substantial incentive to the developer to maximize project returns and general operational performance.
Still, the developer/investor relationship is symbiotic. A developer requires the capital offered by the equity investor. This is not necessarily limited to the upfront capital provided, but to the financial stability often presented by a secure equity partner in the ever-changing and incredibly volatile development industry. However, it is widely accepted that most equity investors do not develop projects for themselves. Instead, a joint venture is often established between an experienced developer (or development firm) and an equity partner (or private equity firm).
Often, development partners are relied upon by equity firms for project management and operational control. While this may vary based on the desired level of involvement by an equity partner, developers often take on the active, daily responsibilities associated with large projects. This includes land assemblage, permitting, entitlements, design, contracting, marketing, leasing, etc.
In exchange for project control and recurring development fees, a developer is often looked upon to provide construction lenders with personal or corporate guarantees – indemnifying the equity partner from any financial recourse in the event of default.
Because institutional money is generally not available to fund “pursuit” costs, equity investors must directly fund predevelopment expenses before project land and financing is a viable funding source. Often interpreted as the riskiest capital required in the development process, if a developer utilizes external capital to fund raw land development, the cost of this capital is often well above market rates due to the high levels of risk commonly associated with the development of raw land.
Perhaps the most critical economic concept in the structuring of any investment is to achieve the appropriate risk-adjusted return for all levels of investment. The greater the overall risk of the investment (whether in terms of leveraged capital structure, the timing of investment, security for investment, etc.), the greater the level of return required. Regardless of a project’s capital stack, it is understood that projects where mortgage debt and mezzanine loan/equity exceeds 85-90 percent of total costs carry the risks of equity, and should bear correspondingly higher equity returns. This is most often the case with the equity requirement for raw land development.
Aside from the logistical and financial obstacles commonly associated with raw land development, equity investors face the hurdles of all parties in a senior position within the capital stack. Equity is typically the last money out of a land development deal, and therefore, at the highest risk of not being paid back in the instance of any monetary shortfalls.
Equity investors often focus on structuring projects so that cash flows and capital proceeds are split between all equity parties. This is done to minimize the downside risk to each equity investor, while at the same time establishing incentives to the developer to perform above project expectations. Through pre-established performance hurdles, investors receive minimum target returns before substantial cash flows are made available to the developer. Commonly referred to as “pari passu” (or “waterfall”) equity, this structure enables both the investor and developer of raw land deals to obtain some nominal return on capital prior to the large payoff at the end of the project.