How do all the smaller GPs handle the funding to closing process?
Right now , my boss is branching out to start a new firm as a GP. A couple of us are planning to join on the side. We are looking at a couple deals with one in best & final. We got three LPs willing to back us on pref equity terms (standard). I just wanted to understand the process once we go under contract. Do we make sure the LPs sign agreements and fund prior to closing. Its so many moving pieces and the fear that one LP could back out as well is scary. How is this managed? If anyone can provide a step by step breakdown after a deal is underwritten that would be great. I heard various things such as LPs sign agreements right at the LOI stage, others around closing. Also what if deals fall out, escrow is lost, or a ton of money was spent on lawyers is gone, etc. Does this fall on the GP or is this equally split among all parties? I am just trying to under the small details.
This is part of the risk of doing deals, why going out on your own is not easy. The GP usually hast to front most of the pursuit, due diligence, and other costs usually including any deposits. Most LPs won't fund until the deal closes. And yes, they can back out (maybe you will have legal recourse, but it won't help close the deal).
The way to mitigate is to get funding at the GP level, or use loans/lines of credit/personal wealth.
Hence why to be careful what you are signing, taking personal liability, etc. In general, you are just risking any cash spent/invested and your reputation (i.e. looking like a loser who can't close).
So you're saying in most cases the GP fully closes with their own equity and then gets funded after the fact, sort of like a reimbursement? For deposits and closing cost, will they be calculated towards equity?
Could you clarify getting funding at the GP level? Do you mean a Co-GP?
This depends on the relationship between the GP and LP, there can be arrangements where an LP (usually a sole LP in the deal) may pre-fund pursuit costs and deposits. There will likely be some de facto loan arrangement terms if a failed deal or something like that. The reimbursements come at closing (the LP will fund into an escrow account, that is usually the 'proof' of equity for any lenders, etc.). Or in the case of legal bill, other costs, sometimes the bills can be sent to 'closing' and disbursed directly by the attorney handling escrow.
Accounting true-up often occurs after the fact, but those initial monies spent/expenses incurred can be used to count towards the GPs own investment in the deal (few are 100% funded by the LP). All of this is subject to negotiation and the nature of the relationship between the GP and LP(s).
And yes, funding at the GP level could be Co-GP equity, it could also be loans/lines of credit secured by the GP interest or something like that.
Generally the GP doesn't "close" with their own equity. All the costs of pursuit are borne by the GP, and then your equity contribution at closing is a true-up to your agreed upon split.
And we had this happen recently, where an LP wanted to back out last minute because of COVID-19 concerns. There is no real recourse. And yeah, it's a major issue - LPs don't want to throw good money chasing mediocre returns and have the financial heft, usually, to not mind walking away from their share of a pro-rata deposit, if they even are required to do that. GPs are generally putting a much larger percentage of their available cash/net worth/etc into the deal, so walking away isn't always an option.
Trust, relationships, flexibility, and an appetite for risk. Ideally a strong balance sheet to go along with all that too.
The answer to every question you asked is "it depends." Every deal and every partnership is different.
I'd suggest hiring an experienced lawyer to guide you through the closing process. They will know what is "market" and what is not when it comes to negotiating all these little items.
Worked in this space a lot. If a GP is raising from multiple LPs, then the GP raises more money than needed because they must prepare for LPs to back out at the last minute. If all LPs are prepared to fund, then the GP just says sorry, we're over-committed, you'll have to reduce your allocation and save some for the next deal (that we happen to already be looking at).
As the GP grows, they often build relationships with a couple LPs that can fund the entire deal. So, they'll do one deal with a singular non-institutional LP.
You can deal with the DD costs any way you want. But for less-established GPs, they're funding the DD costs themselves. Some will raise this capital in a separate bucket and offer a higher return due to the greater risk. Basically, do whatever you need to do to get your first few deals closed with the limited capital you have. The money is made when you have a track record and negotiating power with LPs, or when you can raise so much capital that your low-teens IRR still nets you real money.
That said, this is all written for non-institutional LPs. And it sounds like you're dealing with more institutionalized players based on the "standard" pref equity quotes your getting. So your mileage may vary.
GPs typically fund 100% of the earnest money and pursuit costs required to get a deal under contract and close on the acquisition. They may be refunded for part, or all and then some (acquisition fee) at close....but the GP is on the hook for hundreds of thousands (or more) in "risk capital" that's at stake if they can't close for pretty much any reason. The "risk capital" that's required is one major items that justifies a GP's promote, acquisition fee, overall compensation, etc.
A lot of GP's will fund their first few deals with friends and family funds in $100k to $1MM+ increments via a 506c offering. I think it's important for newer GPs to have multiple potential investors, significantly more equity raised than needed to close and significant personal liquidity relative to the total capital raise.
It's not impossible to close on your first deal with a single equity investor and I'm sure it's common practice...but I wouldn't recommend going this route...especially if the risk capital required is your entire liquid net worth....
Makes more sense to close smaller deals with own equity(if you have enough), then just sell off equity post closing. Maybe doing this on the first deal makes more sense until some LPs get comfortable.
To play devil's advocate - my partner and I went out on our own and funded our first deal with one equity partner. Since then, we've closed on 9 more with that same equity partner. Sure, we will outgrow this investor's balance sheet and need to bring in more investors (in process), but it has been nice to manage one relationship while getting established rather than try to keep track of reporting to 100 investors while also pursuing new acquisitions, managing developments, handling the leasing, property management issues that pop up, etc. The risk is the investor could decide to pull the plug at any time, but sometimes you just need to get started rather than wait another 20 years until you personally have enough liquidity.
To the original question though, we are like most others are commenting. We fund all earnest money and due diligence costs (and pre-development costs prior to closing) and then get reimbursed at closing. If we don't close for some odd reason, those pursuit costs are now sunk costs, but that's part of doing business and the fees and promote will more than offset the cost of an occasional lost deal. If you're walking from deals all the time, you're doing something wrong.
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