Are You Giving Your Syndicator A "Free Spin"?

Question

I'm looking at more and more syndication investments, because it is a personal interest of mine.

And it really rubs me the wrong way when a syndicator puts together a deal in a way that has very little of their own capital in the game, but raises money from other investors in a huge way.

Example:

Syndicator purchases $100M in real estate. Syndicator raises $35M in equity. Syndicator invests basically nothing (less than $1M) of their own capital in the deal.

In this deal, the syndicator, will make, in fees, something like the following:

- $1M acquisition Fee (1% of asset value)

- $2M in management fees (2% of equity per year, for 5 years).

- $1M disposition fee (assuming property value at exit does not change at all)

- $0-5M+ carried interest (20-30% of profits).

Look, this model has been around a long time. I get it. And, if the syndicator delivers, it's a win/win for investors. No issues there.

But, what really makes me scratch my head is the fact that if the syndicator does not put in a meaningful chunk of their own net worth or a meaningful percentage of the equity, then there is almost no downside to them for raising this deal, other than perhaps their reputation.

If I lose everything I invest in this deal, then I feel the syndicator should come out with a negative as well. Net of all fees, net of everything, they need to lose if I am wiped.

There is no real incentive to protect downside risk in some situations, because everything is upside for the deal sponsor.

If it does really well, then they make $4M in fees, and another several million in carried interest. If it does poorly, then they make $4M and lose little to nothing. Heads they win, tails they win.

As an LP, I'm not interested in playing a game where the syndicator can win and I can lose.

Any syndication investment that does not involve a meaningful percentage of the syndicator's wealth (10% of their personal wealth, excluding any acquisition or deal related incentives) in the deal is a non-starter for me personally going forward.

And no, investing the acquisition fee does not count. A sponsor "Investing" the $1M acquisition fee earned just by buying an asset with my money does not count as an investment. I want to see someone who is pitching me on a deal putting their own capital to work in a meaningful way, someone who believes in the deal so much they will put their own money where their mouth is.

I'm listening if 10% of their personal wealth is in the deal. And specifically in The deal that I am being invited to invest in.

I'm interested if 25% is in it.

And I know that they at least, truly think they are for real when they approach 50% of their wealth in the deal.

What do you think? Is this a reasonable stance to take? Do you feel as uncomfortable as I do about giving a syndicator a "free spin" on their next deal, and will you throw out investment opportunities that do not have the sponsor committing a serious chunk of the pie?

Or, am I being unrealistic and idealistic, as has been the case many times before?

Brian Burke · Answer

@Scott Trench you know I love you man, and we often agree, but in this instance I think you are being unrealistic and idealistic.

I'm not sure why you want sponsors to meet this metric--is it vengeance, i.e. "I want them to lose if I lose", or is it an attempt to achieve an alignment of interest?

If it's vengeance, I get it.  No one wants to lose on the watch of someone who wins.  But this concept of potential loss hovering in the background doesn't make the sponsor any more competent, honest, experienced, and so on.

If it's alignment of interest you seek, I have bad news.  The dirty little secret is that alignment of interest in a sponsor/investor relationship is impossible.  The simple fact is these interests are not aligned, even when the sponsor has money on the table alongside the investors on the same terms.  I wrote a whole chapter in "The Hands-Off Investor" about this--not only how alignment is impossible, but how a significant portion of the sponsor's net worth invested in the deal not only fails to create alignment, but can actually further enhance the misalignment.

Don't get me wrong--there is nothing wrong with sponsors investing in their own deals.  But there is something wrong with investors thinking that it matters--or at least that it matters in the way they are thinking it will.

What is important is finding a sponsor that has experience, a track record, a strong management team, a strong balance sheet, and perhaps most importantly, a brand and reputation to protect.  On top of that, you want someone who understands that their interests are not aligned with yours and can and will prioritize and balance your interests over their own.  That trait can't be measured in dollars.

If your hard-stop is 10% or 25% of net worth invested into each deal, you'll be limited to sponsors who are topped out at three to eight deals (lenders require sponsors to meet certain net worth and liquidity thresholds, so that means that at least 10% to 25% of their net worth has to remain liquid).

