How to Vet a Syndication Sponsor

A common challenge among investors exploring syndication as an investment vehicle is how to vet or choose the Sponsor(s) they will invest with. It’s a reasonable concern. With plenty of options, how does one effectively vet a Sponsor to a level at which he or she feels confident in placing their hard-earned money with that group? Every Sponsor is different. Every asset class is different. If broken down in extreme detail, every Sponsor can be vetted in a different manner, whether slightly or greatly. However, at a high level, every Sponsor and every offering can and should be vetted with the same approach, which provides consistency in comparison. I believe that, whether you are vetting 10 Sponsors or 100, your approach should always remain consistent, uniform and unchanging. It should BE STATIC.

Background I Experience

Structure

Team

Approach

Track Record

Investor Relations

Character

Background | Experience

In an ideal world, every Sponsor would have extensive experience in the niche in which they operate and would also have operated through a downturn with little or no loss. While these Sponsors exist, they are not always readily accessible to the average investor. Nor are they the only good Sponsors out there. Many different backgrounds or experiences, in both real estate and career, can equate to a solid Sponsor. To name a few; a person with asset management experience with a private or public firm, a person with experience in SFHs or small MFHs, a person with background as a commercial broker, a person with experience as a construction or property manager, and the list goes on. I would be weary of Key Partners (KP) with little to no direct or indirect experience in syndication or a related career.

Things to Consider / Questions to Ask

1. How many and what type of real estate deals have they done in the past?
2. How many years have they been involved in the syndication space? What is or was their career path before now?
3. What is each KP’s area of expertise? Underwriting, asset management, marketing, construction, investor relations, property management, other? Any Sponsor with a KP without experience in at least one of these areas is cause for concern. For example, I would walk away from a Sponsor who has one KP that is a computer programmer with no previous syndication or real estate related experience.
4. Google the Sponsor company name as well as each KP’s name. Do you find anything negative?

Structure

It is important to ensure that how the Sponsor structures the hold period, fees and share of earnings is aligned with your interests. Otherwise, the deal is destined to disappoint from the beginning. For value-add syndications, a hold period of 5-7 years is common, but can vary. Make sure that you are comfortable with tying up your money for this amount of time; maybe you want long term cash flow, or maybe you are looking for a quicker turnaround.

Some investors will give up a preferred return (pref) or accept a low pref with a 50/50 split thereafter in exchange for an experience Sponsor with a strong track record. For others, anything less than a 7-8% pref with a 60/40-70/30 split is a deal breaker. Personally, I like to see the presence of a preferred return with a catch-up or rollover. What this means is that in any year that the Limited Partners (LP) don’t earn the pref, it rolls over and compounds on the next years pref. I also believe that Sponsors should only make money when the LPs are making money. A straight split with no pref means that they make money regardless of performance, whereas your returns might not stack up well to your invested equity. A 70/30 split after pref is common and nice to see; however, a 60/40 or 50/50 split may be acceptable after an attractive IRR hurdle is met. I would walk away from any deal in which the split leans in the Sponsor’s favor, in other words anything below 50/50.

Last but not least, you should fully understand what fees the Sponsor will charge throughout the life of the deal. Common fees that you may see include the acquisition fee, the asset management fee, the loan guarantee fee, and the disposition fee.

Things to Consider / Questions to Ask

1. Are fees exorbitant to the point that the General Partner (GP, aka Sponsor) will make money regardless of performance? Fees are okay, but these should be what I call “keep the lights on” fees – fees that cover costs associated with running the deal.
2. Is the hold period firm? What happens if we’re in a down market at the projected sale date?
3. Does the Sponsor have a catch-up or rollover clause for the preferred return?

Team

You should consider two aspects of the team; the Sponsor team and third-party partners. The group of KPs that comprise the Sponsor team should not only pass your background check, but they should also complement each other well. For example, if there are 3 KPs, one might be great at underwriting and asset management, while one might be a marketing and deal sourcing wiz, and the third a guru in relationships (sellers, brokers, investors, etc.). If you have a group of three KPs that all specialize in asset management, where does the expertise come in for the other umpteen responsibilities?

You will certainly run across Sponsors that have project manager (PM) partners, general contractor (GC) partners, and so forth. Do your research on each of these groups; how long they have been in business, in what markets they operate, past projects, etc. On the other hand, some GPs will have their own PM and / or GC companies. Research and ask questions sufficient enough to feel confident that they are experts in the industry and that there is no conflict of interest with the Sponsorship.

Things to Consider / Questions to Ask

1. How do the third-party partners mesh with the GP? Do they have a strong working relationship or do they communicate minimally?
2. Think about what you uncovered during your background and experience due diligence, do the skill sets of each KP complement each other well?
3. What qualifies the PM or GC? What is their experience? Would you consider them experts in the market in which the property is being purchased?
4. Where applicable, why did the GP decide to start their own PM and / or GC group instead of working with a third party? What are the pros and cons of each?

Approach

The Sponsor’s approach to the deal is comprised of two vital aspects; the market and the underwriting / assumptions. A mis-step here can sink the deal before it is even under contract. The GP should be in a market or markets that (1) you like and are comfortable with, whatever your criteria, and (2) has strong job growth, rent growth, income, strong opportunities (properties not overpriced, competition is manageable, etc.). Major metro areas and suburbs of major metros are hot spots for commercial value-add plays.

I also like to see GPs whose underwriting leans heavily to the conservative side. A conservative approach is important to ensure capital preservation and downside protection, both of which should be top priority to the GP. A few high-level assumptions to check off as conservative; rent premium, occupancy rate, exit CAP, and rent growth. If these four metrics aren’t modeled well below the market, consider moving on. An added bonus is the presence of a sensitivity analysis, which will show you how returns fluctuate with the change in data points like those mentioned above. If Sponsors can show me a small return in a drastically bad market with the sensitivity analysis, I’m on board.

