GPs give away too much equity
I always find it funny when people on here or X shit on GPs for taking more than a 20% promote, without knowing anything about the specific deal and the specific structure. In a typical structure where there's a preferred return based on a hard hurdle, the investors are getting the best of both worlds - priority in the capital stack for both return of their capital and current cash flow and also a large piece of the common equity, if you will. They essentially own both the preferred shares and a large portion of the common. Below is an example to illustrate, with very simple assumptions. Curious to hear others thoughts on this.
Project cost of $10MM, 8% yield on cost, exit at 6% cap rate in 5 years, NOI growth of 3% annually.
Debt at 65% LTC, 6% interest, 25-year amort.
All equity ($3.5MM) funded by LPs with an 8% cumulative, non-compounding pref and the GP getting a 20% promote. I chose this for simplicity and to mimic paying out current preferred dividends and common dividends along the way. Using an IRR-based pref with the GP only getting paid at the end would likely amplify what I'm showing.
At the project level, the deal is a 28.1% IRR and the LPs IRR ends up being 25% - not bad at all. However, this is a blended rate of a return to the preferred equity and the common.
The preferred equity receives their pref of $280k annually for 5 years, with a return of their capital of $3.5MM upon the sale. Discount this back at, say, 15% and the PV of this preferred equity is $2.68MM.
That means they're paying $820k for 80% of the common equity. Based on the residual cash flows from operations and the sale, their common equity IRR is 43.5% and their equity multiple is 5.8x. Not a bad investment.
If you change the promote to 50%, the LPs now achieve a 19.8% IRR. Still not bad. Broken down, the preferred equity metrics don't change, but the LPs now paid $820k for 50% of the common equity, which returns 30.2% IRR and a 3.7x EM. Still a great return.
Thoughts?
Based on the most helpful WSO content, here are some insights on the topic of GPs giving away equity and the structure of preferred returns:
Key Points:
Preferred Return Structure:
Example Scenario:
IRR and Equity Multiple:
Impact of Changing Promote:
Analysis:
Conclusion:
The structure of preferred returns and GP promotes can significantly impact the returns for both LPs and GPs. While higher promotes might seem excessive, they can still result in favorable outcomes for LPs, especially when the project performs well.
Sources: LPs/Investor Return Structure, https://www.wallstreetoasis.com/forum/real-estate/gplp-structure-friends-and-family-capital-jv-structure?customgpt=1, Do you think it's justifiable to ask for 25% of the GP for being the fund raiser for the projects?, Unique LP/GP Setup - Governance Mechanics, Economics, Other Fun Considerations, Special Sits PE Case Study Example
Haven’t been long enough in the industry but have you seen a case where GP does not have skin in the game? In structure outlined the LP is essentially taking all the risk and GP collects promote in addition to management and other fees. Too good for GP
I was keeping the example as simple as possible, but agreed, GP would most likely need skin in the game. A lot of times it’s just rolling in a acq/dev fee. I have done a couple deals with nothing in as the GP, so yes, it’s done. Full recourse debt, so while the LP has first loss, we have more to lose if it goes to hell.
What kind of gypsy voodoo Borat magic did you pull to not have to put down >5% of equity portion of cap stack
I’m at an LP and we’d never put in more than 90%, such that it’s 90/10 LP/GP
Aware of a few LPs that’ll do 95/5 but that’s it
When I was an LP, I thought it was crazy that a GP wouldn't put money into the deal. "But they won't be incentivized to perform!". Once I came over the GP side, I understand how silly that argument is. A GP isn't going to work any harder because they have 5-10% of equity in the deal. They are going to work hard because: (a) their nuts may be in a vice with a partial or full recourse obligation; (b) your ability to raise $ for future deals is dependent on your performance; (c) most good GPs just fundamentally want to knock it out of the park; and (d) GP's put in 50-100x the amount of effort & time that an LP does into a deal. There is no way to be compensated for that work without carry on the backend. If a deal doesn't generate a promote, that was a horrible allocation of your most limited resource (people hours). Co-invest to me is just diverting working capital away from the GP's business.
Can you explain your last sentence please?
Don’t think anyone views pref from the lens of it being preferred equity. Just a return you need to beat, which with leverage is not particularly high. The 50% scenario you call “not bad” - you went from taking 3 points of return out of the deal to over 8. How is that not bad?
Well yeah, that's the whole point of the post, to break it down in another light to show where returns are being generated. But the mindset of "the GP took 8 points out of the return instead of 3, avoid the deal!" is also just hilarious. Some would rather get a 10% return instead of 20%, as long as the GP isn't getting too much. As an LP, I'd be glad the GP crushed it for both of us and hope they call me for the next one.
Again, all of this assumes things go well and betrays an almost comical lack of understanding of motivations for both parties in this conversation.
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