The Importance of Swap Impact on Investor Buyout
A North Georgia real estate LLC consisting of 10 equal partners recently bought out 3 of the partners. Under the terms of the Operating Agreement, the property was appraised and the partners were paid their respective portions based on the equity available. The appraised value was $10,000,000 and the remaining debt was $7,000,000, leaving equity of $3,000,000. Each partner received $300,000 (10% of the equity).
Sounds fair, right? Far from it. In this case, the outgoing partners received TWICE the amount that they would have realized had the building been sold and the equity distributed. This occurred because the calculation of equity failed to consider the value of the interest rate swap at the time of valuation. In this example, the interest rate swap had a negative value of $1,500,000. If the partners had sold the building for the appraised value of $10,000,000, they would have had to repay the remaining debt of $7,000,000 AND the termination of the swap of $1,500,000. Each partner would receive $150,000 from the sale as their portion of the equity… NOT $300,000.
Not only did they overpay the retiring partners a total of $450,000, but each remaining partner was left with only $85,714 in equity as opposed to $150,000. If the buyouts had been calculated with the all-in value considered, each remaining partner would have retained his true equity of $150,000.
In order to determine the value of the swap, the partners could have engaged the services of a swap negotiator who would have provided a true “mark to market”. Unlike the bank, a swap negotiator is an unbiased third party who will shine a light on the bank’s otherwise undisclosed profit. The result? The borrower will most certainly unwind its swap closer to par and therefore save money.