Your Equity Hurdles Are Too High. Here is How to Set Them Right.
I get it, you’re eager to do that deal with that institutional investor you’ve been in conversations with for months now. Striking that deal would put you in another league. In many ways, you’ll be able to tell yourself that you’ve made it, that you’re off to bigger and better deals, and so you’re willing to accept a high equity hurdle because that will “align your interests with those of the investors”. You may want to think again.
What Is an Equity Hurdle?
For the reader unfamiliar with the term, an equity hurdle is an arrangement the investor is willing to accept to incentivize the sponsor to maximize the returns of the project. It is common practice in the Private Equity world and especially in real estate. Pursuant to these arrangements, sponsors earn a share of the profits exceeding their share of the equity contribution to the project. With a profit-sharing agreement, a sponsor putting up 10% of the equity could be entitled to 40% of the profits, but only after a pre-specified hurdle has been attained. The lower the hurdle, the greater the share of the profits the sponsor would be entitled to. How and where to set the hurdle is a tug of war played out by sponsors and investors, and it normally results in hurdles that are so high, they end up discouraging sponsors, defeating the purpose they have been established for. I think there is a better way.
Looking at the Big Picture
In addition to profit splits, another way that sponsors get compensated is via management fees. These can take the form of acquisition, construction, and exit fees. The idea is that management fees compensate for the ongoing business costs of the sponsor, to keep the lights on, so to speak, whereas equity splits provide the cherry on the cake. Best industry practices dictate that management fees cannot be too high, or otherwise the sponsor will get complacent; best if the sponsor gets a share of the profits, thereby “aligning” his interests with those of the investors. In my opinion, low management fees and high equity hurdles are a recipe for disaster. The reason is the nature of the industry. Real Estate is unique in that total potential profits are limited by a) what the market is able and willing to pay for a property and b) what it costs to get the project built. There is only so much control the sponsor has over each of these variables. When management fees and equity splits are established, they are the result of negotiations between the two parties that have taken place on the basis of a base case scenario. The greatest contribution of the sponsor to the deal is his market expertise, his ability to accurately project revenues and costs. To the extent the sponsor has correctly established the base case, his greatest contribution to the project has been realized.
Also, it is common for real estate projects to take many years to be completed, during which time the market can take many twists and turns, a factor completely out of the sponsor’s control. If you are an investor in a real estate development deal that has gone south due to no fault of the sponsor, you’ll want to make sure the people managing your capital are compensated adequately so they remain focused and dedicated to your investment. When everything seems to be going wrong, a poor management agreement is more likely to have the sponsor search for other streams of revenue and look away from your interests, not towards them. A much better approach is a management agreement that pays well but affords the investor, who is a majority shareholder, ample termination powers. Ideally, these powers could be exercised for almost no reason and without excessive notification periods. I, as a sponsor, would not be concerned about these powers being exercised frivolously; no investor in its right mind would swap out sponsors in a project capriciously, especially if the said sponsor has acted with diligence, transparency, and honesty. Successful Joint ventures between sponsors and investors are very much like marriages; what keeps them together is honesty and fluid communication, not the severity of the breakage clauses of their prenuptial agreement. If anything, you’d want an unhappy investor to have the flexibility to break up, if that’s what they wished.
This approach better aligns the interests of the sponsor and the investor. Generous management fees are the carrot that keeps sponsors marching forward, and the termination clause is the stick that keeps them from slacking off. Unfortunately, it is all too common for eager sponsors looking to partner up with institutional investors to sell themselves short and accept compensation schemes that rely too much on factors beyond the sponsor’s ability to impact the project. The first test of the sponsor’s competency will be his handle on the project costs and his market knowledge; if he predicted these correctly, it is more likely he’ll make the right decisions if the downturn eventually comes. Make sure he has an incentive to do so.
Originally published at https://realproperty-investing.com.
