Last week, we laid out three pillars of LP investing:

• Execution - track record and counterparty risk

• Alignment of Interests - coinvest, waterfall, and fees

• Property - valuation and business plan

I suggest reading about the first pillar, Execution, before continuing if you haven’t read it already.

Also, as a reminder, these three pillars are independent. In other words:

• You could find an investment that scores really high on two of them, but performs poorly on the third. For examples, visit last week’s post.

• Such an imbalance is fine, as long as you are aware that you’re taking on that additional risk and are being compensated for taking it on

• The best investments will have risks that you get comfortable with due to their respective mitigants

**Alignment of interests **- coinvest, waterfall, and fees

First, a quick introduction on this entire section.

As a general rule, when you invest in anything as an LP you are putting your trust (both practically and legally) into the GP to do the right thing.

• That is why the first pillar was execution (track record and counterparty risk) - this is something that’s hard to compensate for, but it’s possible.

• For instance, a new GP might not have the track record or experience for the given investment, but you still decide to invest based on what you find in the other two pillars.

Alignment of interests are important, both in the case of upside (when things go well) and downside (when the investment goes sour). Hope is not a strategy, as depicted in the picture below.

Let me say that again - when you look at an investment as an LP and are trying to decipher whether there’s a good alignment of interests between you and the GP, be sure to think about both favorable and unfavorable outcomes.

A lot of LPs will only focus on the successful outcome, and that’s because the deck tends to show this and is a sales pitch. “The IRR is great, and therefore,” one could say, “the coinvest, waterfall structure, and fees are irrelevant.”

This, of course, is a big mistake. Every GP needs to make money - that’s why they’re presenting you the deal. It’s equally important, though, to ensure that the majority of a GPs earnings comes from actual success rather than the probability of it.

In the three sections below, we’ll touch on all three parts of alignment of interests and I’ll explain why thinking about both favorable and unfavorable outcomes is important for the overall investment decision.

1) Coinvest

Definition: A coinvest is the amount of equity (usually expressed as a percentage of total equity raise) that the General Partner is putting up as part of the deal.

**How it works: **

A coinvest is the GP’s vested economic interest in the deal at the outset - the day you close.

Although the GP has other interests (the promote, as we’ll discuss below in the waterfall section) it’s important to have both “upside” and “downside” economic incentives. In other words:

Upside -

The GP is economically incentivized to perform, since the upside of the promote is material sum of money that’ll only be realized upon a sale (in most cases). Notice how, in good times, the coinvest matters very little since the promote is services as a material incentive.

Downside -

One of the challenges in GP/LP alignment is ensuring that the deal stays on track. If a project starts to deviate from its intended path, the returns can diminish significantly. In some cases, LP equity might even become entirely worthless (i.e. you lost your entire LP check). This is a scenario I've witnessed repeatedly.

From an economic perspective (and it's essential to highlight that there are also ethical and legal considerations), the most effective way to keep the General Partner (GP) committed to the deal when their promote has diminished in value is by the GP’s coinvest. Specifically, the GP needs to be aware of the substantial monetary loss they could incur on the initial capital that they put up if the project doesn't succeed.

This is precisely where the concept of 'coinvest' comes into play. The coinvest serves as a crucial incentive for the GP to remain dedicated to the project, rather than diverting their attention to other opportunities. In essence, it's a safeguard to ensure that the project receives the attention and dedication it deserves.

What’s market:

A healthy GP coinvest is 5%-10% of the equity raise. Of course, all else equal, the larger this amount is the better.

Things to be careful about:

Firstly, remember that a coinvest needs to come out of the GPs pocket - otherwise the downside doesn’t “hurt” as much in our example above.

Many coinvests come directly from acquisition fees. Although the GP does deserve to get a fee (see more on that here), it’s important to realize that their coinvest is really coming out of your own pocket.

Let’s run through an example.

For instance, if a deal is $100MM and is 80% Loan to Value (i.e. equity raise is $20MM), a 3% acquisition fee (which is high!) would apply to the overall Purchase Price of $100MM = $3MM. Now let’s say that the coinvest in the deck says 10% (a great number, right?). The coinvest, as a dollar amount, is $20MM * 10% = $2MM. **So you paid $3MM in acquisition fees to the GP, they “contributed” $2MM of that $3MM back to the project as a coinvest, and pocketed the rest. **I would look out for this.

The source of the GP coinvest is important as well.

If the GP doesn’t seem wealthy, you’re probably right.. and the check might be coming from a Co-GP that’s not even mentioned in the deck. There’s nothing fundamentally wrong with that (as long as they’re transparent about this up front), but you should understand whether they have worked together as a team, and what this co-GP is bringing to the table that the existing GP isn’t.

In almost all cases, the co-GP is getting more favorable terms compared to your terms as an LP, and you have to ask yourself “what is he bringing to the table here, that I am not.” Hopefully there’s a good answer. See more on execution and GP team risk analysis here.

Fundamentally, remember the purpose of the coinvest - it should be meaningful sum of money to the GP (note that this brings in net worth) in order to align incentives.

