As a capital advisor, we’ve placed joint venture equity into a variety of project types. We are not in the business of syndication, so the types of equity groups we’ve chosen to align ourselves with are all institutional in nature. These include opportunity funds, hedge funds, private investment firms, and even sophisticated family offices.
Some of our clients seek a next evolution of capital when their previous equity sources have fallen short. Perhaps the check sizes have grown too big or their current sources can’t provide enough capital to satisfy their increasing pipeline and grow their business. We work with various types of clients so not everyone fits this profile, but quite a few have dabbled in less institutional sources at one point or another.
The focus of this article is to compare institutional joint venture equity with other private equity raises, such as syndication, friends and family, or high net worth individuals. While there are significant disadvantages that one must understand, there are considerably more advantages that make engaging with astute institutional partners highly compelling.
The Advantages:
Bigger Deals
One of the main advantages of institutional equity is the ability to do big deals. At some point, you run out of friends and family, limiting the ability to write increasingly bigger checks. Sponsors know that many times it takes just as much work to do a $2MM dollar deal as it does to do a $12MM one.
Under equal outcomes, sponsors obviously do better financially with bigger deals than small ones. Institutional partners also see these advantageous economies of scale and, therefore, desire to do larger deals. Many equity partners won’t even evaluate projects below certain whole dollar thresholds. In fact, it’s incredibly difficult to find institutional equity for investments below $5MM.
Programmatic Relationship
Institutional partners don’t just want to do big deals; they want to do a lot of big deals. Time and time again, prospective equity partners ask what a sponsor’s pipeline looks like, because one-off projects are less desirable. There are large hurdles to overcome when doing the first deal with a new partner (which we will delve into later), hence it becomes much more efficient to do multiple deals with each partner.
The same way friends and family can run out of money with large deals, they can’t handle a lot of projects concurrently. This source of capital doesn’t scale well. Institutional partners, on the other hand, have deep pockets, crucial to business expansion. Now, maintaining investment discretion as a sponsor within a programmatic structure is rare, but interests are aligned to do multiple deals. Institutional equity wants a programmatic relationship because of the efficiency it brings.
Institutional Credibility
Partnering with an institutional joint venture partner brings immediate credibility to a real estate project. When a $500MM opportunity fund or a $1B investment manager invests capital, people take notice. This element creates a variety of advantages, such as helping the project secure debt financing, more ease in gaining approvals, and solidifying contractor confidence and interest. In some situations, the capital partner’s good name may open up debt options previously unavailable.
Superior Experience
Being institutional means being professional; these are the best capital partners in the space. There are reasons why they are tasked with investing billions of dollars each year. A well-seasoned capital partner can help with the ins and outs of a project, acting as another set of eyes. While the sponsor may be the local market expert, an institutional partner can bring experience in other geographic areas to the project that can’t be gained without a larger footprint.
Referrals
Institutional partners have large financial mandates; in order to fulfill those mandates, they often need to leverage off of sponsors’ expertise. Once a relationship with equity is solidified, a sponsor can become a preferred vendor for a regional or product type. This means capital partners may refer projects to their preferred sponsors. Often times equity shops don’t want to do deals directly (i.e. where they are both the GP and LP and there isn’t a JV equity partner), but they have a vast set of relationships that generate project leads. In many cases, they’ll want to get boots on the ground through their preferred joint venture operators rather than directly.
Speed
The advantage of speed that institutional equity brings is almost incomparable. When necessary, institutional partners can move incredibly quick. For example, we worked on an REO project a couple of years ago where our client was in second position after the initial offer. The seller requested that our client conduct due diligence in parallel to the other buyer in case they pulled out. After the seller gave notice of the first buyer’s failure to perform, our client had only one week to close. The equity partner, a specialist in distressed assets, was able to mobilize and close in this timeframe, quite an incredible feat. Compare that to a timetable involving presenting 50 different investors with your PPM and answering each one’s individual questions.
Efficiency
More often than not, when using non-institutional capital a sponsor is combining a variety of sources. This may mean friends and a family or upwards of 50 different accredited investors in a syndication. Comparing the management headaches associated with one institutional equity group versus 50 individual investors demonstrates a clear advantage.
