Overview – the Flowback Issue
Unlisted real estate investment trusts, or unlisted REITs, have enjoyed tremendous success raising and deploying capital into real estate investments. Unlisted REITs raise capital through public offerings and make filings with the Securities and Exchange Commission as part of their offering process and ongoing operations. The securities of unlisted REITs are not (at least initially) traded on any securities exchange. Investors in unlisted REITs typically consist of retail investors who acquire the securities through broker/dealers that market the unlisted REIT’s securities in connection with its offering process. From a liquidity standpoint, an unlisted REIT will generally indicate to investors through its offering process an expected horizon for the vehicle to seek some type of liquidity event - whether in the form of a sale transaction, liquidation or an initial public offering or listing transaction. A number of unlisted REITs have recently opted to pursue liquidity for their shareholders through initial public offering or listing transactions in which the securities of the vehicle are listed on a national securities exchange. In some cases, the vehicle itself may issue securities in connection with a capital raising event. In addition, the shares held by the dispersed, largely retail shareholder base will become freely tradable. Even a very small percentage of these existing shareholders selling into the market following the transaction can represent significant volume and result in downward pressure on the stock price. Without the implementation of appropriate steps, this scenario can result in institutional investors refusing to participate in the transaction or, at best, participating at reduced levels and at decreased prices relative to what could be achieved with appropriate measures in place to address this issue. To further exacerbate the issue, the magnitude of the importance placed by institutional investors on the issue is unpredictable and may vary from investor to investor.
Alternatives to Address the Flowback Issue
A number of potential alternatives exist to combat the flowback issue and the pitfalls arising from the retail overhang on the stock. In general, these potential alternatives can be grouped into three broad categories: (i) do nothing; (ii) structure a lock-up to control the volume of flowback; and (iii) enter the market and absorb a portion of the flowback. The following discussion addresses each of these potential categories of alternatives and covers specific ideas within each category.
- Do Nothing. As indicated by the heading, in this scenario the issuer takes no proactive steps to address the retail flowback of shares into the market in connection with the transaction. A review of precedent transactions where this option was implemented highlights the potential negative implications of the flowback issue. Frequently, trading in the stock exerted significant downward pressure on the share price as retail shareholders attempted to exit the stock. Further, the composition of the ownership of the stock trended significantly from retail to institutional holders during the initial trading year of the stock indicating that the full demand for the stock from institutional investors may not have been captured in connection with the initial public offering.
As an initial consideration, investment banks prefer for the trading markets following the initial offering of a security to be free of pricing pressure caused by trading by existing securityholders. Unlisted REITs pursuing listing transactions may be unable to find investment banks willing to participate in an offering in which no action is taken to address the volume and price pressure associated with the flowback.
- Control the Flowback – Implementing Lock-Ups. The flowback issue has its origins in the scope and character of the unlisted REIT shareholder base. The unlisted REIT shareholder base is largely dispersed and made up of retail holders that, individually, do not generally own any meaningful position in the security. For a more traditional private company pursuing an initial public offering, the clean trading market post-closing in respect of existing shareholders (as required by investment bankers) is typically handled through a customary lock-up agreement. The group of potential options to address the flowback issue outlined below are intended to moderate the degree of flowback just as lock-ups are imposed in connection with more traditional initial public offerings.
- Traditional Lock-Ups. The idea of implementing a traditional lock-up with existing shareholders of unlisted REITs would effectively require the unlisted REIT to solicit each shareholder to sign and return a lock-up agreement in connection with the listing transaction. While effective from a legal perspective with respect to any shareholder that returns the lock-up, this approach is unlikely to be successful for a number of reasons. We are not aware of any unlisted REIT pursuing this approach in connection with an initial public offering or listing transaction and do not view it as a viable alternative to addressing the flowback issue given the economic and practical considerations involved with this approach.
