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Episode 7 of Offshoot brings my long-time friend and acquaintance, Peter Kleinberg, onto the show.
Peter is Vice President of ESI Ventures, a diversified and opportunistic commercial real estate investment firm that focuses on the acquisition, development, and repositioning of value-add and adaptive reuse projects through a variety of positions in the capital stack.
Importantly, ESI plays in the space of CO-GP investing, placing money alongside a project sponsor as they concurrently raise more commodity LP equity investment. As a feature of that investment, ESI may also provide credit enhancement for their operating partners who lack the net worth and liquidity to secure bridge or construction debt.
The space of credit enhancement is loaded with nuance and complexity as significant downside risks exist. Peter goes deep with me on the deal attributes and structures which allow ESI to mitigate some of these risks. I hope you appreciate the prying I did to illuminate how well they see these risks, and how they are protecting themselves. Throughout the exchange Peter comes through as thoughtful and deeply aware of the fact patterns associated his investments and the industry as whole. Peter’s one of the younger guests I have had on the show and I think you will see why he’s every bit as qualified to be here – he’s fully got the plot.
Listen for some of the highlights:
- Where ESI invests in the capital stack (up to 98%)
- The size of ESI’s investments and the assets attached to those investments.
- The nature of the emerging manager partnerships and the high level of expertise and experience their partners’ exhibit.
- Institutional investment managers are not truly discretionary, it all must fit in their box. ESI is discretionary as they are an extension of a small family office.
- Why net worth and liquidity are a central function of the commercial real estate space.
- CO-GP investment and credit enhancement pricing mechanisms employed by ESI to secure adequate compensation.
- The real estate business is the pursuit of transactions, people are at the core of that.
- Unknown, unknowns are huge blind spots which deserve respect and should be mitigated.
- Run your development business like a business. Be thoughtful, persistent, and fill the deficiencies that come with each investor rejection. Ask questions; there are no bad questions.
- Your pitches have a marketing aspect to them. Make them professional and draw in the reader.
Transcript
Kevin Choquette:
Hello, everyone. Thanks for tuning into my conversation with Peter Kleinberg, who’s the Vice President of ESI Ventures, a diversified and opportunistic commercial real estate investment firm that focuses on the acquisition, development and reposition of value add in adaptive re-use projects, through a variety of positions in the capital stack. Since inception, ESI Ventures which is really an extension of a family office, has transacted on over $1 billion of deals across multiple property types and geographies, approximately 500 million of which has come in the past five years.
Importantly, ESI plays in the space of Co-GP investing, placing money alongside project sponsors as they can currently raise more commodity LP equity investment. ESI also provides credit enhancement for their operating partners, who may not have sufficient net worth and liquidity to secure bridge or construction debt on their own. That whole enterprise reminds me of Ed Raquel lyrics about her walk on the slippery rocks.
Credit enhancement is for many industry players a space they simply will not enter seeing way more downside, satisfying a loan guarantee than the offsetting upside. We will of course, get into all of this. Peter is a longtime acquaintance and friend who I met many years ago, as he departed Vanderbilt’s graduate business program to enter the commercial real estate space as an analyst for one of our capital providers.
Since we’ve both gotten a good bit older and maybe wiser, and Peter’s had a great career moving from the buy side analyst role to a note sales group at SunTrust Bank as part of the Great Recession, to assisting in the formation of a high performance sell side team at George Smith Partners in 2012. From there, he went on to lead the successful IPO of Landmark Infrastructure Partners on the NASDAQ in 2014.
And following that, he launched a commercial real estate operating company and fund. Peter received an MBA from Vanderbilt University, and a BA from the University of Colorado. And like more than a handful of the show’s early guests, also loves to chase powder after spending months at a time in Jackson Hole. Peter, welcome to the podcast. Thanks for joining me.
Peter Kleinberg:
I appreciate being on. Thanks for the nice intro.
Kevin Choquette:
Yeah, of course. To start, could you just tell me a bit about yourself and ESI Ventures?
Peter Kleinberg:
Sure. Well, as for me, went to Colorado for undergrad as you mentioned. I’m actually born and raised in Boulder, so didn’t go far from home. Lived in Southern California for a number of years, which as you mentioned, but I think you had the dates a bit mixed. I actually met you after I finished at Boulder. And before I went to Vanderbilt-
Kevin Choquette:
I was worried that might have had that wrong.
Peter Kleinberg:
… when I was with MKA Capital Group. And again, as you mentioned, went back for my MBA during the Great Recession at Vanderbilt University, and got hired subsequent to that at SunTrust Bank and helped co launch the Note Sales Group in 2010, housed underneath their commercial real estate and credit risk management groups in a group that’s often referred to as special situations but in this case, it was the special assets division. We worked down through a triage of workout strategies, which are generally defined as foreclosure loan modification.
And where I worked in Note Sales, we worked out about a $3 billion balance sheet. The catch 22 of being in a role like that is that you work yourself out of a job. So took the opportunity to move back to the West Coast. And again, helped found a team at George Smith Partners, was there for a number of years and moved on to more of a private capital role. And so now at ESI ventures, enjoying things. As you said, I like to get out, ski, be outdoors, live on the beach in LA. And it’s a lovely day in the neighborhood.
Kevin Choquette:
That’s great. So what can you tell me about ESI and your role with that enterprise?
Peter Kleinberg:
Yeah, it’s interesting. We’re a pretty lean team. So my role is if the printer is out of ink, I go put it back in. And if a deal needs underwriting, I underwrite it all the way through to the closing process. So think cradle to grave, whatever is necessary relative to closing the JV Equity transaction. Again, we focus in the Co-GP space. It fits our DNA pretty well. ESI is structured as a family office. And that family office is comprised of three principles.
Those three principles are also principles of a much larger firm, which is ESI, Enterprises International or International Enterprises, excuse me. And so they know over the past 30 to 50 years have done about a billion dollars top line revenue, which sort of creates this evergreen wealth source for us and for investing strategy. They are the largest privately held consumer electronics manufacturing and distribution company in the United States, or one of the largest at this point.
Kevin Choquette:
Very good. And look, I certainly understand the Co-GP space. It is a bit esoteric though in particular. Well, let’s just say this, I suspect certain of our listeners won’t understand of what you mean by Co-GP. So in your words, how do you define a Co-GP investment?
