Partnerships in Management Rights : Do They Really Work?
Over the years I’ve worked with various partnership vehicles in financing the purchase of management rights businesses.
Some come to me fully formed while in other cases I introduce people who may be of like mind and manage the entire process for them. With multiples down and the market somewhat depressed there seem to be more than usual numbers of potential partnership investors emerging. I think both working partners and investors need to understand very clearly what it is that they entering into, the likely return and any downside. My observation would be that in some cases investors in partnerships have little or no idea what they are getting themselves in to.
Just to set the scene let’s have a look at the basics of partnership investment and return calculations. The following is a simplified version of the maths:
What we see here is that through the miracle of low interest rates and leverage investors have the potential to enjoy significant returns. In fact, even if an investor in the scenario above borrowed their portion of the equity required the return is still pretty attractive. Let’s say you have real estate or indeed a management rights of your own with significant equity built up. You decide to take a 20% stake in the scenario I’ve outlined. That’s an equity contribution of $320,000 and let’s assume you borrow the lot at 8% on an interest only basis.
Again, here’s the simple maths:
This all looks too good to be true and sadly in some cases it is!
First, you will notice that in my example I’ve used a gearing ratio of 70%. This is, in my view, the absolute maximum a partnership should go to. It’s tempting to gear higher due to that miracle of leverage and low rates I mentioned earlier but there’s an unpleasant downside.
If, for any reason, the value of the business falls then the partners will be asked by the bank to contribute additional funds to pay down debt in order to comply with maximum gearing ratio guidelines. You may recall I wrote about bank reviews and valuations last month. I know of instances where, due to the scale of some buildings, the multiple on which they are purchased and the gearing involved, that partners have been faced with significant debt reduction demands when these assets have been revalued by the lender.
These capital call ups by the lenders can be a real cause of disharmony in a partnership as the various investors seek to understand why the business value has fallen. I think it’s better to be a little conservative on gearing and have a sustainable business model. While on the subject of lenders you should try and avoid an unlimited personal guarantee when your partnership borrows money. Not always possible but certainly preferable.
My second concern is partnerships involving investors with no history in or particular knowledge of the management rights industry. In some cases we even see situations where the working partner has never run a management rights or accommodation asset before. To me investing in such a model is akin to throwing your super into a managed fund operated by a fund manager with no prior history of making wise investment decisions. It may work out but the risk seems excessive, even for a 24% return.
These business models need to be robust. I see little merit in partnerships purchasing buildings running less than $700,000 net profits and I don’t think equity stakes of less than 10% are useful. In fact, in the $700,000 to $1 million net profit range, I think 20% equity should be the minimum investment.
The partners need to understand the business model and the industry. There will be highs and lows in profit performance so unrealistic expectations of the management rights industry can be a cause of friction within the investor group. These investments should be designed for a passive return on equity and hopefully some future capital gain. Don’t go into one if you need the return to pay the food bill and don’t invest with someone who does.
I find that approaching partnerships (I prefer to call them syndicates) in a disciplined manner usually results in a happy outcome for all. Run off the rails and risk a train wreck.
Yes, you can invest in a management rights partnership via your SMSF but you’ll need expert legal and accounting advice.
Mike Phipps
Mike Phipps Finance
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