- Recapitalization in Connection With a Listing Transaction. The recapitalization option for installing a lock-up mechanism in connection with a listing transaction has become the preferred answer to the retail flowback issue for unlisted REITs. The recapitalization option converts existing common shares of the unlisted REIT into a new class of stock that is not listed as part of the transaction. The initial public offering or listing transaction then lists a new, separate class of stock on the relevant exchange. The new shares obtained by the existing holders in connection with the transaction then convert into the listed security over a staggered period of time. Generally, the unlisted security is divided into three separate tranches that convert to the listed security in equal installments over the 60-, 120-, and 180-day periods following the closing of the transaction. The recapitalization event is appealing in connection with listing transactions as it moderates the amount of flowback on a wide spread basis across the entire shareholder base of the unlisted REIT. Further, by controlling the volume of flowback, the recapitalization option encourages institutional investor participation in the transaction by eliminating the element of downward price pressure on the security immediately following the transaction from retail flowback.
While the recapitalization option is attractive given its effectiveness in addressing the flowback issue, the recapitalization option is not without cost and timing implications for the overall transaction, including the need to seek a shareholder vote to approve the recapitalization.
- Absorb the Flowback – Offset Opportunities. In addition to structural mechanisms to control the flowback, there are a number of alternatives available to unlisted REITs to absorb some portion of the flowback in an effort to eliminate the volume of shares entering the market on a post-transaction basis. While these alternatives may be sufficient to eliminate some portion of the flowback, by their nature they are unlikely to be sufficient in size or scope to completely address the issue. Rather, each of these options acts as a mitigant in reducing the amount of pressure on the security from a volume and pricing perspective. In general, this group of alternatives can be broken into two general categories— permitting investors to participate in the initial public offering and the issuer entering the market on a post-transaction basis to acquire shares of the listed security.
- Selling Shareholders in the Initial Public Offering. The unlisted REIT may consider permitting existing members of the retail shareholder base to participate in the offering. This approach addresses the flowback issue by redirecting a portion of the flowback directly into the public offering and alleviates the overhang caused by potential post-transaction sales of those shares by the existing holders. It is not unusual for some portion of the existing shareholders of a company to monetize a percentage of their holdings in connection with an initial listing of a company’s securities. However, this process is not particularly attractive for unlisted REITs primarily for the same reasons that drive the flowback issue itself. The widespread nature and the retail character of the typical unlisted REIT shareholder base makes the potential for allowing existing shareholders to participate in the offering impractical.
- Issuer Enters the Market to Address Flowback. Perhaps the most interesting set of alternatives for the unlisted REIT in addressing flowback issues is entering the market as a buyer to purchase some portion of the flowback entering the market. There are a number of considerations relevant to the unlisted REIT in making the determination to move forward with this option. In general, these considerations can be grouped into two separate categories: (a) legal and timing considerations relative to the repurchasing program to be implemented and (b) the form of the repurchasing program to be implemented. As the legal and timing implications are the threshold question regarding when the issuer may enter the market and, in some instances, dictates the size of the program.
Implementing Share Buy-Backs. The issuer has a number of alternatives available in connection with implementing the share buy-back process to mitigate the impact of the retail flowback. Specifically, the issuer may enter the market directly through direct market purchases, implement a so-called 10b5-1 program where the purchases are placed through a broker under a defined set of criteria, or have one more intermediaries conduct open-market purchases on the issuer’s behalf. To the extent that these open-market purchases are not significant enough to mitigate or impact the negative implications of the retail flowback, other more significant alternatives are available to the issuer. For example, the issuer may determine to launch a public tender offer for a designated number or dollar amount of its outstanding shares.
Conclusion. Unlisted REITs pursuing a listing transaction should consider the potential implications associated with the retail flowback issue. A number of options are available to mitigate the risks associated with this issue. Unlisted REITs should consult with their legal and financial advisers regarding the most appropriate strategy to address the retail flowback issue based on the vehicle’s individual facts and circumstances.