Bad LP Diligence Questions

Happy Thursday!

I’ve written many articles on diligence over the years, which I’ll include below with the most popular articles in bold. It occurred to me, however, that I haven’t spent time on what an LP shouldn’t ask. Today I’d like to address that head on.

• Minimum Viable Deck

• Investor Beware: Feeder Funds

• Guaranteed red flag

• The Refinance Assumption Trap

• 26 questions to ask your GP

• Top 15 Syndication Mistakes

• 4 reasons why cap rates are misleading

• Don’t budge on return of capital

• Why acquisition fees in a syndication matter

• Three Pillars of LP Investing:

• Execution

• Alignment of Interests

• Property

• Asset Specific Posts:

• Single tenant net lease syndications

• 6 Lessons on the Perils of Quick Advice

• We renovated, but will they come?

• Filtering using IRR and CoC is dangerous

• Fees erode more equity than you think

• Track record audit

• Minimum Viable Due Diligence

• Cap Rate Compression Trap

• The dangers of “trust but verify”

• 6 reasons to put down a deck

• Does the pref even matter?

• 10 reasons why deal flow rules the world

• Can you teach me to be a GP?

• Are funds safer than single asset deals?

• Top 10 misconceptions about syndications

• LP Risk Mindshift

• Does due diligence matter?

• Tariffs and pricing control: why GPs control less than you think

• Should struggling GPs be raising money?

• 5 common LP investment biases

• Top lessons from an allocator & GP

• LP due diligence guide

• Should you invest in emerging managers?

• Return of capital strikes again

• Last mile LP risk

• Filtering investments by GP AUM

• Anti-stock marketing tactics

• Two concerning trends

• Never say never

There are levels to phrasing a question which I discussed here at length. That won’t be the topic for today, but I just want to note that you could be asking the right question, but by phrasing it the wrong way you won’t get the full benefits of the due diligence feedback you’re seeking.

Alright, let’s dive in - what are the 6 things you should not ask a GP?

1) References

This is likely the most common mistake. A GP (whether you like it not) will not put you in touch with someone who’s sitting in a bad deal, and to their credit there’s always two sides to a story. What’s even worse is that ~half the LPs who are currently sitting in challenging investments don’t even realize that, and speaking to them would be extremely misguiding.

All to often, the LP will speak to another LP (who might be clueless about investing themselves) and use that conversation as validation to invest. This is a common trap, and the uncomfortable truth about investing is that you need to build up the confidence in your own investment abilities so that you don’t need to depend on others.

To close - speaking to others is great, but the LP you’re speaking with:

• shouldn’t be personally biased (sometimes the referral you’re speaking to has a personal bias for you to invest, whether that be saving the deal, helping the sponsor, or perhaps even monetary compensation,

• shouldn’t be “hand picked” by the GP

• should know what they’re doing when it comes to investing … otherwise you’re simply doing yourself a disservice.

2) Have you ever had a capital call?

I wrote about this topic at length in **Should struggling GPs be raising money? **and would recommend starting there before you continue.

The short reason why I believe this is a bad question is the following:

• Real estate is a capital intensive business with cycles

• Every single great investor makes mistakes eventually

• Therefore, a capital call is always a question of when rather than if

Let me translate: every single GP will eventually face the need to run a capital call.

“Ok, got it… but why can’t I ask them whether they’ve had one?!”

Because the answer you’ll get is extremely biased for a few reasons:

• 1/3 of the GPs who answer “we haven’t” are going to issue one in the next 12 months

• another 1/3 of the GPs who answer “we haven’t” didn’t issue a capital call, but raised external capital (often pref) which has the same exact impact (arguably worse actually) as a capital call to their LPs

• the last 1/3 of the GPs who answer “we haven’t” simply haven’t been in the business long enough most likely

So, in summary - the question simply doesn’t help you. What you’re actually trying to ask is the performance of the existing deals - and you can certainly go that route, but go direct and be mindful of how many questions you’re asking (see preface here for more on that topic). Asking about capital calls is an indirect question that’ll lead you astray.

