How much of their own capital should a sponsor have in a multifamily investment deal? It’s a fair question, and one that investors may ask to gauge how vested their partners are in the deal.
The general thinking is that when sponsors invest their own capital, they’re more incentivized to ensure the investment is good and the deal won’t lose money. But the real question is this – how important is it for a sponsor to invest their own capital? And is it a deal-breaker if they don’t?
As a sponsor, there's no better place to park our money than in these syndications. It’s important to understand exactly why a syndicator would put less money into the deal and, seemingly, have less skin in the game.
Typically, it's not so much that the sponsor doesn’t want to invest their own capital. It’s that they're not in a position to put money in. The reason is that liquidity is really important as an operator for a variety of different reasons.
- Sponsors need to show liquidity to secure bank loans.
- Sponsors need some liquidity set aside as an emergency fund.
- Sponsors need liquidity to put deposits down on new deals.
If a sponsor doesn’t have cash, it can put them in difficult positions. If we’re putting bids on multiple multifamily deals, it could tie up $300,000 to $400,000 pretty easily.
It’s a fair question, though. If an investor asks a sponsor how much of their own capital they are putting into the deal sponsor replies with “none” it’s totally fair to ask – “Why not?”
Obviously, if the sponsor indicates that they don’t want to personally invest because they are unsure about the deal, that’s a red flag. But typically, at least in our case, if we're not putting in money or putting in less than the minimum, it’s due to these issues of liquidity.
In order to preserve deal flow, it’s important to have liquidity.
Aligning The Interests of the GPs and LPs
At the heart of the question about having “skin in the game” is the determination of how aligned the General Partners (a.k.a “GPs” or “operators” or “sponsors”) are with the Limited Partners (a.k.a. “LPs or “investors”). In other words, how much are the operators going to care about the deal and, if the deal goes south, will the GPs be affected in the same way as the LPs?
Could one party simply walk away?
Let’s dissect that here. It’s nice for a sponsor to show skin in the game through their own capital investment, and trust me they would LOVE to put their own capital into every multifamily deal, but what’s really more important is that the GPs have liquidity. This is the real question that investors should be asking of sponsors – how much liquidity do they have available to ensure the deal stays on track?
What happens if something doesn’t go quite right with the deal? One of the things that sponsors don't want to do is call up our investors and go “gosh, uh, something went wrong and we need another half million dollars.” We’re much more inclined to simply pay for it out of pocket, making liquidity very important to sponsors.
What’s MOST important is that interests are aligned so that the operators are motivated to do a good job. One way to make sure of that, for example, is to have the equity aligned and the fees aligned. In other words, if the property makes money, the General Partners should make money as well as the Limited Partners.
Signs of Misalignment
A sign of misalignment is when the property makes money and the General Partners make money, but the Limited Partners don’t. Or, it could even be the other way around. The LPs make money and the GPs don’t, which happens with preferred returns. This is also a misalignment of interests.
Remember, the GPs don't make any money in the actual deal. Their equity is worth less until they have forced the appreciation of the multifamily asset. For example, if the GPs own 20-30% of the deal, that equity won't become valuable unless that deal has gained enough value.
Related: Forced Appreciation VS Market Appreciation
The GPs are very, very incentivized to make that equity worth something because, if they don't, it won't. It'll be worthless and we’ll find ourselves working for free.
Also keep in mind that the General Partners are guaranteeing the loans. If there's ever a default situation the Limited Partners might lose a part or even all of their capital, but the General Partners now have lawsuits on their hands.
The downside could be very severe for the GPs. So while it's worthwhile to ask how a sponsor has skin in the game, it should not be a showstopper if the sponsor isn’t investing their own cash into the deal itself.
The Bottom Line
The partnership between multifamily operators and their investors should be seen as a long-term relationship where both parties are looking after the best interest of their partner.
- Operators need to be transparent with investors about their liquidity requirements, and show confidence in the team. Related: How to Vet a Multifamily Syndicator
- Investors need to understand the additional amount of risk that the Operator is taking on by guaranteeing loans, and recognize the importance of available liquidity.
For our current investors, I want to say THANK YOU for taking the time to educate yourself because as you do, you're getting better. No one cares about your wealth quite like you do.
If you're new to multifamily investing and want more information, I’ve put together an awesome report comparing the returns of stocks to multifamily investing.
Finally, if you’re interested in finding out about the multifamily deals we have brewing at Nighthawk Equity, go to our website and click the join button. We’ll setup a call to learn more about each other.
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