BOOSTING YOUR RETURNS WITHOUT TAKING ON MORE RISK By: Ofer Vilenko, Managing Partner VTS Capital Partners
The Power of joining a Private Equity Sponsor as a GP-Co-Investor Real Estate Private Equity [PERE] deals are typically structured by its sponsors as a limited partnership or a special purpose vehicle [SPE], which has two types of partners: limited [LPs] and general [GPs] partners. LPs are passive investors who provide most of the equity for the deal while enjoying limited liability and GPs, are the ones who carry the load, have a fiduciary duty to all investors and are responsible for delivering the expected returns. Incidentally, the Sponsor/GP, is the private equity firm that makes it all happen. The GP roles include but are not limited to: sourcing and underwriting the deal, identifying the intrinsic added value, structuring and negotiating it, financing it, executing the guarantees on the loan, conducting due diligence, raising the equity capital, closing the transaction, executing the business plan to extract value, disposing of the asset to maximize profits, reporting and profit distribution. In addition, the GP may invest alongside the LPs in the deal. Typically, the GP contributes anywhere from 5 to 10% of the equity portion of the deal, however on large transactions that percentage usually gets reduced. Essentially, a PERE deal is a collaborative effort between GP and LPs in a “for profit venture” in Real Estate. However, how are these profits manifested? What metrics do investors focus on, when selecting an investment? Well, the most common metrics used to evaluate PERE investments are: [a] Cash on Cash Returns, which basically represent the distributable cash flow before taxes, [b] Internal Rate of Return [IRR], which in plain English, represents the value an investment generates over the entire holding period. Simply put, the IRR is the percentage of “interest rate” earned annually on each dollar invested in a property during the time it is owned. The calculation takes into consideration the capital invested; all the cash flows received, capital events and time value of money [c]
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The Equity Multiple, which without any consideration to the length of time, indicates to potential investors, what they are expected to get in return for each 1 dollar invested. It considers the gains from the investment as well as the return of the initial $1 dollar invested. Also, considering that real estate investments offer an added bonus in the form of depreciation, investors also take into consideration Sheltered Income, which is the amount of income they may shelter from taxes through this mechanism. Finally, Investors also focus on the Preferred Return, which is basically the return on equity investors will receive before, the sponsor earns the right to participate in the deal’s Promote. What is the Promote? Why does the GP deserve it? The promote is a pre-determined percentage taken out of the profits on the deal that is set aside for the sponsor/ GP. The promote is, therefore, a bonus for the GP for delivering returns to investors that exceed the Preferred Return. Even though the GP is also compensated through a variety of fees that are paid by the project, the promote has a special relevance, since it represents the lion share of the sponsor/GP’s potential earnings on a deal, but as indicated earlier, it is not “earned” unless certain performance hurdles such as preferred returns have been achieved, further aligning the sponsor/GPs interests, with those of the LPs. The sponsor/GP deserves the promote in consideration of all the work outlined above, as well as for delivering outstanding results in the project as the other fees it collects barely cover the GPs expenses. Most of us, from our early forays in the investment world, have worked and allocated capital under the unquestioned understanding that there is a direct relationship between risk and reward; the investment gods will allocate lower returns to those who take less risk, while higher returns will be bestowed upon those who dare to take higher risks… however, is it so? Is there a way to earn a disproportionate higher return for virtually