Finally, while we’re on the topic of the source of the coinvest, it’s important to note that sometimes coinvests are funded through loans.

Two things to note here:

• It's not the GP's money & hiding the source of capital (i.e. if it wasn’t clear how they’re coming up with the cash) is sketchy

• Misalignment between GP and LP starts forming earlier since that debt accrues interest

In short, make sure a coinvest is coming from the GP

It goes without saying that the entire purpose of a coinvest is an alignment of interests

If the money isn't yours, it simply doesn't feel the same and the risk to LP is undoubtedly higher

2) Waterfall

Definition:

Imagine you and your friends decide to set up a lemonade stand. You're the main person running it (let's call you the GP or General Partner), and your friends chip in some cash to purchase the table, lemons, and equipment (they're the LPs or Limited Partners).

Now, you all agree that when you start making money, the LP will get a preferred return (for putting up their capital). Then, everyone gets their initial investment back (this is also called return of capital). Once both are complete, you’ll split all remaining profits 80% to LP and 20% to GP.

The "waterfall" in a GP-LP real estate syndication is just like this setup. It's like pouring water into a series of buckets – the first bucket needs to be filled before the water overflows to the next one.

What’s market:

A standard GP/LP structure is:

• First, an 8% preferred return is paid to the LP

• This interest will typically accrue if it’s not paid current

• You should also clarify whether the interest compounds or not

• Second, all initial equity capital is returned

• Note that sometimes return of capital precedes the preferred return stage listed as #1 above

• The economic difference of one vs the other can add up, but generally won’t make or break an investment decision (in our example you’re simply earning 8% on more principal, for longer, since the return of capital isn’t reached until step 2)

• I will write a lot more on the importance of return of capital in a later post

• Finally, the rest of the profit is shared 80% to LP and 20% to GP

• Note that the 20% is called the promote, which is just a fancy term for compensating the GP for their hard work with an outsized sum

Note: this is just the “standard” and this varies a lot by asset class, track record of the GP, etc.

Downside -

Waterfalls are a delicate balance, because you want to ensure that the GP is incentivized in a downturn. You also don’t want to give up too much of your upside (via the promote, mainly) up front.

Things to be careful about:

• When considering an investment, I would look at the waterfall above and compare to what you have in front of you - how do they differ, and most importantly, what are the implications to those changes in case of downside.

• All else equal, an LP should be able to accept slightly less favorable waterfall terms when the the two other pillars of the deal (Execution and Property) are great.

• I will also write a long form article on the importance of return of capital, because I believe that’s something an LP should stay fairly firm on in nearly all cases.

3) Fees

Definitions:

Here are the most common 7 fees you’ll come across in a syndication:

• Property Management Fee: This is a regular fee, often calculated as a percentage of either the invested capital, Revenue, or NOI (big difference - so make sure you ask). It's meant to cover the operational costs of managing the investment.

• Acquisition Fee: Charged when the GP acquires a new asset or investment. It's meant to compensate the GP for the time and effort spent sourcing and closing the deal. A bit more on acquisition fees and their impact to you as an LP here.

• Disposition Fee: This is charged when an asset is sold. It compensates the GP for the effort involved in selling the asset. I’ve seen this be subordinate to certain thresholds (e.g. a target return), but this isn’t always the case.

• Financing Fee: charged for arranging financing or refinancing for a building.

• Asset Management Fee: This is for the ongoing asset management (not to be confused with the Property Management Fee above).

• Construction or Development Fee: If the GP is involved in developing or significantly renovating a property, they might charge a fee for overseeing that process.

• Guarantor Fee: Sometimes a GP will charge to put their Personal Guarantee on the loan.

Downside - a GP needs fees, or otherwise they’ll go out of business. With that said, you need to be cognizant of the impact the fees are having on your investment and ensure that they are market. You can find an example of the impact fees can have on your investment returns here.

**What’s market: **This is a fairly complex topic, since it varies by asset class, strategy, etc, and I will post a longform article on it later.

Things to be careful about:

• Always make sure you understand what the fee is (both as a percentages and what you’re multiplying against). This varies a lot by GPs and you might assume one thing and then realize it was something else after signing documents.

• While fees are intentionally placed last in our list within alignment of interests, be cognizant of GPs who might be “overly” incentivized by fees - in such a case (ethics aside) they might show you deals that have a lower probability of working out only because they need to “grow through” their problems (operating losses) at the GP entity. This is more common than you might think…

Next week, we’ll move to the last of the three pillars - Property!

Whenever you’re ready, I could help you in 3 ways:

• Limited Partners:

• Future positions - you’re considering investing and need an independent opinion

• Existing positions - there’s a lack of communication, you’re concerned about fraud, or perhaps you got a capital call request and not sure how to proceed

• LP Course - if you’re interested in reviewing investment memos to get practice vetting deals, you can reach out by replying to this email.

• General Partners:

• Deck review - I’ll look over your marketing materials from the perspective of an LP and provide feedback to streamline and professionalize your process

• Investment review - I’ll provide independent feedback on an opportunity you’re pursuing

• **General Consulting **- modeling, strategic advisory, underwriting training, and much more.

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