Peter Kleinberg:
Sure. So I think the easiest way to think about it is, take a step back and the 30,000 foot view of the capital stack and it basically bifurcates, right? You’ve got debt, and you’ve got everything that’s not debt. Everything that’s not debt can be made up of a whole bunch of exotic things but let’s just call it equity for conversation’s sake. The equity is usually it start out as a GP, as the general partner, right? Who’s the sponsor of the project. They oftentimes, especially as you get into high dollar project, don’t have enough liquidity or don’t want to invest the liquidity in the entirety of the equity stack.
So they go out to more institutional groups, traditionally called LPs. And that’s sort of a limited partner. And those limited partners will, in a circumstance they liked the transaction, invest 80 to… Well, let’s just say 80 plus percent of the equity requirement. So now you’ve got to split of the equity stack into LP and GP. The LP, whatever they may fund leaves a remainder. And that’s the GP equity requirement. Oftentimes, for emerging sponsorship groups, they don’t have the liquidity or don’t want to spend the liquidity on investing in just a single project.
We’ll come in and fill that gap. So usually, that looks like 50 to 80% of the Co-GP requirement, we like them to continue to have skin in the game. So they’ll need to invest at least 20% of what that requirement is, and we become a Co-GP or a co-sponsor. It is and will remain in the hands of the lead sponsor, who’s the group that brought it to us. And that’s sort of generally how it works for that investment. We participate in the economics relative to the GP, whether it be fees or promotes.
Kevin Choquette:
Yep, perfect. And I think we’ll get into all of that. But what key events… I mean, you’ve had a very interesting career and have seen a lot of different aspects of the industry. And I know you’ve been involved with some pretty esoteric product types, the cell phone towers and some of the energy projects, and kind of stripping out revenue streams and finding ways to monetize them. And also, you’ve been on the sale side, doing what I do. You’ve been on the analytical side and the buy side, obviously did all the workout stuff. What is it that led you to join ESI because I would say, this is a very interesting and narrow niche, there are not a lot of players in this space?
Peter Kleinberg:
Yeah, I mean, like anything else, the options you have or relative to the options available, when I was looking to start on at a new firm, ESI is a couple of things, right? Number one, it’s highly entrepreneurial. Number two, it’s a pretty flat organization. So you’ve got a lot of nimble decision making, which is going on. Number three, you get to work with a wide variety of sponsors, including those individuals, and this is how it frequently occurs, that we get emerging sponsorship groups that are x senior management at one of the large institutional LPs that I mentioned before, and those individuals have done a lot of deals. They’re really smart. They’re emerging sponsors and they’re probably going to make a big impact.
And you get to be on the front end of what that journey is for that. So all of those items made it a compelling opportunity. Plus, it’s entrepreneurial in its own, right? So it’s existed for a number of years as a real estate investment vehicle for the family who principles it, but in its current iteration, it’s only about five years old. So when I joined, it was year three. And it seemed like a great opportunity to get in on the ground floor of something which, again, is a bit esoteric, it’s unique within the community. And yeah, seems like a lot of fun.
Kevin Choquette:
That’s great. What’s happening in the business now? What are you guys seeing? What challenges are you facing?
Peter Kleinberg:
So interestingly enough, we made a number of acquisitions over the past 12 to 18 months, those acquisitions were anywhere from existing buildings with adaptive re-use plans to ground up development in markets we saw were attractive. We’ve spent time checking all the necessary boxes and we are in the capital markets in a very real way, with regard to a number of different property types. So the exposure that we have to what the debt markets look like, what LP appetite is relative to ground up versus adaptive re-use and things like that, it’s been pretty interesting.
I will say that the most recent asset we were taking a look at was the Pacific Northwest of a hospitality nature. And it’s been difficult to generate or maybe I should say it’s been challenging to generate the interest that you would ordinarily see in a frothy market. So I think people are starting to come around, but I don’t think we’re there yet. And on the project for the construction element, we’re seeing a lot of raw materials pricing impact our ability to push the yields that we had anticipated previous. So, there are a lot of timing considerations and other items, not a typical of the project’s lifecycle.
Kevin Choquette:
Construction materials, I think, lumber had just spiked sometime in this kind of February, March 2021 time-frame. What other elements, if any, are driving you guys’ concerns on construction costs?
Peter Kleinberg:
So a lot of the stuff that we’re building is type three, modified type three. So lumber as a raw material is very impactful for what we’re analyzing. Outside of that, I’ve seen a number of ancillary materials. I think there was something in the Wall Street Journal this morning, even on copper and some other items, which is significantly impacting the pace at which homes are able to be built.
Kevin Choquette:
Interesting. So look, you mentioned the hospitality project, and I know you’ve also looked recently at some multifamily assets, where is the general investment mandate? Or where is your interest in terms of the markets, the assets? You’ve already covered kind of types of financing being that Co-GP, slice your maximum investment, geography, what’s kind of to the extent there is a target, as opposed to just a broad mandate to be opportunistic, what do you guys looking for?
Peter Kleinberg:
So historically, we focused on three asset types, multifamily, hospitality and office. Those are targets, and it’s not gospel, it’s just guidance. I mean, we’re fairly opportunistic in nature. So we’ll really kick the tires on anything that’s got a good story. Obviously, office has lost its momentum. I don’t know if it’s lost its full appeal, but it’s lost its momentum. It’s difficult to define what that looks like going forward. So we’ve focused our attention on multifamily and actually really on hospitality during this downturn because we’re believers in it from not only experienced but also because of what we see in the market.
Geographies are Texas and West, that’s generally driven by the fact that getting on a plane flight that’s over an hour is it can become a fairly arduous exercise. That’s not to say that we wouldn’t take a look at something, again, that was opportunistic and less located on the East Coast, but Texas and West is where we focus our time. We don’t love getting into competitive bidding situations but it’s unavoidable at some point. But a good example of a transaction that we closed on is the Georgian Hotel in Santa Monica right on Ocean Avenue, which we were able to get as an off market transaction. And that to us is ideal.
Kevin Choquette:
And what about investment minimum and maximum for for you guys?
