Should Syndicator for Multifamily Invest Their Own Money In Deal

Question

Alignment of interest is one of the most important things in any real estate syndication deal. The alignment of interest is when the syndicator actually puts their own money into their deals along with their investors.

As an investor myself, I do not like participating in syndication deals unless alignment of interest is at play.

How many of you invest (or plan to invest) in your own deals?

In addition to adding money to a deal, what other ways have you found to create an alignment of interest?

Finally, for the newbies, how do you put money into your own deal to create alignment of interest when you have no money of your own?

Brian Burke · Answer

The idea that the sponsor contributing capital creates an alignment of interest is more myth than reality.  Certainly this opinion is coming from a long-time syndicator so one could certainly argue bias here.

Investors are misreading the psychology if they think that having my own personal cash in a deal is going to cause their investment to perform any differently. Or that I could walk away and risk nothing if I have no cash in a deal.

I invest in my deals when I can, not for alignment of interest but because I want a return on my money just like anyone. But I can’t invest in all.  To qualify for loans I have to have very specific cash reserves.  To get deals in contract I have to put up very large earnest money and financing deposits (can be $500K or more in some cases). Plus I have to front the upfront costs for legal, inspections, etc.—and if I have more than one property in contract you can double that capital outlay.

So I say that my cash is the spark, your cash is the fuel.  I’ve had investors opt out because I didn’t have 10% of the equity committed from my own cash.  I understand that, but it’s a misguided decision in my opinion.  I’ve raised over $80 million.  If I had 10% in every deal that would be $8 million. Investors are sensitive to how much sponsors charge in fees—but how much would I have to charge in fees to have an extra $8 million laying around?!  Plus another million or so to satisfy deposits, costs and lender’s liquidity requirements. The math just doesn’t work.

Instead, I see it this way:  I have cash reserves so I’m never in a position to feel like I have to do a bad deal just so I can earn a fee and make a living. And I’ve been the first one to take a bullet for my investors, sacrificing my own financial well being to protect my investors. If I walk away from a deal, the last thing on my mind would be my $100K skin in the game.  If I ever did that it would be the last time I’d earn the trust of the very folks that provide the lifeblood of my business.  So this means I have more like $80 million and my future income stream at risk at all times.  I can’t think of a stronger alignment of interest than that. Except, perhaps, that the majority of my compensation is predicated upon performance.

But I get it—if you are investing with a first time sponsor (why would you?), having skin in the game gives them something to lose. But an experienced sponsor (which is what you are looking for) has so much more at stake, which will keep their interest aligned at all times.

Ian Ippolito · Answer

I'm going to disagree with the consensus, and provide a different perspective that I think is missing from this conversation: that of the experienced, conservative investor.

The reason a conservative investor requires a sponsor to put skin in the game/cash in the deal has nothing to do with falsely believing that it somehow guarantees that the sponsor won't bail. Nor does it have anything to do with falsely believing that it somehow guarantees that the deal will end up with the highest return possible. (In fact, it's because they want a slightly lower return in exchange for incentivizing the sponsor to take less risk…which I'll explain in a second).

The reason is because of what Paul Kaseburg calls the "dirty secret" of the real estate industry. (For those who are not familiar with Paul, he's sat on both sides of the table on over $1.7 billion of real estate deals, and I think has a balanced perspective that is missing from people who mostly sit on one side or the other. He devotes a whole chapter of his excellent book talking about this issue).

The dirty secret is that many sponsors pitch (and many probably genuinely believe themselves) that their promote compensation structure (a preferred return and then a split of profits between investor and sponsor) is aligned with their investors. After all, they only get paid if they perform.

But in actual practice, it handsomely rewards sponsors the more they maximize returns (i.e. which can only be done by increasing risk). And at the same time gives no financial reward for minimizing losses. For a conservative investor, this is the exact opposite of what they want their sponsor to be paid to do. (Now for an aggressive investor it's the opposite situation, so it's actually ideal for them).

