Qualifying a Sponsor lies within the larger picture of a passive investors’ overall portfolio allocation strategy. By that I mean before rushing off to vet Sponsors, consider how you want to allocate your portfolio (paper securities v. physicals) and then for the physical portion think how you want to divide up the rest of your pie. Below is a brief road map.
- Decide target allocation to real estate
- Within real estate, debt vs. equity
- For debt & equity, consider asset classes, geography, returns, terms, etc.
- Find sponsors and qualify them
- Evaluate deals
Don’t waste time qualifying a Sponsor who offers debts while you are seeking to place your money in equity. Similarly, if you are already up to the bream with, say, exposure to CA multi-families, perhaps you should direct your attention to other Sponsors who offer opportunities in another part of the country, perhaps even consider other CRE asset classes. We blogged about debt v. equity. At the cycle we are at, I know lots of investors are parking their funds at low leverage real estate debt funds and wait for the market to turn but it’s a personal call. BTW you should absolutely diversify/spread your investments in CRE across different Sponsors, asset classes, geographic regions, debt & equities. You wouldn’t invest in a single stock and call it a day; it’s no different here. Sorry for a little digression; back to qualifying Sponsors.
A podcast guest once commented on why the right Sponsor matters more than the actual deal itself and it resonates a lot with me. He says:
“Good things happen to good properties, more so than to bad properties. Bad things happen less badly to good properties than to bad properties. Good management cannot avoid problems and they do make mistakes but they are better at recovering from problems AND they are better at finding opportunities.”
(Note: The guest was Peter Linnerman, who used to teach real estate at Wharton. By “management”, he was referring to Sponsor, not property managers though I would think the same principle applies.)
Passive investors should focus on selecting Sponsors they want to work with first even before looking at deals. This is not because passive investors are not smart or capable enough but that to evaluate deals well requires a significant amount of time, skills, knowledge and experience in the industry and market that isn’t feasible for most passive investors who work full-time jobs, particularly if they also try to diversify across asset classes and geography. Going with the right Sponsors allow passive investors to make the trade-off between time + diversification with control + judgment.
Below is what I would look for when evaluating Sponsors. It’s not meant to be an exhaustive list. In no particular order:
Sponsors should provide a list of actual deals they’ve done and the corresponding performance metrics reflecting the actual net returns to investor, preferably in the same product type and strategy. Needless to say, higher returns, and consistency of those returns, all else being equal, are good to see. Make sure the numbers presented are from deals already exited and not projection of exits at assumed levels. Longer track records with deals done through one market cycle or more is even more desirable. It doesn’t mean you should write-off those that haven’t; investors simply require more digging on how the Sponsors are prepared for a significant downturn. Some Sponsors employ shenanigans to make their results appear better than they really are so understand what the numbers represent and derived.
Admittedly integrity is a quality that is hard to discern without repeated interactions and even then it’s really difficult to know for sure until things go south. But there are crumbs that offer clues: if the Sponsor squeezes investors on fees, overpays for assets, underwrites aggressively, misleads on its proforma and structures compensation that’s less performance-based and unfairly tilted to itself. I have yet to encounter a Sponsor who doesn’t claim to be conservative or prudent in its investment philosophy and underwriting approach. Action speaks louder than words so investors should always verify and observe: review assumptions used in financial projections, the type and terms of debt being used and business plans to be employed. Is the Sponsor pushing the envelope or being reasonable? It’s also helpful to know what deals it passes up on, especially given where we are in cycle. Meet the Sponsor face-to-face whenever possible, not just speak on the phone. Trust your gut feeling. Sometimes our intuition/6-senth tells us if something is off, even if we couldn’t put a finger on what. Inquire with other investors or check from various investor communities. Simple Googling names of executive team members for lawsuits/indictment, postings on social-media could help shed lights. Start investing with a small amount and see how things shake out.
Sponsor’s edge or competitive advantages
In whatever market segment it chooses to operate, a Sponsor should be able to clearly articulate its competitive advantages that help set itself apart from its peers. This can include an edge in sourcing opportunities using proprietary algorithms, or special relationship with industry players that allow it to get to deals before others, or perhaps expertise in deploying certain proven business strategies to drive up NOI, or focus and experience on specific asset class(es).
What you are trying to look for here is alignment of Sponsors interest with those of investors. The Sponsor should be investing a significant amount of its own capital (and preferably those of its friends and families) alongside investors. At times, this is not feasible as their capital could be tied up in other deals, they could structure the bulk of their compensation performance-based rather than transaction fees-based.
Investor retention (or % of repeat investors)
The extent of investors who keep coming back and re-investing with the Sponsor across multiple deals should be a positive sign. This suggests Sponsor delivered actual returns that at least met and most likely exceeded expectations and projections, consistently. I don’t think reasonable investors would stick around if they got burnt or the Sponsor doesn’t “show them the money!” Ability of a Sponsor to retain investors and get them to roll from one investment into the next is both a by-product of and a telltale sign of Sponsor’s track records.
Is the Sponsor an Allocator (A Sponsor of Sponsor)?
There are Sponsors that raise capital from investors to invest in other Sponsor’s deals either as co-GPs or LPs. Whenever there are two layers of Sponsors and managers, there are usually two sets of fees and thus lower net return to investors. Consider and weigh the option to go-direct to Sponsors. This is not to say all Allocator type Sponsor is to be avoided in all cases; they might able to pool offerings from several Sponsors into one vehicle that adds diversification in a meaningful way, or perhaps the Allocator manages to negotiate significantly reduced minimums without which the opportunity would be off-limit to most smaller investors or, depending on its bargaining power, obtains better promote with the Sponsors. The point here is beware of the incremental costs and understand what are being paid for or exchanged.
Good Sponsors exercise good judgments that lead to good deals that generate good returns. Finding the good ones require investor efforts upfront and periodic check-up to ensure good Sponsors haven’t strayed. After all, one doesn’t earn 10%+returns without doing work – yes, even for passive investors – taking risks and making some decisions.