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.
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....
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.