There are a couple of things that can offset this. One is actually fixed fees (which sponsors who focus on promotes will often malign). They do have a point that this it's not a perfect solution, because it introduces potential conflicts of interest on its own. (The sponsor is now incentivized to turn out as many deals as possible). In my opinion, it's important to have a balance between the two types of compensation.

But back to the point: The best tool in the conservative investor toolbelt for fighting the "dirty secret" is skin in the game/cash from the sponsor. When the sponsor invests alongside the investor, suddenly they do have a financial incentive to minimize losses. Yes, this will probably result in a slightly lower return for the investor in good times. But in bad times, it maximizes the chance of minimizing losses and risk. For the conservative investor, that's exactly what they are looking for.

And it is a false choice to say that an investor has to choose between an experienced sponsor who puts no skin in the game versus a new sponsor who will. There are many experienced sponsors who put substantial skin in the game in each investment. In fact, as their net worth grows from the success they've had, it becomes more and more easy. I recently invested in a syndication where the sponsor put in 25% skin in the game on an 8 digit capital raise.

Mike Dymski · Answer

I have strict investment criteria and having the sponsor invest $100k of their acquisition fee in a $10+ million project is not one of them.  The deal structure is more important in aligning interests.

Ivan Barratt · Answer

I'm with @Brian Burke at this point.  I have significantly more to lose than money if a deal goes poorly.

I defer the bulk of my comp (acquisition fee and promote/split) till a capital event (refi or sale). Most of my cash stays liquid so I can control deals (earnest money, upfront costs of reports, lender requirements of liquidity, etc).

Todd Dexheimer · Answer

A good investment is a good investment, whether the sponsor invests or not, so investing in the deal is not necessary, however, I think you will have many more people comfortable with you if you do invest. Currently we invest at least the minimum in all of our deals and plan on continuing that. When I first started, however, I did not have money and even as I started to build up some reserves, I did not invest my own money into my deals. Never once during that time did I have in my mind that it's not my money, so I don't need to protect it.

Alina Trigub · Answer

@Dan Handford You already received a lot of feedback, but I'm in a strong agreement with what @Brian Burke stated. Sponsor's experience level and his current position dictates a lot on whether she/he can invest at a present time. Someone with many years of experience and a large investors' following has a lot more at stake to lose than someone new or relatively new to the business. It's not just about the money, it's also about reputation, following SEC guidelines, and building one's business. So a lot more is at stake for someone who's been around the block for a while.

Good luck!

Kyle Bryant · Answer

I just got into my first syndicated deal. I didn't have much money of my own, but I partnered up with a couple of friends who had money, and we invested in the syndication as an entity, on the KP side. That allows me to gain experience on the operations side, without having to have 100k of my own money. I highly suggest that route.

Joel Owens · Answer

Just something to think about.Sometimes investors get over worked about the 100k they want to invest with a sponsor. There are capital firms out there where  a sponsor can get almost unlimited funds to do deals.

A friend owns over 6 million sq ft of retail as a sponsor. He very rarely takes on the institution and fund money for capital. If he does it is a very small part of the stack. The reason is they can set terms and hurdles not favorable to the sponsor.

So WHY would a sponsor deal with all the mess of dealing with individual investors? It is because they can set up deal structures for a more favorable position to the sponsor.

If all smaller investors are going to demand what institutional money does then a sponsor can simply go to that well over and over for deal velocity and forget taking money from smaller investors. It's a 2 way street. Ultimately a sponsor has to ask themselves (With what this investor wants to invest the money for amount and structure is it even money I want to accept for my investment project?)

There are different investor types also. Some are investing for cash flow immediately, others a mix of some upfront cash flow and then back end equity grow, and yet others care more about larger equity growth in future years and less cash flow today. So you have to match the right investor to the right investment type.

Bob Dreher · Answer

For a large syndicator who is constantly cycling out of deals, the idea of co-investing is fairly easy...but what about the company in growth mode who isn't cycling out of several deals per year? The question then gets dicier.

