Liquidity and hold periods in a syndication

What illiquid means when it is your money

Every offering document says the investment is illiquid. The word is so routine that it stops registering, and investors sign it having understood it as "hard to sell" rather than as what it actually is, which is closer to "cannot be sold at all, by you, for the duration."

Three separate mechanisms produce that result, and they stack. Federal securities law restricts resale. The partnership agreement restricts transfer. And there is no buyer, because no market exists in which to find one. Any one of them would be a serious constraint. Together they mean the realistic answer to "what if I need this money in year three" is that you do not get it.

That is not a criticism of the structure. Illiquidity is what allows a sponsor to execute a five year business plan without redemption pressure, and it is part of why the return can differ from a listed vehicle. But it should be priced as a genuine cost rather than accepted as a formality, and the only way to price it is to understand each of the three mechanisms.

The securities law constraint

Your interest is a security, and because it was sold to you without registration it is a restricted security. The SEC defines those as "securities acquired in unregistered, private sales from the issuing company or from an affiliate of the issuer," which describes a syndication interest exactly.

Public resale of restricted securities is governed by Rule 144, which imposes a holding period before any resale is possible. Where the issuer is a reporting company the securities must be held "at least six months." Where the issuer is not subject to the reporting requirements, which is the case for essentially every private real estate partnership, the period is "at least one year." The clock starts when the securities were bought and fully paid for.

A non-reporting issuer must also make certain information about its business, management and finances available for the rule to be relied on. So even after a year has passed, resale under Rule 144 depends on conditions that involve the issuer rather than only you.

The practical point is narrower than it sounds. Rule 144 governs whether a resale would be lawful. It does not create a buyer, and for a limited partnership interest in a single apartment property there is generally no public market for the rule to operate in.

The legend, and who controls it

Restricted securities carry a restrictive legend, and this is where the constraint becomes concrete in a way most investors have never been told.

The legend has to be removed before a transfer can settle. Per the SEC, only a transfer agent can remove it, and the transfer agent will not act without "the consent of the issuer, usually in the form of an opinion letter from the issuer's counsel."

And then the sentence that matters most: the SEC states that it "will not intervene" in a dispute about legend removal, because the question falls "solely in the discretion of the issuer of the securities" and is governed by state law rather than federal regulation.

Read that against your position. If you want out, and the sponsor would rather you stayed, the federal securities regulator is not a route of appeal. Whatever recourse exists lives in the partnership agreement and in state law. This is one of the strongest arguments for reading the transfer provisions before you subscribe rather than at the moment you want to leave.

The contractual constraint

Independently of securities law, the operating agreement almost always restricts transfer, and typically in several ways at once.

Expect a requirement for the general partner's consent, frequently at their sole discretion. Expect a right of first refusal in favor of the partnership or the other partners. Expect prohibitions on any transfer that would jeopardize the partnership's tax status, cause it to be treated as a publicly traded partnership, or breach a loan covenant, since lenders commonly restrict changes in ownership. Expect a requirement that any transferee is itself an accredited investor and executes the agreement.

Each is individually reasonable and the combination is close to prohibitive. In particular, sole-discretion consent means a sponsor can decline a transfer without giving a reason. Ask directly whether consent has ever been given, in how many cases, and on what terms.

Some sponsors operate a limited redemption or transfer facility, often capped, often at a discount, and usually suspendable at the sponsor's discretion. If one exists, ask what happened to it during the last period of stress, because a redemption facility that suspends precisely when investors want it is a facility in name.

The secondary market, honestly described

A secondary market for private real estate partnership interests does exist, and it is thin, opaque and unfriendly to sellers of small positions. Institutional secondaries trade fund commitments in size. An individual holding one limited partner interest in a single apartment deal is not that market.

Where a sale does happen, expect a discount to any stated value, a slow process, the sponsor's consent as a gating item, and legal costs that are material relative to a typical subscription. The buyer knows you are the constrained party.

It is worth comparing this against the vehicle most often positioned as the liquid alternative. The SEC says of non-traded REITs that they "are illiquid investments" that "generally cannot be sold readily on the open market," and that they "typically do not provide an estimate of their value per share until 18 months after their offering closes." A syndication at least does not imply a price it cannot support. The comparison is drawn out in syndication versus REIT.

Why a five year hold becomes eight

A stated hold period is a plan, not a term. Four things extend it, and all four are ordinary rather than exceptional.

The business plan takes longer. Renovation and lease-up run behind schedule, so the income the exit price depends on is not yet in place. Selling on schedule would crystallize an incomplete plan.

The exit market is unfavorable. Cap rates have moved, or financing for a buyer has become expensive, so the achievable price is below what a patient sale would produce. Holding is frequently the right decision here, and it is still an extension of your lock-up.

The debt dictates it. Prepayment penalties, yield maintenance or defeasance can make an early sale uneconomic, and conversely an approaching maturity can force a refinancing that resets the clock on the whole investment.

The promote is not yet earned. This one is worth naming plainly. Where the sponsor's promote sits above a hurdle that has not been cleared, there is an incentive to hold rather than to sell at a price producing no promote. That incentive is not improper and it is not always decisive, but you should know it exists and ask how the decision to sell gets made.

Ask for the actual hold period of every deal the sponsor has taken full cycle against what was projected at subscription. It is a single comparison and it is one of the more honest things you can learn about an operator.

Planning around it

The useful conclusion is not to avoid illiquid investments. It is to size them so illiquidity never has to be tested.

Assume the money is gone for the stated period plus two to three years. Assume distributions may be suspended for a period within that, because suspension is the ordinary first response to stress and does not by itself indicate failure. Assume you may be asked for more, which is covered in capital calls.

Then set the amount so that all three assumptions can be true simultaneously without changing anything else in your life. If a five year lock-up becoming eight, with two years of no distributions and a capital call in the middle, would create a problem, the position is too large regardless of how good the deal is.

It is also worth staging entry across time rather than committing at one moment, which spreads exposure to a single point in a cycle. That does not reduce the illiquidity of each position, but it prevents your entire allocation from having the same exit year.

Our position

We would rather lose a subscription than take money that should not be locked up, and that is a commercial statement as much as an ethical one: an investor who needs liquidity mid-hold becomes a problem for the partnership as well as for themselves.

What we will tell you before you subscribe is the projected hold, the loan maturity and any prepayment constraint, the transfer provisions in full, whether consent has ever been granted to a transfer and on what terms, and the realized hold period against the projection for every deal we have taken full cycle.

What we will not do is describe a private real estate interest as having any liquidity, or point at a secondary market as though it were an exit. There is no reliable exit before the sponsor sells the asset. That is the deal, and it should be a decision rather than a discovery. Related reading: passive multifamily investing and the SEC's own material on private placements.

What to establish about the hold

1. What are the transfer provisions, and is the sponsor's consent at sole discretion?
2. Has consent to a transfer ever been granted, in how many cases, and on what terms?
3. Is there a redemption or transfer facility, is it capped, and was it suspended during the last period of stress?
4. What is the actual realized hold period of every deal you have taken full cycle, against what was projected?
5. When does the loan mature, and is there a prepayment penalty, yield maintenance or defeasance?
6. Under what circumstances would you hold past the projected exit, and who makes that decision?

What this is built on

1. U.S. Securities and Exchange Commission, Rule 144, selling restricted and control securities
2. Investor.gov, Private placements under Rule 506(b) and 506(c)
3. Investor.gov, U.S. Securities and Exchange Commission, Real estate investment trusts (REITs)
4. U.S. Securities and Exchange Commission, Rule 506(c) of Regulation D
5. Internal Revenue Service, Publication 541, Partnerships