Peter Kleinberg:
So we generally like to invest about one to four million within the Co-GP. So that size is to anywhere from 50 million up to 150 million. I think, the lowest-
Kevin Choquette:
At the asset level, right?
Peter Kleinberg:
At the asset level, that would be total capitalized project costs. So the minimum that we would do is 40 million. And I think that would have to be driven by, it sounds cliche but a programmatic relationship and a pipeline behind it.
Kevin Choquette:
Yep. And then as far as primary, secondary, tertiary markets, where are you guys playing in that regard? I know you’re doing secondary markets, would you consider a Boise, a Bozeman, Spokane, Ogden, name it, any of those? Would you guys ever go out that way? Or are you much more focused on the kind of major league baseball teams and that like?
Peter Kleinberg:
Yeah, I think more of the ladder, I think the the opportunities within primary market, specifically within our home geography of Los Angeles continue to be compelling. So until there’s a real reason to go outside of it, we prefer to stay where we know the most and where we think there’s a growth trajectory. Not to say that, those markets listed don’t have a growth trajectory but it would require, I think, a lot more research on our end to get comfortable. And subsequent to that, get our investment committee comfortable with making an investment there.
Kevin Choquette:
Right. And then you’ve already mentioned you’re doing some development projects which have their own risk, sort of issues some of which you just detailed in terms of construction materials, what about entitlement? What do you guys get into projects that require some kind of entitlement?
Peter Kleinberg:
Not ideally, entitlement risk is not something that we generally would pursue, I think that there’s enough within this sort of construction and permitting area that our risk starts to get out of balance when entitlement comes into play.
Kevin Choquette:
Let’s just zoom out a little bit. I mean, now let’s kind of bring it to Earth. So one to four million, 50 to $150 million projects, you’re willing to do development deals, you’re putting in a fraction of 50 to $150 million project capitalization, running as a co-sponsor. Again, this is like there’s not a lot of people who do this, and we haven’t gotten into the hole, maybe maybe we should go there. And then let’s talk about how you guys wrap this investment in terms of mitigating risk and price. But before we go there, you also on occasion, along with making your Co-GP investment will provide some credit enhancement. So can you talk to that for just a little bit?
Peter Kleinberg:
Sure. So, as I alluded to before, a number of the sponsorship groups who we work with would be sort of colloquially classified as emerging sponsors, right? Which I think means not that they don’t have a ton of experience but that they’re just starting to get into much larger transactions which require a significant net worth and sufficient liquidity so they can get the most competitive financing terms. Our preference is to make a Co-GP investment and include that credit enhancement feature as a benefit to partnering with us, but on occasion, we will consider a standalone credit enhancement in a deal that we don’t directly invest in.
Kevin Choquette:
And what’s that look like for you guys? I mean, credit can come in all kinds of shapes and sizes, right? Obviously the most offensive, most egregious, the most challenging, the most downside is a full personal repayment guarantee back off of that. We’ve got completion guarantees and maybe an interest carry guarantee back off that, you’ve got your bad boy negligence fraud, bad acts, et cetera and your environmental guarantees. So, what elevation are you guys flying when you say, “We’ll go ahead and provide some credit enhancement.”
Peter Kleinberg:
Yeah, great question. We won’t take any recourse risk. We will limit it to usually completion guarantees and standard bad boy carve outs. And that seems to be a pretty competitive offering when it comes to development financing.
Kevin Choquette:
Okay, perfect. So now let’s back it up. $150 million total cap, you guys are doing one to four million, you’ve providing Co-GP investment, you’re becoming a co-sponsor effectively, you’re providing credit enhancement, there’s a there’s more than a small segment of the industry, your investment peers, especially as you cross the line into credit enhancement, just sort of being candid about it, what are you crazy? I would never take a credit risk on a sponsor. There’s so much risk, what happens if he falls on his face? The downside relative to your one or four million dollar equity investment could be substantial. I’m not sure you can get properly compensated for coming into that position.
And generally, as you know from your days on the brokerage side of the industry, the answer is flat out no, you go ask an LP or anybody on that side to provide credit support, I mean, there are some exceptions but more than 90, 95% of the time, if you’re talking to institutional capital… No, let me repeat myself. No, they’re just not going to do it. So how are you guys approaching that space and gaining comfort with the risks associated with the position? Or perhaps more appropriately, how are you mitigating the risks associated with getting into that space?
Peter Kleinberg:
Yeah, so good question. I think that the 30,000 foot answer is that institutional capital doesn’t do it because institutional capital isn’t truly discretionary. We are, right? And so we are not institutional, we invest in institutional deals but we don’t have sort of red tape bureaucracy that prevents us from throwing our weight behind a deal which we think can be completed. Now, in a circumstance where we were purely credit enhancement, there would have to be significant coverage relative to the equity and debt capitalization.
For an example, the last deal that we took a look at had exposure at about 50% of historical market transactions, which is to say, a market where multifamily deals traded at about 600K per door, the debt exposure was at 300K a door. So in a burned down scenario, where the sponsor falls on his face or doesn’t achieve what he set out to or just flat out isn’t capable and it was a myth. The liquidation value of the project, especially after equity is fully funded was acceptable to us. We didn’t see a lot of loss possibility because of the work that would get done with the equity that was coming in prior to the debt funding.
Kevin Choquette:
Right. And look, I’m talking to developers and the entrepreneurial value add opportunistic sponsors all the time. So we should beat on this for a bit because otherwise you’re going to get blown up with guys who are like, “Okay, I got 85% leverage, I just need you guys to provide a personal repayment guarantee.” And this is really important. You’ve already mentioned here, at this emerging manager space, there’s a focus on net worth and liquidity that keeps a bunch of guys from getting up more quickly to the next level. And so the product is clearly in high demand but there’s some really important caveats that you’re articulating just that one example. So 150% LTV, if there’s a $300,000 loan basis, market is 600 grand.
Worst case scenario, it’s probably going to be the case that the lender finds all the remedy they need from just a simple foreclosure. But second, you were saying once equities fully funded, so what’s that aspect of the deal look like, I presume that was a value add deal?
Peter Kleinberg:
Is actually ground up construction.
Kevin Choquette:
Ground up, even better. Okay. So walk me through that.
