This blog looks at what unit pricing in an investment program offering means to your investors and how to determine whether such pricing treats all investors “fairly.”
Investing in units of membership interests in a limited liability company used to be straightforward. Units were often available through one distribution channel, primarily the independent broker dealer (IBD) channel. Other unit types were commonly offered behind the scenes or through separate PPMs. Today, more and more programs are offering units through both the IBD and the registered investment advisor (RIA) channels. And complicating things further, units are also offered through RIAs affiliated with IBDs.
On the most straightforward basis, sponsors offer one class of units and provide for the waiver of selling commissions to RIA purchases and certain other parties (sponsor affiliates, selling group members, etc.). Under this scenario, an investor acquiring units on a commissioned basis would pay the full purchase price. For instance, at a $1,000 unit price, the program would net $900, assuming 10% underwriting fees (7% selling commission, 1% marketing reallowance, and a 2% managing broker dealer (MBD) fee). Pure RIA investors would pay $900 for the unit (assuming the full MBD fee is waived—which is not always the case), and the program would net the same $900. RIAs associated with IBDs would pay $910 per unit, and the IBD would keep the 1% marketing reallowance for its efforts, and once again, the program would net $900 a share.
Now comes the tricky part.
How do you determine an equitable preferred return and return of capital for the three types of investors? Traditional practice for IBD-distributed programs is that investors receive a return of capital and a preferred return on the gross investment amount of $1,000 per unit. The equivalent of this for RIA investors is typically accounted for as a gross-up of the number of units received. For example, the RIA pays $900 and receives a return of capital and a preferred return based on the full $1,000 unit price. Therefore, RIA investors receive a higher preferred return based on their actual purchase price and accretion of the load since their return on capital is based on the unit price rather than the amount of contributed capital. Let’s look at an example.
|IBD||Pure RIA||Associated RIA|
|Net to the program||$900||$900||$900|
|Preferred return (annual)||6.00%||6.67%||6.59%|
|Accretion of load (annual)||0.00%||1.11%||0.99%|
The example is based on a five-year hold and assumes that investors do not share in distributions over the preferred return, which is not usually the case. The spread narrows as the holding period expands since the accretion of the load is recognized over a longer holding period. For example, the annual returns based on a 10-year hold are 6.00%, 7.78%, and 7.58%, respectively.
One thing to note is that this analysis only applies if the distribution waterfall is based on the unit price times the number of units rather than the actual capital contribution. A common drafting error is that the offering documents provide for the waiver of underwriting fees. Still, both the preferred return and distribution waterfall are calculated based on the amount of contributed capital, which effectively negates that commission waiver.
Another method sometimes used by sponsors is to increase the preferred return to RIA investors to account for both the accretion of the load and the calculation basis for the preferred return. This is often accomplished through the issuance of two distinct classes of units. For example, a 9.00% preferred return on a $1,000 unit price would equate to a 12.57% preferred return on a $905 unit price. When a sponsor takes this approach, it must assume a specific holding period to determine an appropriate preferred return. In either case, the economic results are substantially the same as providing additional units to RIA investors.
Is this treatment equitable?
At first glance, this result might appear inequitable in favor of RIA investors; however, we need to consider the other end of the equation. Most RIA investors pay separate asset management fees ranging from 1% to 2% or more. Here’s what happens if we introduce a 2% asset management fee.
Simply put, the 2% asset management fee would reduce the annual return by 2.00% across the board. However, the impact is slightly higher (around 2.18% for pure RIAs assuming the entire year’s earnings are subject to the management fee) if the preferred return and load accretion remain in the account and are also subject to the management fee. The breakeven management fee for a pure RIA over five years relative to a commissioned investment is approximately 2.65%, and for an associated RIA is approximately 2.40%. And so, the breakeven declines to 1.65% for a pure RIA and approximately 1.50% for an associated RIA based on a 10-year hold.
In general, giving RIA investors credit for the full unit price rather than the capital contribution is an equitable method of treating investors. However, disparities in returns can result based on the actual holding period of the investment and the asset management fee being charged by the RIA.
What does this mean to investors?
Ultimately, it's essential to assess equitability across investor types to ensure all investors are rewarded for the risk they are assuming. The standard practice of providing additional units based on the share price is generally equitable. However, RIA investors with lower asset management fees can receive a higher return than fully-loaded commissioned investors. However, when the sponsor uses these methods of price units, it's important to run the numbers to ensure the economic impact is consistent across investors.