4 biggest surprises from advising LPs

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4 biggest surprises from advising LPs

Welcome back! 👋

Since starting this business, I've seen a lot. Some of these lessons come from existing LPs, while others become evident after speaking with many LPs that are looking to place capital.

A subscriber recently asked me what the biggest surprises were, so I decided to share them with you all today as I think they'll help you understand what's happening behind the scenes.

Let’s dive in!

1) Marketing and investment expertise are different

LPs tend to flock around the GPs that have a big social presence, own (or buy) a lot of assets, push out nice looking decks, host fancy events, or push a certain message that resonates emotionally (e.g. quitting your job or retirement).

I'm here to tell you that all of those factors (and more - see #2 of top 15 syndication mistakes) matter very little when it comes to the performance of your actual investment.

Perhaps the best way to explain what I'm saying is a venn diagram. There are great marketers and great investors. The intersection between the two exists, but in my opinion it’s much smaller than the average LPs might think.

If you’re not impressed with my graphic design skills, please send all complaints to aleksey@hey.com 🤪I knew this misunderstanding (equating marketing with investment acumen) was out there, but I didn’t understand to what degree this was true as it relates to syndicated investments. I also didn’t understand to what degree LPs misunderstood this distinction and invested based on social proof tactics (and in some cases, dare I say, ignored everything else).

1. Capital calls eat the uninformed for breakfast

Capital calls are common today and they're not created equal. Of the capital calls I've reviewed to date, I would say about a third require a decision, while the rest either don't provide enough information or contain assumptions that are too far from reality.

Now, what do I mean by "require a decision?"

A capital call is an investment, just like the investment you made at the outset. The only difference is that now you have additional information - the fact that the GP wasn't able to perform to their original expectations. There may be valid reasons for this, but you still need to go into the capital call decision with eyes wide open, because the "marginal" information you've received since investing is likely net negative (underperformance relative to expectations).

A third of the capital calls I've seen require a decision - i.e. they're not a yes (almost none are that obvious!), they're simply within the bounds of giving enough information to make a clear decision about the risk reward of putting additional dollars out. However, much more than a third of capital calls are filled.

To give an example, I once advised an LP in a syndication where the property was worth ~30-40% of the loan balance. Not original value or purchase price, but the loan. This means that not only is the equity in the property gone (see article about identifying distress) but even the loan is deeply impaired. The assumptions to get back to paying off the loan (forget getting the equity back) were so lofty that it was clear that the capital call benefitted the GP much more than the LP (more on this misalignment of interests between GP and LP in the coming weeks). While it’s fairly clear that agreeing to this capital call made little economic sense, the raise was nearly fully committed by other LPs!

One could argue about how ethical such a capital call is (since the probability of success is so low, and this isn’t made clear in the way the request is made), and even though that's not our topic for today I would say it's a worthwhile discussion.

To summarize, just because a GP puts something in front of you and gives you a deadline, doesn't mean you need to respond or commit. Just because there’s a penalty for not investing, that STILL doesn’t mean you need to respond or commit. It's your money, and a decent chunk of it is already at risk.

If you want to read more on capital calls, I’d recommend the following:

• Do sunk costs matter in capital calls?

• 6 steps to a successful capital call decision

1. Psychology of investing is far stranger than I thought

People plow cash into opportunities without knowing the person or without doing proper due diligence. Yet, if someone approaches them on the street for a tenth of that investment amount they'll completely dismiss them. The reality is that the GP you just met online (or clicked on an ad) isn't so different than a random person off the street, but psychology takes over.

So why do they do it?

Sometimes it's how well known the GP is, other times it's a recommendation from a friend (as we spoke about in social tactics in #2 here). In some cases, LPs rush to deploy capital.

Another relevant point that I can't stress enough is overexposing yourself to a given asset class, GP, or even worse, a single deal. Your finances are your business, but always proceed with caution. There's little reward without risk, but just because there is risk doesn’t mean there’s a decent chance of reward!

Downside analysis is something investors don't spend enough time on. This should be one of the most critical components of your analysis, since your upside is somewhat limited (see intro here) - you better make sure that the downside is limited too!

For the majority of people it's much better to invest in a conservatively underwritten 12% IRR deal than “bet the farm” on 20% IRRs. You should come to appreciate GPs who use conservative assumptions and are transparent about risk.

1. Return of capital and “guaranteed”

I’ve only published one official red flag so far, and that’s the use of the word guaranteed. Yet, I see this pop up almost weekly.. and sometimes LPs ignore it.

I also wrote extensively on why I feel strongly about the importance of having a return of capital clause, and I’ve seen many LPs trip up on this as well.

Both of these are aspects of the syndication world that I didn’t expect to see (especially in large numbers)…. but I am here to tell you that they’re alive and well. 😊

As I always like to say … verify, and only then trust!

I advise LPs on existing and potential positions and write articles here weekly on what I see in the marketplace that could help you invest better. You can find me on LinkedIn or Twitter.

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