Peter Kleinberg:
Yeah. So we basically break it in half, right? There is equity and then we break the equity down even further into what we would consider to be ESI’s protection layers. You have frequently in circumstances like this required liquidity reserves by the lender, which are in addition to equity contributions. Those are usually funded by the sponsor and they cover either things standard cost overruns. You got land value, which could be potentially in addition to the appraisal which is being used by the lender, so you can find additional equity cushion there. You’ve got the direct equity in the land, in this circumstance, the land was wholly owned by the family of the sponsor.
So, that is accessible liquidity from our perspective immediately. The cash equity from the LP that was being brought in was also significant at about 75% of the requirement. So we felt justifiably insulated from the potential loss that could happen if this project fell apart. To boot, there was a third party development manager who had been brought on to essentially act as a secondary captain, in the event the project was going away than it should not have. So I mean, we looked at this from a number of different ways and we had to build in a lot of protectionary measures but at the end of the day, we felt confident that the equity in the project was real.
We liked the location, we thought that the sponsor was capable and the sponsor was sufficiently liquid, they just didn’t have the ability to go out and get the type of financing they needed to build 100 million plus project. So I would say to the people who are listening and considering whether or not this isn’t an opportunity to have somebody come in and support them from a credit perspective, I think the initial answer is yes. But for your liquidity, your cash equity in the deal, what’s the ownership structure relative to the land? Do you have enough to build in additional reserves? Have you secured LP equity?
Kevin Choquette:
Right, so there’s a few things there that I think even opening up further the third party development management, was that something that ESI had insisted upon? Or was it something that was coming from the 75% LP investor?
Peter Kleinberg:
So it actually came from the GP.
Kevin Choquette:
Interesting.
Peter Kleinberg:
Yeah. They’re pretty intelligent, sophisticated guys, understands that in the the three buckets of, you know what you know, you know what they don’t know, and you don’t know what you don’t know, there’s possibilities for that third bucket to be detrimental to the project. So to insulate himself, make himself more creditworthy and to enhance the invest ability of the project, he brought on the third party development manager. ESI went on to double check, meet with the development manager, call any resources and the standard checks that you would do on anybody in that role.
Kevin Choquette:
And then the general contractor on that project, were they operating under a lump sum or G Max? Or what was the nature of that, and what kind of protections might have been in place?
Peter Kleinberg:
So at the point that we came in, there was a GMP contract in place. So it was pretty much fully baked by the time we stepped in, just the lender that they had been speaking with had net worth and liquidity requirements, which they couldn’t meet.
Kevin Choquette:
And you had full construction drawings and things were bid or were you still prior to that?
Peter Kleinberg:
No, they’re 100% CDs.
Kevin Choquette:
Okay. And then what about the developer and/or general contractor contingency? I guess that would be yet another line item of potential equity or reserves in the amount of change order, cost overrun or some sort of significant impediment that might actually trigger a completion guarantee. What did that part of the deal look like?
Peter Kleinberg:
Yeah, good question. So significant contingency being carried not only in the GCs, GMP, but additional contingency carried by the developer in their project budget. Further to that, as it relates to any sort of carry guarantee, which in this deal is a typical of what we would do but that was a feature of this particular development, we had built out an interest reserve sufficient to cover, I think, six to nine months post completion. So all that lease up risk was at least mitigated to a degree we were comfortable with through the significant interest reserve.
Kevin Choquette:
And that was the interest reserve within the construction loan?
Peter Kleinberg:
Within the construction loan but also the liquidity reserves that I had discussed relative to cost overruns, also had a feature that went beyond it, which was reserved for additional interest reserves to mitigate the carry guarantee. So, this particular project had a lot of special attributes that were able to get comfortable.
Kevin Choquette:
Yep, that’s perfect. And I think it’s really helpful to kind of, I know that when the developer crowd hears what we’re talking about, they’re going to be super excited because there’s way too many guys who are held back by the lending market and to a lesser extent, the LP market because of net worth and liquidity. But one more question on that, as it pertains to recourse and completion guarantees, is the GP, your sort of Co-GP if you will, first line of defense in terms of perfecting completion guaranteed, does he have some exposure? Or is he relieved of that more or less in its entirety? Is it joint and several? Is it, “Hey, the first millions coming from you?” Is there another level there?
Peter Kleinberg:
There is, it was actually recourse to the lead sponsor. So non recourse to the Co-GP but recourse to the sponsor. So pretty strict from their perspective but these are the times we’re working in right now. This was mid pandemic, so a lot of rigorous underwriting standards coming from the lending community, especially for ground out projects with an emerging sponsor.
Kevin Choquette:
Right. Okay. So, that’s super helpful. I mean, that’s just one example and it portrays the complexity associated with doing what you guys are doing and some of the devices you might employ to mitigate risk. But the obvious question for me is pricing, how do you price something like that? I think though, the marketplace is pretty educated on GP, LP, pref waterfall structures, and kind of what those true splits might end up looking like bringing in a third party who’s going to be a co-sponsor, is going to provide some balance sheet enhancement and potentially get the box checked on the conditions that are required by the lender in order to secure their construction on. How do you guys start to think about value and price on that kind of product?
Peter Kleinberg:
Just to be clear, the question is, what is our compensation for our investment and/or credit enhancement?
Kevin Choquette:
Yes.
Peter Kleinberg:
So let me just start off by saying our goal would be to invest alongside the Co-GP and have credit enhancement be a feature of our investments, not be the feature. Right?
Kevin Choquette:
Yes. That’s worth saying also because like I said you’re going to have a million developers, you’re like, “Yeah, just sign on my recourse guarantee.”
Peter Kleinberg:
Right. Right. Well, that’s an easy no. Look, so the only thing that is sort of capital essential to our investment and going to happen is there’s going to be a credit enhancement fee of 1% if we do it, right? And then there are three other categories which we’ve generally been flexible on but we’ll always want a piece of, one of which is the development fee, the second of which is a fee at refinance. We see the potential for value capture, once this thing gets through development and so we’ll want to be rewarded for getting them to that fence post. That’s usually a flat fee, the developer fee is a portion of the fee. We can structure it creatively how it gets paid out.