3) Questions you can figure out on your own

A great GP likely has a decent number of LP relationships and while it’s true that they’re always looking to create new relationships, there’s a limit on their time and they will naturally select the LPs who they enjoy speaking with.

Put it another way, just like you shouldn’t ask for the hair color of your date while you’re out to dinner with them, you should (to your best ability) not ask basic information that’s contained in the deck. It reflects poorly on you as an LP and perhaps more importantly it starts the “clock” of patience from the GP side. You can certainly take the line that “if they don’t have time for my questions, I’m not investing” but I think this is only true up until a point - no GP has unlimited time. I wrote more on this within 26 questions to ask your GP.

4) When/how often will the distributions be

This one may be somewhat controversial because some LPs invest for cash flow. I’ll explain:

• Firstly, I don’t think you should ever invest while being dependent on distributions. Many people made this mistake and unfortunately realized the hard way that sometimes those distributions stop (and then suddenly all expectations and distributions frequencies go out the window)

• Second, many times these days distributions are coming from your own capital prefunding those same distributions (be weary of that by the way - I’ll write on the topic in full soon) and that shouldn’t even count as a distribution in my opinion

So while you should generally know what the cadence should be and what the cash flow projections state, both of these are typically in the deck and overdependence on them is (in my opinion) a bad due diligence strategy.

4) Can you show me an example of a reporting package?

You’re on the right track here, but this is a ~terrible question on its own because it gives the GP the choice (just like the referral) on which reporting package to send you.

The purpose of seeing a reporting package isn’t to see how fancy it looks - you should be willing to trade quantity for quality any day of the week, and some of the best reporting packages won’t have fancy pictures. Rather, the purpose is to ensure the GP is honest when times are difficult and reports on time. See #17 in 26 questions to ask your GP by the way for more on this topic.

For context on what I’d consider helpful in a reporting package (hint - most are not) please also take a peak at Minimum Reporting Package.

5) Can you walk me through how this deal can achieve the promised net IRR

Some iterations of the same question:

• “Are you confident this will hit a 18% IRR?”

• “What are the chances this goes according to plan?”

• “Do you expect any surprises?”

Any GP (and you should too by the way) can walk through upside assumptions - the key is figured out what constitutes upside and what assumptions are being made that could be tested on the way down.

While it’s true that the upside is important, I think LPs tend to over-obsess with that while spending very little to no time understanding the downside catalysts - I wrote on downside analysis from different angles which I would encourage you to understand:

• 5 ways in which real estate can lose you money

• Losing it all in foreclosure

• Don’t lose money (seriously)

• Filtering using IRR and CoC is dangerous

• Cap Rate Compression Trap

• Does the pref even matter?

• Criss-cross rescue sauce

• Are funds safer than single asset deals?

• LP Risk Mindshift

• Does due diligence matter?

• Is it time to double down?

• Why LPs tend to underestimate risk

• Top lessons from an allocator & GP

• Is it time for LPs to go pencils down?

• Why multiple IRR hurdles are an overkill

• Should you invest in emerging managers?

• Return of capital strikes again

• Unethical capital calls

Here are some better versions of the same questions from above:

• “What has to go right to hit the base case?”

• “What are the main downside catalysts that would cause this deal to underperform?”

The best versions of those same questions require deep thinking on your end, where you personally find some of the downside catalysts yourself as opposed to depending on the GP to tell you which ones they are. Those are the real questions you should ideally be asking.

6) Have you hit projections on your previous deals?

Hopefully you guys can sniff out the problem now - this isn’t what you’re actually after.

If you want to test this, pick a deal (ideally a specific one) and then ask for (1) original OM and (2) most recent reporting package. This will tell you a lot more than any answer to the question above.

Have a wonderful rest of the week, I hope this was helpful!

When you’re ready, I could help you in 2 ways - my email is aleksey@gplpmatch.com:

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