New Red Flag: Giving LPs all of the “Upside”

New Red Flag: Giving LPs all of the “Upside”

As mentioned in previous articles and what will be a continual theme, alignment in private placements is everything. You want to make sure the person who controls the deal (and your capital) is highly incentivized to deliver the outcome you desire, which I hope is to earn a certain return on your investment. 

Today, I’ll focus on profit splits and a concerning trend I have seen in the last couple years as capital has become harder to raise. 

I was listening to a pitch from a multifamily sponsor with over 1 billion AUM. They came out of the 2008 recession and rode the wave successfully, but did get caught up in some of the 2021/2022 mess. Keep this in mind as we start questioning incentives…

As sponsors, they were charging a 2% acquisition fee along with a 2% asset management fee. No major red flags here- I might prefer lower fees but no reason to completely disregard the investment. 

Next, I learned they are vertically integrated and would also collect the property management fee. That’s not uncommon, but it is something to consider when evaluating alignment & incentives.

They got to the end of their pitch and I realized they never mentioned the waterfall/profit split structure, which should have been apparent. 

I asked, and learned that there was no profit split. It was structured 100% to the LPs and 0% to the GPs. Need a refresher on GPs & LPs? Here you go: Investing as a Limited Partner: The Main Parties to a Deal

Their answer was that they saw value in the investment but didn’t think there was enough “meat on the bone” to warrant a promote/profit split. They expected to be compensated through their various fees and the property management of the deal but they would leave the “upside” for the LPs. 

This introduces a whole host of issues around alignment between sponsor and investor. 

For one, sponsors with in-house property management almost never fire themselves to bring in a better property manager… go figure.

Also, would they be incentivized to sell the deal at an opportune time if it meant giving up their fee stream? 

Let’s look at an operational example:

Operating and managing an asset to full optimization requires considerable expertise in today’s environment. The difference between 85% occupancy and 95% occupancy is a skilled property and asset manager who is also motivated.

This difference in occupancy makes little difference to those earning the property management and asset management fees, but a huge difference to the common equity limited partners.

Bear with me here as we do some quick math:

If the asset management fee and property management fee are both based on revenue and we assume $4 million of top-line revenue at 95% occupancy:

The difference between 95% and 85% occupancy to the sponsor is only $25,263 per year.

For your investment, the difference between 95% and 85% trending occupancy cannot be overstated. Depending on the deal, this could be where the bulk of your return is made. But for the no-promote sponsor? It’s barely $25k per year.

They get paid regardless of performance, and they’re not motivated to optimize for a successful hold period or exit.  The majority of their comp is relatively certain, whereas your return lies in the margin.

This question rings in my head as I consider investments with sponsors: Will they be incentivized to operate the asset successfully? 

If they are giving away 90-100% of the upside, you need to ask why and really consider the motives that are at play.

Thanks for reading! If you’re interested in North Carolina single-family development or existing multifamily opportunities, you can follow along by clicking here. I usually only come across 1–3 deals per year that are worth investing in.