And then critical to our platform is participation in the promote. And depending on what the deal economics look like, and a number of other ancillary items, we’ll take a piece of that promote as well. And that’s just specific to a pure credit enhancement deal. And I’m happy to chat about what in the ordinary course, what our deal participation looks like but-
Kevin Choquette:
Yeah, and I’m not trying to carve the credit enhancement out of the Co-GP. So if you want to kind of more broadly talk about how you guys are in this space and think about pricing, I just don’t think there’s a lot of analogous players. And so I think you have a lot of latitude in the sense of pricing, right? If I go get a construction loan, I basically know what it’s going to cost. If I go looking for a Co-GP, yes, there’s some players in the space. Okay, but if I go to Co-GP, especially if they’re willing to kind of say, “Hey, with the following mitigants, we will provide some balance sheet support.”
Peter Kleinberg:
Yeah. Yeah, understood and I do think that it bears mentioning that some lenders are amenable to paying out credit enhancement fee of 1% of loan proceeds or some are not. And so in the circumstance that we were working through just a moment ago, our fee was being paid out of equity. Right? So it ends up being not part of the capitalized budget that’s recognized by the lender, which is another wrinkle that increases your project costs. And you’ll have to have a separate economic analysis, which basically is your equity capitalized cost but it’s not going to be recognized by the lender, and neither will your leverage ratio.
Kevin Choquette:
Yeah, understood. But then more broadly, I think, where you’re trying to go is the pricing and mechanisms that you guys employ for returns if it was a full. I think, I had you in the mindset of here’s what we charge you to do, sorry, credit enhancement. And I understand that’s an outlier case, one out of 99, where you would do credit enhancement and not be Co-GP. So let’s talk about the more likely scenario, 99% of the time, you’re a CO`GP investor, which may or may not include credit enhancement. How do you guys think about monetizing your investment?
Peter Kleinberg:
Yeah, fair enough. And happy to dive into that. So our compensation or fee structure or participation relative to the 50 to 80% of GP equity requirement that we contribute to a project capitalization is generally defined by five items, right? And there could be more and there could be less, it’s highly subjective relative to what stage the deal is in but to the extent available, will participate in the acquisition fee, usually disproportionate to the capitalization ratios, we will participate in the development fee, also generally disproportionate to the capitalization ratios. And when I say disproportionate, I mean to the benefit of the lead sponsor, right?
We understand that they’re the developer, they need to be compensated, we understand that fee income is a large driver of the success of their operating company because they are twofold, right? They’ve got asset capitalizations, and then as an operating company, they need to keep the doors open.
Kevin Choquette:
Right. Which is this, if you guys are putting up 80% of the Co-GP… Oh, sorry, of the GP equity as Co-GP, you’re not taking 80% of the acc fee, you’re not taking 80% of the dev fee, you’re leaving a very disproportionate amount of it available for the operator.
Peter Kleinberg:
Yeah, I don’t know if I’d say very disproportionate, but to an extent that we deem fair, right? It’ll be commensurate with what we think the work required on the project is. And they’ve been running hard and spending a lot of pursuit dollars to get the deal under contract and get the acquisition done. We’ll recognize that and we’ll size it appropriately. But I wouldn’t anticipate it to ever go above what the pro rata capitalization is.
Kevin Choquette:
Right. Okay. So you got acc fee number one, dev fee number two, what are that the other [crosstalk 00:38:12].
Peter Kleinberg:
… private participation, which is pro rata to that to the investment members. And next is to promote participation, where we were generally making our money here. So it will be still disproportionate, generally speaking, to the capitalization ratios and the GP equity partnership but not as severe as you would find on the acc fee and the dev fee. Right? So, if we were to be 80:20 in funding, and the acc fee was 70:30. And so you took the 10% swing, maybe they promote participation 75:25. And that’s just a hypothetical, all of those sort of discounts, it’s a fluid analysis for each particular transaction.
Kevin Choquette:
Yep. Understood.
Peter Kleinberg:
The fifth is the credit enhancement fee. And we do find a lot more comfort diving into that responsibility, when we’re both invested in the deal, right? Because I think if we’re making a cash investment in a transaction, our confidence in its success, very high. And that’s relative to a deal where we’re not necessarily putting cash in, but we’re lending just credit enhancement and it just becomes a much different dance. But yeah, the credit enhancement is very much a feature of our primary investment platform.
Kevin Choquette:
Yeah. And look, one of the things that you’ve portrayed to me in all of our conversations is a pretty remarkable degree of flexibility, right? You’ve basically said to me, “Hey, don’t get overly wrapped up in what you think we might do, just bring the deal forward, let’s understand the fact pattern, let’s look at the market, the deal, the sponsor, their trajectory, what sort of assets and liabilities might be around not in terms of a conventional financials sense but the broader picture of positives and negatives, and see where we can put a deal together.” Am I putting [crosstalk 00:40:24].
Peter Kleinberg:
I mean, as I mentioned earlier, we don’t have any sort of institutional red tape, we’re proprietary investors for the family that we work for and the principles that fund our balance sheet. And that makes our capital truly discretionary. And it’s not following the rules of an investment document that a bunch of passive LPs who sit behind us have signed on to, gigs sitting down and subjectively explaining and articulating what the investment opportunity is to our managing principal and our investment committee. And to the extent it’s compelling, we can generally do it.
Kevin Choquette:
I mean, that’s perfect. And I apologize for going so in depth there but I honestly don’t think the product is well understood. And I might even break out what you said about profit participation from promote because that’s probably going to throw a couple guys off. I’ll say, gentle listener, if you’re confused by what Peter has just said about profit participation versus the promote, Google it, it’s subtle but worth understanding. We’ll let it go for right now but with the platform that you’ve just described in great detail, I have to imagine the deal flow is high because it’s a very significant gap in the trajectory of the emerging manager, right?
How do they get from doing a 12-unit apartment value, add rehab with friends and family money to doing $150 million high rise multifamily development in downtown LA? And the answer is either over a lifetime or you don’t or you find you’re sent a millionaire, billionaire friend who’s willing to really partner up with you and take on balance sheet risk, that’s kind of the conventional way or you’ll find a group like ESI.
Peter Kleinberg:
Yeah, and-
Kevin Choquette:
Yeah.
