What you need to know to take control of the outcome
Effective agreements for holding and managing assets don’t have blind spots – or do they? Partnership agreements of one sort or another have legal objectives to be sure, but they often have valuation objectives as well. These valuation objectives can be extremely sensitive to facts & circumstances outside the agreement. This is not about missing legal matters, but about missing other facts that underlie valuation matters, and that have an effect on the overall goals of the lawyer’s engagement.
The lawyer can have better control of the results by engaging in a simple exercise. Imagine a due-diligence consultation in which the hypothetical buyer of the interest is now your client. What facts and issues (about the family, other partners, financing, their plans, etc.) would you raise with this client? The appraiser will eventually be looking at the same information, which, in addition to the agreement, will form the basis for valuing the ownership interests. Your early detection can bring the overall outcome more directly under your control.
This can be helpful in many ways; for example, when choosing between structural alternatives. Whether to go with an LLC, LP, general partnership or just deeded property interests as tenants-in-common, the choice is partly based on how each will affect the value of individual interests.
There is a long list of agreement provisions that can set up valuation effects from blind spots: Swing vote benefits can result from the selection of voting thresholds; confidentiality provisions and refusal rights can obstruct entry or even assignment; uncertainties can be created by granting specific manager discretion; capital calls can cast an onerous pall over the future; having some control can reduce risk (and discounts) but the prospect that others also have control can act the other way; the ability to block decisions can turn out to be extremely valuable, or worthless; and various types of exit provisions can string out the expected holding period or cut it short. This is not an exhaustive list.
Exits are probably the biggest issue, since the longer an interest-holder is “trapped” in the investment, the greater the discount. Exits are affected by many facts relating to owners, leases, financing, property markets and others. One type of exit provision is the subject of this case study.
It is not within the purview of a valuer to deal with the legal ramifications of agreements, but it is entirely within a valuer’s scope to get inside the thinking of, say, the minority interest holder, and interpret the options and risks attributable to that interest. The valuation question is largely “how would a buyer price the interest, and why?”
This month’s study of an actual valuation case illustrates how the balance between partner exit rights and other facts comes into play when asking a fairly difficult question: “What is the fair market value of this minority but sort-of-controlling interest?”
An agreement between four families as tenants-in-common was intended to provide all a voice in management decisions, although the partners had historically taken their guidance from one partner based on his amazing real estate skills. The agreement was also intended to prevent legal action in the event that any one of them wanted out. It didn’t waive partition, but it provided a refusal right to the others that would allow them to purchase the interest at its pro rata share of the whole; they could take out the exiting “partner” at the amount it would receive through a partition lawsuit, thus saving all a lot of trouble. This is essentially a “put” clause, effectively giving a right to put the interest to the others at its pro rata share of the whole. Good for exits, but generally bad for discounts.
The valuation was for the estate of one of the partners, so the interest included all the rights that the decedent held. (Even if a gift, the rights that transfer could still include the put.) By itself, this clause would have eased the exit path and removed much of the interest’s marketability impairment that leads to price discounts; however, many other facts & circumstances also influence discounts, and this case was no exception.
These other influences overwhelmed the agreement provisions in a direction that happened to be beneficial. The discount ended up at 39%, fairly high for a largely consent enterprise with an exit provision. A much lower discount would have resulted from ignoring family and property facts.
The moral to this story is that clauses have consequences, but so do facts – and all must be considered for the analysis of value to be credible and the goals set up by the agreement to be achieved.
This case involves four families who came together in 1957 to build and lease a light industrial/office building in Los Angeles. It has been leased to the same aerospace company since that time, and the lessee has been continuously renewing its 5-year options. The managing partner has always been Dan Developer, a real estate genius who has consistently and successfully developed many properties, nearly all with partners. By now the families rely largely on income generated by his projects.
The original limited partnership was dissolved in 2004, and the property distributed in kind to the four families, in equal parts. They entered into a cotenancy agreement, which named Dan as supervisor, although operations were to be managed jointly by the cotenants. The agreement had a 25-year term, provided for capital calls, required distribution of net revenues, and allocated distributions pro rata. Management decisions required more than 50% approval (3 votes of 4), except for borrowing and selling or leasing the property, which required unanimous approval.
The agreement allowed interest transfers, but subject to an interesting first refusal right. Rather than trying to give up the state’s absolute right to partition, it provided a “right of first offer for partition” where a cotenant desiring to bring a partition action must first notify the other cotenants, who may elect to purchase the interest. Price is to be set at its pro rata share of the fair market value of the whole property, unadjusted for any discounts. It also provided a timed process for determining the price, which maxed out at 180 days; all in all, a fairly quick exit.
The discount and the facts
Keep in mind that the fair market value premise presupposes a hypothetical buyer and seller of the interest, and it is largely the future options of the hypothetical buyer that are of interest for valuation purposes. With this idea in mind, the lawyer can think “buyer’s due diligence” just as easily as the appraiser, and sometimes more effectively.
