Why multiple IRR hurdles are an overkill

Happy Sunday!

A typical multi-hurdle promote (sometimes referred to as tiers of the waterfall) on a real estate deal might look like this:

• 8% preferred return to LP

• 70/30 split to a 13% LP IRR

• 60/40 split to an 18% LP IRR

• 50/50 split thereafter

I see these structures a lot, and - candidly - I think most are unnecessary for both GPs and LPs. Today I’d like to explain my thesis behind this and also touch on providing LPs multiple investment options, which I wrote on in some detail below.

Announcements (article continued below):

• 🆕GP-LP Match has a new website, Twitter and LinkedIn page - I will be posting a lot more there for content related to the platform so please consider following along and sharing!

• Latest **article: Should you invest in emerging managers - **is manager selection worth the additional risk?

Let’s get some basics out of the way:

• I recommend reading the introduction to Top 15 Syndication Mistakes prior to going further - the gist of this is that the more experienced a GP is, the more they can dictate a structure that’s “outside” of what market is

• Another important caveat is that some GPs are playing short term games, while others are in this for the long haul - neither is right or wrong, it just is

• The more a GP is in the latter bucket (or just don’t have a huge LP investor base), the more I’d recommend staying closer to market on splits and fees early on - you don’t want your LPs to leave you once they realize that what they signed up for isn’t market

• This touches on the broader point that your best LP is almost always your existing LP

Now, obviously the multi-hurdle promotes exist for a reason and that reason is clear - the perspective from the GP is “if the deal happens to succeed beyond a certain point, I’d like more share of the upside because you (the LP) have gotten a decent amount of upside already.”

The biggest issue with this is that this sort of ignores that the majority of the capital risk is borne by the LP. In a typical transaction 90-95% of the capital comes from the LP, and if things go side ways the majority of the capital loss therefore falls on the LP.

The multi-hurdle promote essentially says assuming things go well, I (the GP) want more of the upside … but from the perspective of the LP, neither party knows with certainty that the project will end in the green!

In other words, today (which is when the negotiation is happening with no further knowledge of the future) it’s impossible to know the outcome and the only reason the LP is willing to take the risk of capital loss is precisely to participate in the upside … which is now being (at least partially) taken away by the multiple hurdles.

Now, if a GP does one deal per year and it’s easy to raise the money for it, then they’ll likely ignore this - at the end of the day capital raising is simply a demand and supply marketplace where each side attempt to optimize their own interests.

However, if you’re like most GPs you don’t have ample LP relationships - sometimes fundraising is hard and diversifying your base of LPs is wise. My humble opinion is if you want more of the upside in a deal as a GP it’s better to change other aspects of the deal while keeping the split simple - e.g. reduce your coinvest from 15% to 5%. Simplicity goes a long way and the best way to incentivize an LP is give them more of the upside.

Now, onto the second topic - multiple investment options. I’ve seen it all, gold/silver/bronze or perhaps just a table outlining what the splits/fees are for an LP that invests $1mm vs $50k.

My somewhat unpopular take on these investment options are the following:

• if you’re speaking to an LP investing $50k, they likely won’t appreciate this table - the optics just don’t make their investment seem meaningful to you (while it might be very meaningful to them)

• More on investing sizing from me here

• if you’re speaking to an LP investing $1mm, why negotiate against yourself? Either the LP would’ve been happy at the regular terms or they would know that they constitute a large enough check to ask for a side letter ... right?

So then, all in all, why overcomplicate things? Simplicity rules the world (only after deal flow, of course!)

I hope this helps and have a wonderful weekend!

When you’re ready, I could help you in 3 ways - simply reply to this email if one is of interest:

• Limited Partners:

• ***GP-LP Match - ***a simple way for you to get more deal-flow that matches you precise LP parameters. You can join here in under a minute.

• Potential 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 you’re not sure how to proceed. I have also helped LPs with a “post-mortem” analysis on deals that didn’t work out - it’s important to learn these lessons as opposed to just blaming the GP.

• LP Course - review 4 separate memos in 4 weeks together with me and other LPs to learn how to find good LP investments.

• LP Topics Seminar** - **an ongoing biweekly 1 hour meeting with other LPs where we'll go over investment decks, capital calls, distressed situations, and modeling. This is meant to provide a deeper look into existing LP investments. Please reply to this email if you’re interested.

• ***LP Community - ***free 2,800+ member LP Investor community on Twitter

• ***Find GPs ***in unique asset classes/geographies on my monthly intro post (see LinkedIn’s post as well for more)

• General Partners:

• Deck review - I’ll look over your marketing materials from the perspective of an LP and provide slide by slide commentary to improve your pitch

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

• Capital call advisory** - **you suspect that you’ll need to make a capital call, but aren’t sure how to proceed or communicate the message.

• Other - anything from waterfall/fee advisory to disagreements between co-GPs on the proper path given a set of circumstances

• General Consulting: modeling, strategic advisory, underwriting training, etc.

If you’d like to speak on the phone, you can reach me at aleksey@centriocapital.com.