Peter Kleinberg:
Yeah. I was going to say, I will say, apologies for jumping in, I don’t think that the jump for our target co-sponsors is going to be as meaningful as going for a 12-unit apartment complex to $150 million deal. I’m generally of the opinion that the ideal co-sponsor for us is a group who has meaningful experience, whether it’s with an institutional investment manager or it’s for a large development shop and they’ve been exposed to transactions, and they’ve closed transactions with the size requirements that we put out there. They just haven’t done it for their own account. And so when that’s the case, they’re not in foreign territory and it’s not unfamiliar ground.
It’s just that they haven’t done sufficient business or transactions to have generated capital or net worth or liquidity sufficient to getting a deal done, if that makes sense. And again, it’s not hard and fast but those particular groups who have that experience, that large project experience just not on their own account, I think that to us is appealing.
Kevin Choquette:
Yeah. Look, it makes perfect sense. I think, thank you, is what I would say. So look, you have to have a bunch of deal flow. How do you go about discerning good from bad?
Peter Kleinberg:
It’s good question. We do have significant deal flow. I think right now, what we’re looking for is very competitive basis. The transaction that we looked at most recently was in what I would call an emerging primary market, which is also a large consideration for us. So what market is it in, but it being purchased at what we perceive to be a significant discount to what market would be or market pricing rather. So the last transaction we’re looking at is at about a 40 plus percent discount to the sellers basis and to us, that catches our eye. Other than that, we’re looking for a plus locations as everyone is, in addition to appropriate yield spreads. And if those boxes are checked, we’re happy to dive in. And then it’s just kind of subjective, whether we like to deal or not.
Kevin Choquette:
Perfect, I get it. So look, let’s go a little bit philosophical here. But I kind of touched on this for just a moment. But you have founders of Unicorn Tech companies, who likely have put $0 into their company, you have CEOs of large and small publicly traded companies, who would basically scoff at the idea that they should be putting up any money into their investments. And I’m pointing to this, because I think the commercial real estate industry as a whole has this incredible bias towards like, “Well, what’s your net worth on liquidity as table stakes to go and play the game?” I wonder what your thoughts are on that?
Peter Kleinberg:
Yeah, it’s an interesting concept. Primarily, when you think about it, it’s generally non recourse lending. So the collateral is the asset. So why are they requesting networks and why are they requesting liquidity from the sponsor, and I think generally speaking, it’s a carryover from when loans weren’t so diversified. And it’s become a convention for underwriting within lending institutions and they don’t see a real reason to let it go. I think also, when reporting to their stakeholders, they get to report that this is the networks and liquidity of our borrowers. And I think it surely instills a feeling of safety.
Kevin Choquette:
When loans weren’t so diversified, what do you mean by that?
Peter Kleinberg:
The lending offerings that exist in the market now, with bad boy carve outs, with non recourse which is not really non recourse because they’re springing recourse, and all of the sort of exotic features that exist within loan documents and offerings to make lenders more competitive, continue to add features for when it was more of a commodity product. You just got a loan and if you didn’t pay it, they took the asset and you were probably on the hook to pay it back.
Kevin Choquette:
Yeah, I got you. Before all of the shades of grey were introduced into the contractual obligations, you just look at net worth and liquidity. And since then, the convention hasn’t really backed off. Well look, it’s interesting that you guys find yourself in this kind of 50 million to 150 million asset size space, it makes a lot of sense given the strategy and that you have to get some meaningful dollars out, right? These are small investments within the commercial real estate space but because of your participation or your position in the capital stack, they’re highly levered. But I know previously, you’ve been out as a sponsor and done some work in that space, and had to kind of go to the market and pursue capital and this plays out in a couple spaces, right?
But recruiting capital in general, for small deals whether as a fund manager or someone who’s capitalizing a real estate operating platform that might be vertically integrated, fund an operating company or on a project specific basis, call it even I got 13, 14, $15 million deal. It’s difficult, what are your thoughts on kind of the dynamics that are in play, where it seems you’re a part of the herd perhaps, transactions are going fewer and larger fund managers are going fewer and larger asset allocations are increasing? It’s kind of an interesting ecosystem and I wonder how you see it and then, I guess, maybe where that kind of overruns with ESI?
Peter Kleinberg:
Yeah, I mean, it is for sure a challenging ecosystem. And I think a lot of it is driven by the size of the institutional funds that are out there. When you’re out in the market, and you’re trying to raise a $20 million LP cheque, you’ll find a lot of people telling you that, that’s just not enough. And I think that all comes down to needing economies of scale, right? And smaller transactions being oftentimes more difficult than larger transactions because they’re a bit less sophisticated to close, right?
And so if you’ve got all the money or institutional capital moving toward those large transaction, I think it leaves a real need in the sort of lower middle market to be competitive and place our dollars. I mean, we’re again, a fairly lean shop, we don’t want to lose control of the project ever. And so that’s why we set our size requirements. And we also set our size requirements because we think it’s where we can be the most competitive. So, hopefully what it is that we’re doing is opening up a world of transactions for different sponsors that may otherwise be unachievable.
Kevin Choquette:
Less tactically, what’s one of the best deals you’ve ever done, whether ESI or elsewhere, and brokerage, investment, anything? Just like you’re a real estate guy, you’ve been in it for decades.
Peter Kleinberg:
Sure. So the one that stands out in my mind, well, I suppose that there are a couple. The first one was with a sponsor that I continue to be very friendly with, but it was the first transaction I ever did when I was working at a group called MKA down in San Diego. And it was called College Town Homes. And it was a conversion of a class C, probably 100 plus unit apartment complex at the gates of the University of Arizona. And it was converted into it on the front end of this really high end student housing wave. And it was a great success. And I think, it stands out in my memory not because it was the largest, certainly not because it was the sexiest but because it was the one that I cut my teeth on. And I’ve still got a great memory of how good it felt and knew I wanted to continue in the industry after closing it.
Kevin Choquette:
And that was a conversion from apartments [crosstalk 00:50:57].
Peter Kleinberg:
… class C apartment complex, going in, doing a full gut reno, adding all of the sort of crazy amenities that are endemic to that student having asset class at this point and leasing it to you UVA students.
Kevin Choquette:
What’s the other one, sounds like you have at least two?
Peter Kleinberg:
The other one is a bit different in nature, but certainly it was helping lead the IPO for landmark infrastructure partners in 2014. Much different nature of a transaction but still equally satisfying.
