Boosting Your Returns Without Taking On More Risk - Published in Family Office Magazine, Autumn 2017
Updated: Feb 12
Real Estate Private Equity [PERE] Deals are typically structured by its sponsors as a limited partnership ir a special purpose vehicle [SPE], which has two types of partners: limited [LPs] and general [GPs] partners. LPs are passive investors who provide most of the equity for the deal while enjoying limited liability and GPs, are the ones who carry the load, have a fiduciary duty to all investors and are responsible for delivering the expected returns.
Incidentally, the Sponsor/GP, is the private equity form that makes it all happen. The GP role includes but are not limited to: sourcing and underwriting the deal, identifying the intrinsic added value, structuring and negotiating it, financing it, executing the guarantees on the loan, conducting due diligence, raising the equity capital, closing the transaction, executing the business plan to extract value, disposing of the asset to maximize profits, reporting and profit distribution. In addition, the GP may invest alongside the LPs in the deal. Typically, the GP contributes anywhere from 5 to 10% of the equity portion of the deal, however on large transactions that percentage usually gets reduced.
Essentially, a PERE deal is a collaborative effort between GP and LPs in a “for profit venture” in Real Estate. However, how are these profits manifested? What metrics do investors focus on, when selecting an investment? Well, the most common metrics used to evaluate PERE investments are:
[a] Cash on Cash Returns, which basically represent the distribution of cash flow before taxes, [b] Internal Rate of Return [IRR], which in plain English, represents the value an investment generates over the entire holding period. Simply put, the IRR is the percentage of “interest rate” earned annually on each dollar invested in a property during the time it is owned. The calculation takes into consideration the capital invested; all the cash flows received, capital events and time value of money. [C] The Equity Multiple, which without any consideration to the length of time, indicates to potential investors, what they are expected to get in return for each 1 dollar invested. It considers the gains from the investment as well as the return of the initial $1 dollar invested.
Also, consider the real estate investments offer an added bonus in the form of depreciation, investors also take into consideration Sheltered Income, which is the amount of income they may shelter from taxes through this mechanism.
Finally, investors also focus on the Preferred Return, which is basically the return on equity investors will receive before, the sponsor earns the right to participate in the deal’s Promote.
What is the Promote? Why does the GP deserve it? The Promote is a pre-determined percentage taken out of the profits on the deal that is set aside for the sponsor/GP. The Promote is, therefore, a bonus for the GP for delivering return to investors that exceed the Preferred Return. Even though the GP is also compensated through a variety of fees that are paid by the project, the promote has a special relevance, since it represents the lion share of the sponsor/GP’s potential earnings on a deal, but as indicated earlier, it is not “earned” unless certain performance hurdles such as preferred returns have been achieved, further aligning the sponsor/GPs interest, with those of the LPs. The sponsor/GP deserves the promote in consideration of all the work outlines above, as well as for delivering outstanding results in the project as the other fees it collects barely cover the GPs expenses.
Most of us, from out early forays in the investment world, have worked and allocated capital under the unquestioned understanding that there is a direct relationship between risk and reward; the investment gods will allocate lower returns to those who take less risk, while higher returns will be bestowed upon those who dare to take higher risks… however, is it so? Is there a way to earn a disproportionate higher return for virtually the same amount of risk? As far as PERE is concerned, the answer is yes. As indicated earlier, a GP, to demonstrate “skin in the game”, may contribute 5 to 10% of the equity deal. However, due to its desire to make the best and highest use of the existing capital to scale its operations, fill a temporary capital shortfall needed to capitalize on an awesome deal or another reason a GP may want to limit or reduce the amount of capital it deploys and still meet the above equity contribution.
In order to reconcile the above, meet the expected equity contributions to ongoing deals and maintain sufficient capital to participate in further deals and maintain sufficient capital to participate in future deals, GPs have resorted to using a GP co-investment model; where they invite selected investors (very select few), typically UHNW individuals and family offices to join them as GPs in the deal and provide a portion of the capital they need to help them fund their GP equity contribution.
Clearly, this mechanism does not come cheap. In return for their assistance, these investors benefit handsomely, as they [a] receive as any other equity investor, the returns allocable to their share of the equity invested in the deal, [b] they enjoy lower costs as they typically negotiate a lower fee structure on their equity contribution and most importantly, [c] as they proverbial carrot, they may also receive a share of the GPs promote, effectively enabling them, at the end of the day, to walk away earning the highest share of returns [IRR & Equity Multiple] of any other passive investor in the deal, arguably, for virtually the same amount of risk that everyone else took.
So next time you get a call from a sponsor to invite you to participate as a GP co-investor on a deal, take the call, do your due diligence but take the invitation seriously as it may be the key to higher returns.
Ofer Vilenko is a managing partner and CIO of VTS Capital Partners. An experienced private equity and real estate professional with over 15 years of real estate investments, including acquisitions, due diligence, asset management and dispositions.