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6 Lessons on the Perils of Quick Advice

Welcome back, and happy 4th of July! I came to the US at 11 and I’m so thankful to be in the US writing to you today.

I get a a ton of inbound questions through direct messages similar to the following:

• “Hey is a 50/50 split market?”

• “Isn’t charging a 3% acquisition fee ridiculous?”

• “Are 5 exited deals with a 15% IRR a strong track record?”

I initially took the time to answer these questions, but today I’ll explain why I’ve changed my mind (and think you should too) through 6 case studies.

If you’re an LP, this will illustrate the complexity of investment decisions and pin point areas where you have to be particularly careful to mitigate losing your savings.

If you’re a GP, I hope this article will touch on what LPs might be sensitive to and thereby improve how you communicate your investment thesis.

Let’s dive in:

Importance of a Balanced Approach

First, I want to remind everyone that I’ve authored a framework around LP investments with three pillars. These pillars are ordered very intentionally for the perspective of an LP (notice how property is last!), from most to least important:

• Execution - track record and counterparty risk

• Alignment of Interests - coinvest, waterfall, and fees

• Property - valuation and business plan

We will refer to these throughout the examples below, so I do recommend you reading them prior to continuing to get a flavor of (1) what they are and (2) why they’re ordered this way.

Examples of Quick Decisions and Their Pitfalls

Example 1: 50/50 Split

LP Question:

“Hey is a 50/50 split market?”

Quick Answer:

“A typical split on a syndication is between 70-80% to LP, with the remainder going to the GP”

Decision:

LP passes on the deal because GP is “way too aggressive”

Pitfall:

LP didn’t consider the fact that the GP is coinvesting 50% of the equity (market is 5-10% of equity), has fees that are far below market, or perhaps is paying an above market preferred return .. in hindsight, the split was actually not so aggressive once you consider these other aspect of the investment.

Example 2: Fee loads

LP Question:

“Isn’t charging a 3% acquisition fee ridiculous?”

Quick Answer:

“Acquisition fees will typically range between 1% to 3%, with the percentage getting lower as the purchase price of the property increases”

Decision:

The purchase price was only $1 million, so the LP deems the acquisition fee to be fair and invests

Pitfall:

A lot that can go wrong here.. a few examples include no coinvest from the GP, higher than market fee loads, an unfavorable waterfall, poor sales and rent comp support, or perhaps even a business plan that wasn’t well thought-out!

Example 3: Experienced General Partner

LP Question:

“Are 5 exited deals with a 15% IRR a strong track record?”

Quick Answer:

"A GP with a great track record is generally more reliable and it’s great that they’ve achieved a 15% IRR to date!"

Decision:

LP invests based solely on the GP's reputation.

Pitfall:

I probably sound a broken record by now (here’s an extra meme if you’ve made it this far :D), but again we have so many challenges here. Here is a very simple one:

• When the LP says 5 deals and 15% IRR, you (as the person responding) have to assume that they know what they’re doing and have done their due diligence on both of those figures.

• I have seen cases where listed exited deals weren’t actually attributable to the GP in full (e.g. they were the LP on the deal - that helps, but I hope we can all agree that it’s not the same and such facts shouldn’t be on the LP to uncover)

• I have also seen cases where the IRRs were either wrong or missing vital details (a simple example would be that they had 4 deals that did terribly & 1 that did extremely well … and the average of the 5 was 15%, which is what they showed in the deck with no more details)

Example 4: Attractive Location

LP Question:

"Do you think Florida is a good place to invest?"

Quick Answer:

"It’s complicated question, but between more favorable landlord laws and positive net migration it’s certainly a good place to look for investments."

Decision:

LP invests based solely on the location's appeal

Pitfall:

Just because Florida has positive net migration, a certain part of the region that the investment is in might not be growing (and in fact might be shrinking).

Furthermore, even if you do assume that the area is growing and will lead to higher rents over the investment period, there are so many more things to consider:

• Who’s the GP and are they able to execute on this business plan?

• Alignment between GP and LP

• As well as many other questions remaining on the property itself

Example 5: Preferred Return

LP Question:

"Isn’t 10% an above market preferred return?"

Quick Answer:

"Yes, a typical range is 7-8%"

Decision:

LP invests based solely on the promise of a preferred return.

Pitfall:

Let’s keep this one simple - what if I told you that the split above this 10% was 20/80, 20% going to LP? I hope you’d agree with me that this becomes a lot less interesting (and I can tell you it exists).. and now you can understand why the 7-8% market range feedback is missing a lot of critical context.

Example 6: Co-Investment by GP

LP Question:

"10% of equity is a solid coinvest from a GP, right?”

Quick Answer:

"Yes, the typical range is 5-10%”

Decision:

By now I’m sure you guessed it, the LP invests!

Pitfall:

What if I told you that the same GP was also (1) charging an above market acquisition fee, (2) has little to no track record, and (3) the acquisition fee, in dollars, is actually greater than the promised 10% coinvest?

I hope these case studies were helpful! As always, would love to hear any questions or comments and wishing you a wonderful weekend ahead.

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