That doesn't bring you a sponsor with a breadth of experience.  Now you'll be invested with only small-time syndicators who have so much money tied up in deals they'll have few resources when things go wrong, will not be able to ride out adverse markets, will be forced to "do deals" just to keep their lights on, and might make decisions far adverse to your interests just because they are painted into a corner.  This is all the opposite of what you want as an investor.

Chris Seveney · Answer

As a LP and a GP, I can give you my opinions from both sides. I definitely think a GP should have skin in the game, the amount is of course is what makes you as an investor comfortable. I do not think a GP would put (or should) put 10% of their net worth into one deal. I look at it more as what isthe min or average investment and they should be a multiple of that.

Where I pay more attention and focus to is the fee structure. I do not sponsor MF syndications but have worked for a company that did them. My opinion is I do not like the GP/LP fee structure. Just because its been that way, does not mean its correct. We are going to see this come to a head very soon as the GP's collecting the acquisition and management fees (which are profit centers) and the deals going sideways is going to be interesting.

I know of two well-known syndicators on MF who stopped distributions. One put out a newsletter about they are no longer taking a management fee. The other stopped distributions and did not cut their fees (I also see them raising money for a new syndication)...

To me if I was invested in the latter, I would be very upset because they are spending their time raising money on a new deal (because they got their money in fees) and not focusing their time and effort on my deal.

The GP/LP interests should be aligned, and at end of day it really comes down to the syndicator and people who represent them to do the right thing, which we are gonna see peoples true colors in the next few years.

Doug Smith · Answer

We've been operating funds since before the last crash, so I've got a unique perspective. One thing that I've personally found is that the longer I've done it and the better/longer our track record got, the less I want OPM. I also see that the less I want OPM, the more people try to give us money. Even at higher interest rates, levering the capital is cheaper than paying out equity. Now-a-days, we're much, much more selective about taking capital...not based on the amount or pedigre of the investor, but on how nice the people are to work with and how patient the capital is. I would have killed for institutional money in 2008-2011, now we don't want to deal with the strings and hassle the comes along with it. Give me a good person with a smaller sum or leverage over institutional capital any day. It's not really directly related to your post, but it got me thinking. To your post, a lot of the syndicators I'm seeing don't really have the experience in doing what they are doing. I served on an IMN panel about a decade ago with some big fund managers including Blackstone's Distressed Debt Fund with over $4B under management. I was the only one with a true credit background, but I also had by far the smallest Assets Under Management. I was intimidated at first until I realized that he other managers simply knew how to raise capital. None had real experience in the field. I sort of rant on people building investment pools that read a few BP articles or took a guru course and now they are building a fund. I'm not as concerned with skin in the game as a syndicator might have multiple deals going at the same time, but having experience is key.

Scott Trench · Answer

Great discussion here guys. I am new as an LP, and this is good feedback. Sounds like I am being way too idealistic here and while it is reasonable to have meaningful skin in the game, it's not to have this much as a percentage of net worth.

I'm changing my viewpoint on this, and one of the reasons I love this forum is because of the ability to throw out what I'm thinking and be influenced by more experienced investors.

Scott Trench · Answer

Good perspectives here.

It looks like I will walk a lonely road of requiring those who I invest with to have material skin in the game, and will find those opportunities few and far between.

That's totally fine, and I will probably miss out on a lot of good opportunities!

I believe that investment is fundamentally different than a service like a dentist, personally, and that operators behave differently when they can not only win, but also lose painfully.

Dan Rowley · Answer

@Scott Trench

I think you have overstated the risk/reward here for GPs...

I would not want folks to be under the illusion that mngt fee is nearly as high as you state.  It's not % of the equity/$ raise but rather it's a % (often 1-2%) of revenue/rents collected.  This means there are significantly lower $s paid in ongoing mngmt fee (vs. the $2M you list).  And, I'd argue that often the work/effort GPs (hopefully) are putting in to manage the property probably exceeds the fee $s.

Also, 25% of net worth put into a single deal is not really realistic and if that were the bar then I believe there would be very few syndicated deals offered to LPs.

You also have not factored in that GPs are 'on the hook' if it's recourse debt used in the deal, while LPs have not exposure at all.  Certainly there is a $ value to LPs for this.

Todd Dexheimer · Answer

I'm guessing that most, if not all syndicator would fail to meet your metrics. If you're buying $100mm deals, then you likely have a net worth north of $25mm, so for that single deal, they would need to invest $2.5mm, excluding any AQ fees and 6.25mm to hit the 25%.