Kevin Choquette:
And what that looked like? I mean, obviously, you could probably do a two hour podcast on that alone. But some-
Peter Kleinberg:
Yeah, sure.
Kevin Choquette:
Some experience, sure there. I mean, what’s the brain damage level of pandemic-
Peter Kleinberg:
It’s pretty high, right? I think the majority of our management leadership team was spending probably 90% of their time in Houston working with our law firm. And with the investment bankers, we had at least two firms that helped us out. And we were currently at that point, managing five funds for probably not a huge capitalization, there were probably 100 million each, we took two of those funds that had the least amount of time left. And we contributed them as seed assets to what eventually would become the first real estate driven master limited partnership to be publicly traded on the NASDAQ.
Kevin Choquette:
And so the MLPS are their dividend yielding vehicles that are freely traded, right? I mean, I only know [crosstalk 00:52:36].
Peter Kleinberg:
Generally speaking there reserved for midstream oil and gas companies, which is to say transportation of commodity. And what we were dealing in was ground leases, so think ground leases underneath micro infrastructure assets, cell phone towers, outdoor advertising or billboards as they’re probably more well known. And so that was how we were able to take it public, and since then it’s grown exponentially and they’re quite large.
Kevin Choquette:
Well, look, so you’ve spent a ton of time on capital formation side of things, right? Whether on the buy side now, on the sell side previously, you have too just mentioned this IPO, I mean, to say you have an understanding of how the capital markets operate is probably significant understatement. So for people thinking to approach you for potential investment, what advice might you give them?
Peter Kleinberg:
Yeah. I think, the economics of your deal, be able to explain what its value proposition is, what its position in the market will be and how it will be competitive. And most importantly, how its profitable. And I think if you’re able to speak intelligently, subjectively, about your transaction, then there’s a great conversation to be had. I mean, I don’t get into the more nuanced parts of my career when discussing a transaction. So no big deal.
Kevin Choquette:
Right. Right. I mean, give me an example of horribly done, right? I mean, I’m sure there’s probably five emails that get deleted for everyone that gets open, but what are the absolute stumbling blocks you see people kind of hitting regularly?
Peter Kleinberg:
Yeah, that’s a great question. I mean, the aesthetic of your presentation, I think needs to be digestible. Frequently we’re in receipt of investment packages that don’t necessarily flow. They don’t pull you in. There is a marketing aspect to what it is that you’re doing. And at a certain point in every project and every business transaction, you need to be a salesperson and so I think, if you approach it as such, that’ll be helpful. The other things which would be a non-starter are totally unrealistic and sound trends relative to a market. We understand that miscounts getting there and financial modeling can occasionally be challenging. But you should have a pretty comprehensive and dynamic financial model that you’re able to provide, which supports your analysis of the deal.
Kevin Choquette:
And the typical sponsors you guys see, getting the emerging manager vibe, what kind of body count sounds horrible? Headcount, headcount? How many people are typically on this team?
Peter Kleinberg:
I appreciate you clarifying, two plus and, yeah, small team.
Kevin Choquette:
Two plus, yeah.
Peter Kleinberg:
And I think it’s very frequent that that those two or three individuals are the people who are doing all the work, right? And so, the principal who you’re chatting with is probably the same one who could call 200 different properties, and finally found a good piece of land to buy and has been negotiating every aspect of the deal. And that’s kind of a fun part about it, right? Where you’re not dealing with a disconnected leader at a company that’s doing very well. But you’re chatting with the person who soup to nuts is responsible for the transaction.
Kevin Choquette:
Yeah. How do you think about that team? I get it, it’s one, two, maybe three people that emerging manager profile. But outside of that, I suspect they have a reasonable array of third party consultants, whether it’s in the civil, the landscape, the structural, the MEP guys, how do you think about-
Peter Kleinberg:
Yes. Of course, the team is going to be built out differently depending on the stage of the project and a number of other elements that we take into consideration. But you’d want to see intelligence with regard to those firms which were higher, you’d want to see every angle of the deal covered through some resource. And further to that, it would just need to be comprehensive. And so it’s hard to say subjectively what is required, but it should follow some logical path that if you have experiences in the acquisition of operating multifamily assets and you do light touch value add in the past, but now you’re hoping to do a deep cut, renovation of a mid rise building in an urban core, you should have accessed the appropriate resources or staffed the appropriate individuals to give you the ability to do something which you may not have endeavored before. And if you haven’t, then it’s pretty big red flag.
Kevin Choquette:
Well look, Peter, I appreciate you taking all the time to kind of go through what I would call product and attributes conversation, if we shift over a little bit to personal and kind of the way you’ve navigated your career, and maybe even as granular as how you kind of navigate your days. I mean, I know I mentioned at the top, that part of your recipe for success might be powdered [crosstalk 00:58:04]. Right. But, let’s start with maybe daily routines. Do you have anything that you employ on a regular basis to? I’ll say, ground or I’ll just leave with it. I want to leave it as open as possible. Do you have any daily routines that help you kind of navigate life?
Peter Kleinberg:
Yeah, fair question. And I think probably in the contemporary environment, it has even more meaning sense, it’s been almost exactly a year since everyone’s routine was turned upside down. And I think getting used to the world as it currently exists, and hopefully we’re departing from as we ramp into vaccine territory, it’s important, I think, to wake up and walk and have a cup of coffee and not just start the day straight out of the gate. I’m fortunate enough to live in a neighborhood where I get to get out with my dog and clear my head, and then sit down and be comfortable to have 10 zoom calls in a row. But I do think it’s important to take that moment at the front end of the day. And in the ordinary course, I’d also go to the gym.
Kevin Choquette:
And then anything that you do, just curiosity here, meditation, reading, any-
Peter Kleinberg:
No, nothing like that. I mean, look, I digest a lot of information throughout the course of the day, I like to read books, of course, but haven’t dived into sort of that meditative arena.
Kevin Choquette:
Look, the longer I’ve been in this industry, the more it becomes clear to me that the conduit for pretty much the entirety of our ecosystem is relationship. I wonder what your view is on relationships, I would say in particular around our industry but perhaps more broadly.