@Brian Burke posted a blog about a property he bought with no personal money in the deal...and what happened when it turned sour. Alignment of interests is much more than putting $50-100k in a deal...it's more about integrity and reputation! Unless, of course, you don't plan to be around for the long haul...

https://www.biggerpockets.com/renewsblog/colossal-fail/

Below is an excerpt from an article in Pension & Investments...

Wall Street investment firms with real estate management subsidiaries created the strategy of co-investing to coax wary investors into real estate portfolios the firms had bought through the Resolution Trust Corp., a federal program begun in 1989 to liquidate assets held by insolvent savings and loans.

The idea of shared risk with managers gave investors comfort and worked to draw them into these investments, explained Ted Leary, president of consultant Crosswater Realty Advisors, Los Angeles. Now, co-investment is de rigueur in the industry.

“It makes everybody feel better if the general partner loses money alongside the limited partner,” Mr. Leary said in an interview.

In a letter this month to clients and colleagues, Mr. Leary wrote, “I continue to see no demonstrable evidence that manager co-investment makes a manager a better investor. In fact, some of the most dramatic loss situations I dealt with involved very significant co-investment by the manager. On the other hand, several of the most successful programs I observed had minimal manager co-investment.”

Some managers have defaulted on their co-investment, consultants say, although none would name names.

“Some managers overstretched because they bought the dream that they were selling,” Franklin Templeton's Mr. Weidner said. He would not identify any firms.

Still, not all of the big managers that made large co-investments suffered lousy returns. Many held their own, even during the latest financial crisis. Warburg Pincus LLC, Madison Capital Partners and Square Mile Capital LLC all managed to return investors' capital plus some profits, insiders said.

Alignment of interests is serious business to investors. Last August, CalSTRS bought out its partners' 10% interest in four joint ventures it entered into in 2005 with First Industrial Realty Trust, a real estate investment trust.

“The move was done to achieve full control of the properties because CalSTRS felt there was not a full alignment of interest between partners,” Mr. Duran told P&I at the time.

Most institutional investors are reviewing their real estate investment strategies and how they invest in the asset class, but few are jettisoning their co-investment requirements.

“I must admit I have not won this argument with my clients and certainly not with the consultant community,” Crosswater's Mr. Leary said.

Making changes

Ernst & Young's Mr. Grinis said real estate investment managers already are making changes. Even existing funds are getting restructured to make sure interests are more aligned with investors' interests. In essence, managers of these newly realigned funds are getting paid at the end, rather than reaping fees during the life of the fund, whether the fund makes money or not. Mr. Grinis declined to name any examples.

Paul Greenwood, managing director of Northern Lights Capital Group LLC, a private equity firm that invests in asset management firms, said, “Alignment of interest ... is crucial to the long-term success and the success in providing clients with a consistently good product.”

But achieving it varies with each investment, he said.

“If I'm a start-up investment manager with no personal wealth beyond what I've invested in my firm, I might have a good case for a tight alignment with my investors,” Mr. Greenwood said. “If I'm worth $100 million and I've invested $1 million in the fund, I may have alignment with my investors, maybe or maybe not.”

Glenn Shannon, president of San Francisco-based Shorenstein Realty Services LP, agrees that co-investment is not a quick fix that automatically aligns manager and investor interests. Shorenstein has committed $500 million of the $5.4 billion raised in its nine funds since 1992, but alignment of interests is more than making a co-investment, he said.

Bill F. · Answer

@Dan Handford I agree with your first sentence 100%. Reward and punishment superresponses  play roles in so many of our interactions that we don't realize.

Your second sentence I would amend to " One way to align interests is when the syndicator actually puts their own money into their deals along with their investors"; it is not the only way.

High water marks, offset, cumulative, trailling  performance metrics, non-financial rewards, vesting plans, ect... all can mix together to create an alignment of incentives without requiring the GP to invest cash up front.

I care more that the GP has to "eat their own cooking" and share in any downside, than if they have, what in most cases, is some symbolic portion of their net worth in the deal.

Should Syndicator for Multifamily Invest Their Own Money In Deal

Most Popular Reply