Things to Consider / Questions to Ask

1. Why did you, the GP, choose the market(s) that you operate in?
2. How do you, the GP, source deals? Broker relations, off market deals, relationships with owners / sellers, etc.
3. Does the GP model conservatively in relation to other groups?
4. What would returns look like for this deal in a recession that rivals 2008-2009? Look to the sensitivity analysis here, compare with historical occupancy, rent, etc.
5. How do the past, current and future market data points compare to projections? Rent growth, population growth, rent premium, occupancy rate, taxes and other expenses, renovation costs.

Track Record

If the Sponsor’s portfolio performance to date is not readily accessible on their website, which is not uncommon, request it. Compare past performance with (1) initial projections on corresponding deals and (2) the projections on any deal(s) that you may be considering with them.

Additionally, check that the Sponsor is consistent with the deals that they do. A Sponsor who frequently jumps from different asset classes (multi-family, self-storage, retail, etc.), does different strategies (stabilized, value-add, etc.) or even big jumps in asset class (A-D) is inconsistent and I would walk away. A good example of consistency is a multi-family Sponsor that rarely strays from 150+ unit, B-class, value-add apartment complexes built in the 1980s. If they do stray, maybe it’s for the occasional B+/A- 2000 property, which fits all other criteria, to add a slightly more stabilized asset to round out their portfolio.

Things to Consider / Questions to Ask

1. How long has the Sponsor and each KP been in the syndication business? If not long, what things did they achieve in their related career prior to moving to the syndication space?
2. What is their portfolio performance since inception?
3. Are the returns that they have achieved in line with your goals?
4. If they have a negative outlier, or an under-performer, can that be reasonably explained? What changes have they made to avoid that moving forward?

Investor Relations

Alignment between the GP and LPs is of the upmost importance. The GP should be a firm believer in and a religious practitioner of the “win-win” approach. I favor Sponsors who invest a significant amount of money (this is relative to each Sponsor’s specific situation) alongside the LPs as well as structure deals in a way that they only make money after the LPs have earned a solid return.

How does the Sponsor handle communications and distributions? Communications should be of high quality and content, occur on a regular or semi-regular basis, be upfront and not shy away from bad news should there be any, and they should be consistent in timing and formatting. Distributions most frequently occur on a quarterly basis, but some Sponsors offer monthly distributions. If you are primarily concerned with cash flow, perhaps you might prefer the Sponsor with monthly distributions; if you are primarily investing for capital growth, both are equally sufficient.

Arguably the most effective way to gauge the quality of investor relations and alignment is by tapping into the Sponsor’s existing investor network, aka references. Ask the GP for the name(s) of one or a few investors that currently invest with them or have invested with them in the past, then cross check the information you’ve gathered with their experiences. You can also gather references via social media sites like BiggerPockets or Facebook by outright asking “Who has invested with Sponsor XYZ?”

Things to Consider / Questions to Ask

1. How much money is the GP investing in the deal? Note: $100K may not seem like a lot for the GP to invest in a single deal, but if you consider that they are likely doing multiple deals per year, say 3-5, $300K-$500K and up is nothing to scoff at. Plus, they need their balance sheet to remain liquid to guarantee the loan.
2. How and how often do you communicate updates to investors?
3. Ask references for their experience with the Sponsor. How consistent are they with distributions and communications?

Character

There are two primary ways to judge the Sponsor’s – or, more effectively, each KP’s – character. First, via conversation with them over the phone or in person if possible. Second, through the references that you gather during your due diligence of the “Investor Relations” phase. When speaking with them directly, what kind of vibes do you get? If a Sponsor, and the KPs of that Sponsor, are not genuine, down to earth and caring people that I believe I could be friends with outside of the real estate world, I would never partner with them. Of course, here you have to trust your own judgement of character.

To supplement your own judgement, ask the references that you’ve been put in contact with about their experience with the Sponsor and what kind of people they believe the KPs to be. Lastly, if the KPs are active on social networking sites (BiggerPockets, Facebook, Instagram, Twitter, etc.) you can learn a lot about them there.

Things to Consider / Questions to Ask

1. What does the company and each KP have to lose? Are they full time syndicators or do they have another job? If another job, is it in a related field?
2. Ask the Sponsor – we’re all in this business to make money, but why else do you do it?
3. How would you handle an investor who has fallen on hard times and needs out of an investment?
4. Question for references: Do you get the vibe that they truly care about their investors and want everyone to win on every deal?
5. Question for references: Has your experience with the Sponsor been overall positive, negative, or neutral?

On a final note, any Sponsor or KP who is unwilling to share any of the above information, walk away. They should be willing and happy to help, honored and thrilled that you would consider investing with them. Unwillingness to share information is a red flag, although it does occasionally mean that it is simply not available, so be sure to clarify.

You will hear many folks assert that syndication is a passive investment. This is not entirely accurate. While the investment itself is quite passive, the upfront due diligence required to vet a Sponsor as described above is anything but passive. You need to deliberately collect information on any Sponsor that you are considering to ensure they are trustworthy, qualified and align with your interest. On the bright side, by investing time initially to thoroughly vet Sponsors, you can greatly reduce this due diligence in the future by continuing to invest with Sponsors that you have already vetted, currently invest with, and are satisfied with their background, structure, team, approach, track record, investor relations, and character!

If you would like further help in vetting a Sponsor, or would like to take a deeper dive into the specifics of what to look for when asking the above questions, feel free to reach out to me at mike@bishopinvestinggroup.com.