Investor Beware: Why Misunderstanding Deal Structures Can Lead to Costly Mistakes
By Brad Hreha
Some of the questions you should be constantly asking are:
- What should the equity split be between the general partners and the limited partners?
- What type of debt should you use on a particular asset — bridge or agency?
- Do you charge a standard 3% acquisition fee or reduce it to 2% to make the deal work?
- Can you charge the normal asset management fee of 2% or reduce it to 1.5%?
- Should you charge a refinance fee or consider that part of the active role in the property?
- Do you charge a disposition fee when the project is ready to sell?
- Do you offer the investors a preferred return?
Some investors have a set criteria, but I think that is a mistake on their part. Some deals you need to get creative to make them work for both parties.
Every deal is different and should be treated that way. A change in the structure of the deal can turn it into a good deal or vice versa. The main concern of mine is if this aligns with our investors. The bottom line is, investors do not want to pay excessive fees and general partners do not want to work for free, so where do we meet on common ground?
I have seen many deals over the last few years with preferred returns to the investors with no cash flow to the general partners for three or four years. Some deals have no cash flow over the hold period. I do not understand how this investment structure can be attractive to a passive investor. On one hand, the passive investor knows they will get paid first but, on the other hand, you have a sponsorship group working for three to five years not earning any money from the investment.
Can a passive investor really expect they will operate the investment to the best of their ability? How much time and effort will the sponsorship group invest in the deal knowing they will not make any money until the deal sells, especially if they have other investments that are cash flowing for them? On the flip side, if the sponsorship group collects fees every chance they get, how can you feel confident that they care about how well the investment turns out at the end? There must be alignment between the sponsorship group and the investors.
Investors should be looking at each deal on a case-by-case basis. If you are used to a preferred return, that does not mean that a deal with no preferred return will not be a good investment. Dig into the structure of the deal and the fees associated with it. Ask the sponsor why they are charging a specific fee or why they are not charging a fee. The answer you are provided should have a valid reason behind it. I always like to see waterfalls in deals. This shows me that the sponsorship group has incentives for the asset to perform well. If the deal performs better than expected, then they should be rewarded for it. If the deal falls short but they hit you with numerous fees throughout the hold period, then they were paid but what about you? The structure should be clear that when the deal does well, everyone does well.
So, how does a first-time investor determine which group to invest with? Well, that should be determined by your investment goals. If your investment goals line up with the structure of the deal, it could be a good fit for you. Dig deeper. Speak to previous investors about their deals and hear how their deals have performed compared to their projections of the deals. You are making a passive investment, but it is not completely passive. At least not upfront. You need to perform your own due diligence on the groups you are considering investing with to ensure you are working with the right people.
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