Forget IRR - start with Sources & Uses

Happy Thursday!

Most LPs spend 95 percent of their diligence on the IRR (reminder to not do that), the rent comps, or the pro forma. The place I usually start is the S&U (Sources & Uses) table, which some decks don’t even have.

In short, a S&U table is exactly what it sounds like - it explains what the sources of your capital are for this transaction and the uses of those funds, line item by line item.

Today, I wanted to take some time to explain why I value it so much and what things to look out for as an LP (and why it’s definitely among the things you should have prior to investing in a deal).

Here are the top 5 things I look for:

1. Acquisition Fees

• Always check the Uses for acquisition fees.

• A normal fee might be 1 to 2 percent. Anything above that deserves a conversation - more on that and other common missteps here

• On a 20M deal, every 1 percent fee is 200k. That is real money that you and the asset must earn back - more on fees eroding returns with an example here

2. Working Capital

• Working capital is normal. In fact, you want them to have a cushion because running out of cash is bad for everyone involved

• What you do not want is a “working capital bucket” that mysteriously ends in dividend payments (aka you paying yourself back)

• LPs should only contribute what is absolutely required - you can (hopefully!) manage your own cash and don’t need the GP to manage it for you

3. Capex

• If this is a real value add (or in a somewhat distressed state), it will take money

• Always ask for details about the capex budget, and hopefully there’s a contingency baked in too (particularly important for older buildings)

4. GP Co-invest

• The most obvious place to look for the coinvest is the Sources table - part of the equity should come from the GP and I generally guide to 5-10%

• higher percentages are obviously harder to reach if you’re doing a larger deal and/or if the GP is younger. What you’re ultimately after is whether what they’re putting into the deal is material to their net worth…

• Ask if the GP co-invest is cash. On development deals especially, half of what gets labeled as “co-invest” is actually non cash (e.g. contribution of land, sometimes at a very high mark up)

• Don’t forget to compare coinvest in dollars vs acquisition fee (or all front end fees to the GP, for that matter) in dollars - ideally the GP has net cash in the deal as opposed to walking away with cash day 1

5. Lumpsum Closing Costs

Every LP should get into the habit of scanning for suspiciously large lumpsum numbers in the Uses.

Common offenders:

• Quasi acquisition fees buried in closing

• “broker fees” paid to an affiliate

• Rate buy down fees to the lender (which use your LP equity in order to sell you a “positive spread” deal)

As always, I hope this was helpful and I look forward to your feedback!

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