Going in assumptions as an LP

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Going in assumptions as an LP

Welcome back! 👋

Today I’d like to touch on the going in assumption as an LP investor.

When you open up a deck for a new investment, should your “going in” assumption be:

• You are investing, in which case you’d be on the lookout for convincing evidence to not invest, or

• You are NOT investing, in which case you’d seek out convincing evidence to invest

The practical difference is how much evidence you need to be convinced out of a deal.

Let’s dive in:

You might be thinking “isn’t this just semantics?!” I don’t think it is, and I advise people daily that approach the topic in a very different way.

For example, let’s take someone who’s eager to invest cash (perhaps it’s burning a hole, as they say, in their pocket). Such a person might lean much more to the mentality of assuming you’ll invest unless you get convinced out of it.

Another factor to consider is how well you know the person sending the deal to you, right? With a GP you know well (and not just as a person but also as an investor), you might again lean to investing unless you see anything clearly wrong.

Finally, a third factor to consider is your alternatives - if 5 year treasuries (using 5 since that’s the average life cycle of a real estate deal) are earning 0%, you might again be worried about your cash not earnings anything and want to invest. You can find more on the comparison between treasuries and real estate investments here.

With that intro out of the way, let’s start with a simple principle I speak about: if you don’t have time to understand what you’re investing in, don’t invest.

If you don't have time to understand what you're investing in, don't invest

Now let's look at an obvious counter example - the public markets!

How many people truly understand what they invested in when they put money into the S&P 500 or a similar index? My hunch is that this number is likely less than 1% of investors, if not significantly lower.

The reason why this is okay (unlike a private placement deal), in my opinion, is due to four factors:

• liquidity

• diversification

• barriers to entry

• long investment horizon

Liquidity

Unlike a private offering, you have the liquidity benefit and can sell your position in the index at any point if you choose to do so.

There is certainly a risk of selling out of emotion, which one could argue is a negative implication of liquidity, but overall I think it's hard to argue against liquidity being a net positive option to the investor.

In other words, an investor should expect a premium in their returns for locking up their capital and not having control of when they will receive it back.

Diversification

A private offering is tied to the outcome of a single GP, whether that is through a fund structure or a single asset deal. An index fund, on the other hand, gives you diversification across 500 different companies ran by different management teams.

I write openly about the fact that I don’t believe people should be over allocated to real estate syndications for this reason - it’s your money and you should diversify it because you’ll never understand all the risks. Furthermore, if you want exposure to real estate there’s a way to do that in the public markets - you can find a compare and contrast between REITs and syndications here.

Barriers to entry

It takes a lot in order to become a publicly traded company and this barrier to entry tends to weed out bad actors.

This process isn’t perfect and obviously there are plenty of cases of fraud in the public markets, but I think it’s hard to argue that statistically speaking these numbers are comparable to ones you could find in the private placement (syndication) universe.

Long investment horizon

When you invest in a stock market index, your investment horizon can be decades. Most syndications, however, are investing in ~5 year deals and the GP is mainly incentivized by the promote at the end of that period. They also have hard deadlines that are defined by capital providers, such as debt maturities.

The reason why this matters is because you could catch a bad time in the macroeconomy and have it impair your investment in a syndication. While you could experience a significant drawdown on your index public investment as well, nobody will call you for more capital (capital call) and the risk of “losing it all to foreclosure” (i.e. losing your entire investment) is statistically improbable across a long investment horizon in an index that contains many public investments.

Ok fine, now what? Which going in assumption should I go with?

So, for all of these reasons, you can now see why it’s normal to invest blindly into an index fund. The same might even be true about individual stocks - many people invest without truly understanding the full business models or valuations of the business. Some people invest simply because they like the product and think it’s currently underappreciated in the marketplace.

As I said earlier, I strongly believe that you shouldn’t invest in syndications without understanding what you’re investing in. Either take the time to understand the investment or admit you're sort of gambling.

The next obvious question is “how do I know if I know enough?” One good rule of thumb is that you’re likely gambling if you:

• Can't state three significant risks in your investment

• Numerically state what the impact on returns would be if one or all of these risks were to occur, and

• State any relevant mitigants to those risks

So, in summary, I believe that - particularly in illiquid investments where you’re a silent partner - your going in assumption should be not investing, and you should be convinced to invest.

Your assumption should be that you’ll look at dozens of deals before finding one you’re comfortable with. If that makes you nervous or you don’t have the time, that’s ok … just don’t confuse investing with gambling when you wire that investment. Both are ok, but at the casino people tend to be a lot better at sizing their bets and thinking about downside.

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