Maybe a sponsor can do that on a deal or 2, but very quickly they run out of cash and the only way for them to do another deal is to sell existing deals. If you're in one of those existing deals, the sponsor is no longer aligned with your best interests, but looking at his/her best interests.

The other issue is let's say the sponsor has a $50mm net worth and is buying a $25mm asset, raising $10mm. In this case, they have to just buy the deal with their own cash and cannot offer it to investors.

I totally agree with your line of thinking. Sponsors should have skin in the game, but rather than it being a product of their wealth, maybe consider it a percentage of the equity to be raised. Maybe that's 5%, 10% or 25%

Jay Hinrichs · Answer

most syndicators would not have 25% of their NET worth sitting liquid waiting to do a deal I am guessing., as well as new syndicators would never ever get started.. I would be curious to know what syndicators are actually putting up 25% of the equity in cash before commissions.  Is there a lot of them to choose from ? I look at it just like Brokers that would bring an investor a trust deed investment.. they have zero cash in it and are taking a fee for their expertise. I dont see how apartment syndicators would do it much different. Of course I dont really know much about the syndication world.  Other than the sponsor is everything. Even if the sponsor puts in 10% or more and it goes bad your still out your money right ?

PS I do know some brokers will participate in trust deed investments with their clients.. but I think thats a minority.  And state specific given the securities laws.

Mike Iger · Answer

Don't worry, it's not such a lonely road. While it's true interests will never be fully aligned, it doesn't have to be all or nothing. There are many like-minded investors that are starting to demand more favorable structures. Whether no acq fee, deffered acq fee, etc, the point is many of us are not going to repeat the mistakes of 2021. Not every group can put in a massive chunk of the equity, but that's okay. It's usually very easy to tell if the GP really believes in the deal or he's just doing it for the fees.

John Sayers · Answer

@Scott Trench co-invest percentages may be high, but aside of co-investments / "skin" numbers etc., he is quite spot on that the overall risks are normally too lopsided. "Heads they win, tails they win." is a horrible model for the investor. It's the foundation of the Wallstreet fund model; things some investors are trying to distance from, yet get stuck in still via many syndication models. I will throw out deals that have 5 different fees and all at maximum levels. The gold rush made a lot believe they earned something that they have not. It's just how many guru classes are taught. Some sadly teach how to exploit and manipulate the new investors. Raising capital is a popular class/topic that is not always taught with best intentions.I am with @Brian Burke  on "The dirty little secret is that alignment of interest in a sponsor/investor relationship is impossible". With that, it does not by any means imply that the current methods, percentages, fees, contracts etc. are the very best version to reduce/lower the misalignments to a smaller delta than the current status-quo.

Sadly, Scott is right that many deals are setup so that if a LP loses capital the GP still has profited; many do so on day one! Only a few have claw backs in the docs, and the rare will step in and forfeit unilaterally (but rarely contractually) to try to make things right. LPs should also not forget that the docs are written by the lawyers of the GPs and they represent the interest of the GP.

Some GPs will give 10+ reasons why one method is more "aligned" than other etc. As always, opinions are, just opinions. Note that when the words "incentive" or "incentivizes" are used, the reasoning tends to be often aimed at the lower level of scruples and integrity type of person. A low moral person needs more external incentives to stay involved in a deal they sponsored but is now a major challenge. A high moral person will not run nor only think just of self. LPs should think about the content of the taught alignment concepts, as well the source. Consider if they could have any inherent bias.

Ultimately, the most important thing is a GP that is honest, skilled, fair and actually acts like a fiduciary. The % of skin is below all that. Brian says it better: "What is important is finding a sponsor that has experience, a track record, a strong management team, a strong  balance sheet, and perhaps most importantly, a brand and reputation to protect.  On top of that, you want someone who understands that their interests are not aligned with yours and can and will prioritize and balance your interests over their own.  That trait can't be measured in dollars."As long as there are a ton less savvy or under-educated investors (be it stocks, bonds, RE etc), the markets will be overly tilted to GPs that never really are at risk to lose any capital, even in a crap deal. The syndication market can do better. But will it and how?

Are You Giving Your Syndicator A "Free Spin"?

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