For example, what would you advise the hypothetical buyer of the interest, as a matter of due diligence, when considering its ability, under the agreement, to force its way out of the entity in the future? Would you advise that taking advantage of the “put” provision would be no big deal – an easy way for your buyer/client to get out? Should he pay more for that right?
This is important, because the valuation discount for cotenancy arrangements is always heavily dependent on the time it would take for the interest holder to exit with its pro rata share of the whole. (The other component of the value equation is the risk associated with a particular holding or exiting scenario.)
A buyout in the short term is possible, but for a new interest holder to force such an action in a family that has successfully operated as a group for 50 years is a little extreme. Also, the fact that they are worth over $100 million suggests that the ability to force anything, agreement or not, might want long consideration. If it were attempted, then the timeline could be much longer than expected, particularly if it generated lawsuits. Either way, risk would not be low.
There are several other facts having to with a possible holding period: Dan is 76 years old, and his actuarial remaining life is another 11 years; death of a principal is sometimes an exit opportunity. The lease is up for renewal in five years. The remaining term of the agreement is 25 years. (There was no loan in this case, but sometimes its remaining term, balloon payments and prepayment conditions can have a big influence.)
A successful near-term buyout could very well be disadvantageous from a real estate point of view. Renewal of the lease would add to value, but there was some concern about the tenant’s desire to remain in the old improvements. Economic conditions were declining, and profitable redevelopment of the property could be iffy in five years. If the buyout process had to work its way through court, conditions would be anybody’s guess, and the risk that a buyout would occur when the property’s value was substantially lower was significant. A holder of real estate who cannot control timing faces increased risk. These conditions should be part of any buyer’s due diligence, and therefore must be part of the discount analysis.
Our analysis and conclusion of value
The valuation question (for the buyer’s part) turns to how he or she would see their future prospects as part of the association. How would they exit if they had to? What risks would they face? The results of a thorough due diligence investigation from the set of facts that are material to the discount analysis.
Our analysis postulated that a hold as long as Dan’s remaining life would be possible, a very short hold would be unlikely because of the lease and ownership circumstances, and concerns about exercising the agreement’s put clause; a five-year hold would be most likely (for modeling purposes). The assumption includes an orderly exit, accounting for the risk that the lease would not be renewed, the period might be different from five years, and a small possibility that any exit would require enforcing rites under the agreement. Income methods are able to incorporate all these conditions with more than reasonable precision, making the valuation quite rigorous and persuasive.
The effective discount from net asset value, concluded for the subject interest, was 39%, fairly high based on the long history of stable cash flow and the theoretical ability to exit in 180 days. However, a close look at the family, the lease and other real estate facts, and the rest of the hypothetical buyer’s due diligence suggests a much different likely outcome. Explicit consideration of the facts and agreement terms led to a deep discount, which was accepted repeatedly as we valued this and later interests in the same common tenancy association.
TIC arrangements and general partnerships usually involve fewer limits on control and marketability than more complicated structures such as LPs and LLCs. This makes the valuation process much less straightforward. Clearly, understanding the facts & circumstances can be a critical part of a credible and persuasive analysis. The agreement and the facts must be considered together as a whole.
Of course, facts can influence discounts in both directions. Having cake and eating too can often work, but the proof requires full consideration of the facts. The discount was significant in this instance, and some practitioners would have wanted it capped at, say, 15%, given that the ownership arrangement was largely as tenants-in-common. Such caps are entirely unnecessary, as described in “Taxpayers and Short Sticks.”
There are so many variations on this theme that it would require quite a lot of space to describe even the main possibilities. A paper that provides a catalog of likely facts, terms and conditions that are encountered with fractional ownership, “Asset Fractions: Integrating Real Property and Business Valuations (Getting a Handle on the Facts)” is available for download. The lawyer can take many other actions to assure successful outcomes; these are presented in detail in “Reappraising the Appraisal Process: A Guide to Successful Results.”
We are normally called in after the cake is baked, but do consult on formation of entities designed for wealth transfer and on repair of existing agreements prior to making gifts. We can help clarify the terms, conditions, facts & circumstances affecting value, and their interactions, which can place outcomes more securely within your control.
 A blog essay on the crisis with tax overpayment, based on “Dennis Webb: Estate Plans in Chains – The Unfortunate Trend Toward Unnecessary Discount Caps,” LISI Estate Planning Newsletter #1802 (Leimberg Information Services, Inc., April 21, 2011) at http://www.leimbergservices.com
 Dennis A. Webb, ASA, MAI, FRICS “Asset Fractions: Integrating Real Property and Business Valuations [Getting a Handle on the Facts],” paper presented at the ASA International Appraisal Conference, Los Angeles, CA (July 15-18, 2007).
 Dennis A. Webb, Susan A. Beveridge “Reappraising the Appraisal Process: A Guide to Successful Results,” Estate Planning, (September 2010): 11-18.