The institutional shop is in the business too; they know the plot and its nuances. Private investors, on the other hand, are not necessarily real estate professionals and may be acting as part-time investors. Now, imagine how this will play out when things go wrong. If the pro forma gets off track, you may have to explain that to 50 “angry” investors versus one. There is a liability concern here too; opening oneself up to 50 “emotional” potential litigants could prove disastrous.
Staying Power
Unfortunately, in real estate, things can (and do) go sideways. This may mean things get a little off track, or it may mean complete derailment. Having a partner with staying power is advantageous during hard times. Fund life can be a factor in this equation, but in general institutional capital can stay more patient than private funding. When times are good, they may want to sell sooner and realize the return, but when times are bad they are willing to hold when it’s prudent.
Fees
Private investors can have real heartburn about the inclusion of any operator overhead as a project cost. On the other hand, institutional capital realizes that this expense is a necessary cost to run the business. Providing this allows partners to focus on the business plan and not capital constraints. There are limits of course to these fees; we have seen institutional equity conversely get heartburn when fees get considerably higher than a sponsor co-invest.
The Disadvantages:
Project Hold Period
As alluded to above, many institutional investment funds have a life cycle consisting of only five to eight years. It’s rare to find a fund that has the flexibility to hold for up to 10 years. Certain family offices are excluded here, but generally funds want to execute a business plan and sell before placing capital into another opportunity.
Keep in mind that many REITs, for example, may want to sit back and clip coupons, but project-based investors for value-add, redevelopment, or development projects are typically looking for three to five year-hold periods. We have, on occasion, represented clients with seven-year business plans but have found that these garner must less interest from equity groups.
Structure
With institutional equity, everything is going to be more structured than private capital. These types of groups have fiduciary duties to their investors and processes in place that are essential to running billion dollar platforms. Not to mention, they’ve seem a broad array of potential variances in previous business plans. Operating agreements, for example, will certainly be more rigid and often times driven by the equity partner. Their unwillingness to deviate too much comes from management headaches; they seek to standardize operating agreement across their various joint venture partnerships for consistency. Also, there are often more reporting requirements than may be necessary for private investors.
Profit Split
We’ve been privy to the terms our clients have been able to achieve from “country club” type money, and it can be shockingly good. There has to be an upside to private raises given the lack of efficiency, speed, depth of capital, and experience. The true split will often be better with a private raise, and in addition, a sponsor may participate at an earlier point of returns as well. We typically see much simpler structures at the private level as well. The difference for institutional equity, however, is bigger checks and more deals, so while the splits get lower there are more whole dollars flowing to the sponsorship.
Process
The first project with an institutional equity partner can be a real process. It’s time-consuming for them to run their underwriting process and conduct due diligence on the sponsor. Negotiating the LLC operating agreement also takes time and legal expense. Internal approvals on the equity side can slow the process down too. The good news is that the second time around things go much smoother; the burdens to do that first deal are so great that it’s exactly the reason why equity wants to do repeat business with their operating partners.
Summary:
We may have some bias because we exclusively deal with institutional capital sources, but for the right opportunity, these equity partners absolutely do have many more advantages than disadvantages. Smaller equity investments with longer hold periods don’t work well for institutional money. However, institutional equity can be ideal for large equity investments and can lead to programmatic relationships.
Institutional equity partners bring credibility and experience a project; they might even have referred the project itself. These partners offer speed and efficiency in execution, staying power when times get tough, and project fees to fund overhead. On the other side of the coin, working with institutional capital traditionally rules out long-term holds or simple cash flowing type projects. Sponsors also must endure more structure, process, and often times lower profit splits in order transact.
A couple of final thoughts to ponder: First, one of the interesting things about institutional equity is that working with one of these partners gets you in “the club.” Our clients are often asked for equity investor references. If that reference is institutional in nature, it can open the door to many other institutional recourses. Second, while this article has focused on advantages of institutional investors over private ones, don’t forget those sources as the business grows. Institutional equity can fund larger deals, but this means that the sponsor co-invest will also get larger. Private investors can sometimes be a great source for funding this piece of the capital stack.