Peter Kleinberg:
Yeah. So I echo that sentiment in a very real way. Each time I’ve taken on a new opportunity, it has been with meaningful help from those individuals who not only are my mentors, but also my peers and also those that are outside of the industry, right? Just chatting about what the pros and cons might be, again, going back to those three buckets of, you know what you know, and you know what you don’t know, and then there’s great big abyss, which is you don’t know what you don’t know. And I think the only way to solve that is through, number one, asking questions. And number two, accessing your network and asking them those questions, and finding out what their experiences are and then drawing intelligent, educated conclusions based upon that network.
Kevin Choquette:
And then how about just a general kind of flow of opportunity. I have found opportunity through you, it was an opportunity that I was looking for, I have found opportunity through a bunch of other relationships. And I wonder how opportunity and relationships might?
Peter Kleinberg:
Yeah, I think they’ve got a very dynamic relationship. I mean, the observations that does in your network and those who have relationships with the observations that they make, could lead them to coming to a conclusion that you might be a good fit for some role that comes up in their world. And otherwise, you wouldn’t have heard about it. So, what we do within the real estate ecosystem is, we’re all in pursuit of transactions basically, right? And each person who we met, each person who we come across in that pursuit gets sort of filed away. And depending on what type of relationship you were able to establish with them, you may find that that’s a significant source of deal flow down the line. Or you may find that they help you complete a transaction of your own and benefit from it at the same time. So, yeah, it’s very important.
Kevin Choquette:
So look, I know I’m bouncing around a little bit here, this is like the lightning round. For me, I find 2021 to be a noisy place. Some of that is my own doing and my own kind of personal afflictions, call it ADD or whatever. I wonder for you the pace of quote unquote, modern life, your Outlook calendar, or Gmail calendar, your email inbox, your text messages, your cell phone calls, I don’t know if you participate in social media. How do you view the noise of the day? Is it an impediment to you? How do you navigate kind of the cacophony that’s seems to surround many of us? Maybe that is something that isn’t an issue for you but I’m curious if-
Peter Kleinberg:
Yeah. Well, look, I think sort of in the technological age compounded with a pandemic and other elements, it is a little bit difficult to keep your attention on things that truly have value. One of the things which I’m able to do, so number one, I don’t really participate in social media. So, that’s not a huge factor. I do however get hundreds of emails a day and going through those emails and trying to prioritize and remembering what it is that you need to do, I think it’s helped by sort of an old school technique of keeping the actual notebook and segmenting it into different particular tasks, some of which can be transactions, some of which can be administrative, and keeping a running tally and quite literally checking the box off. So by kind of rewinding it 20 years, I found an ability at least for me to keep better track and be less impacted by the sort of volatility of the environment and the pace at which things move.
Kevin Choquette:
Yep. And then just how about the noise? I mean, ding, ding, text, phone, email. [crosstalk 01:04:13].
Peter Kleinberg:
So, I don’t get any dings. But I’ve found myself fairly well conditioned to how it all goes at this point. It feels like I’ve been living with a cell phone and email for a very long time. So I’ve at least had a good runway to get used to it.
Kevin Choquette:
Failure tends to be the place where I’ll find enough pain to really learn a lesson. It’s unfortunate that that’s vibrant learning opportunity. One example I’ll give you, I had engaged a client who had a project in Hawaii, and it was all in the very preliminary stages and I was kind of just getting a feel for the market. I called up a lender in Hawaii, and I didn’t ask the question, do you have a loan that looks like this? And instead just started to ask them a bunch of questions about the marketplace and the deal and shared high level some of what I was trying to get done potentially, with the client. Little did I know, I was literally talking to their lender. Catastrophic failure and huge embarrassment, I mean, it’s to this day, an unbelievable embarrassment but as such a pretty significant learning opportunity, any favorite failures-
Peter Kleinberg:
They all blend together so well. But that’s not to say that they are frequent and with consequences, right? And consequences almost always has this negative connotation. But generally speaking it’s what happens after something occurs? And I find them to be often positive, right? I mean, you’re asking what questions could I have asked to sidestep the net result of what I was trying to achieve. And I think it informs you as you go forward. So, people will talk about wisdom and getting older and things like that and I’m not sure that wisdom is so much built through successes. But it’s still through learning lessons and being successful because of them.
Kevin Choquette:
Well said. I think at the outset, we’re coming into this, I’ve kind of given you the rest of the podcast teams, supporting real estate entrepreneurs, giving experts a place to voice their opinion and fostering relationship and connection on the one of supporting entrepreneurs, real estate entrepreneurs, you have a unique vantage point into the market, into the industry. Any advice you would give, and you’ve also stood at the vanguard slaying those dragons on your own, any advice or words of wisdom, if you will, that you might want to share?
Peter Kleinberg:
Yeah. In the hopes that everything that I’m about to say is not too cliche, but it probably has existed for a long time because it’s helpful, and it works, and it’s true. But, I think, if you’re a real estate developer, you need to treat it like a business, you need to be thoughtful about what you present to the people who you’re asking money from. You need to be persistent, because most things are not going to work. But if you come into contact with a group that turns you down, there’s a reason and your success is going to be dependent on whether or not you get those deficiencies solved. And so feel free to ask questions.
And my general philosophy is that there aren’t really any bad questions. If somebody is trying to figure out a problem or make something work and doesn’t know the best path to get there but is competent enough to go out and discover a resource. And maybe they have that resource at their fingertips and ask the right questions. And so yeah, I think if you practice those things, it would be helpful to promoting your career.
Kevin Choquette:
Perfect. Peter, thank you for taking the time. Listeners, thank you for taking the time. Peter, I don’t know that we discussed this on the front end but if you want to share contact information, a web address, whatever it is that might help the listener find ESI Ventures, feel free. Alternatively, anything you just want to say in closing here.
Peter Kleinberg:
Yeah, I appreciate you having me on. And I would drive any interested listeners to our website at efiventures.com. You’ll be able to find general contact info there and a deal portal. And I think if you’re looking to potentially explore a transaction with us, just get a hold of us and we’ll have a look. In general, I love commercial real estate. It’s why I do it. I don’t think anybody should be pursuing anything they don’t like to do. And from an entrepreneurship perspective, there’s almost nothing out there which matches the commercial real estate transaction.
Kevin Choquette:
Great. Again, Peter, thanks so much for the time. I really appreciate it.
