Vetting a Passive Deal Sponsor
Updated: Sep 17, 2020
It can be a significant emotional event anytime we entrust someone with a large amount of our hard-earned money. As such, it is not something that should be taken lightly or without proper due diligence.
There was a time when operators pooling investor capital to take down large apartment building were a rare breed. The most prominent players ruled over their markets and had relationships with the best brokers. But soon the secret started to get out. Before long, thanks to large conferences put on by apartment investing "gurus" and best-selling books by celebrities like Grant Cordone, the apartment investing club got a whole bigger.
This brings both risk and opportunity for potential investors. Passively investing in real estate syndications can certainly offer competitive returns and other attractive benefits, but with so many new players in the space, how can they vet deal sponsors?
What follows are some of the criteria I think are worth exploring before investing in what may be a lucrative deal or a prelude to your unintentional staring role on the next episode of American Greed.
Basic Background Check
This is probably not a surprise, but your first step should be to hop on the Google machine and look up the company and individuals with whom you are considering investing.
Hopefully, you will find nothing out of the ordinary, and you can move on, but you may save yourself a lot of time and heartache by starting here. If there is a class-action lawsuit brought by investors claiming misrepresentation or straight-up fraud, better to find it early and save yourself the trouble of researching further.
As with an interview of someone who may be working for you, you should ask about their practical experience. My words in that last sentence were intentional; investors are the customer of the deal sponsor. You are primarily hiring them to take your money and make it multiply.
For some sponsors, this will be easy. They will have a long and storied track record of deals and performance. For newer deal sponsors, this may be a challenge. If they haven't done a deal, that shouldn't necessarily be a deal-breaker, but you should be more critical of other criteria. If they lack experience in one area, then they should have a team member who makes up for that deficit. We'll look more closely at why the team is so important a little later.
After general competency and trustworthiness, this is my next top criteria. Because passive deal sponsors can expect to be a part-time teacher for their investors, transparency is vital. There should be no reservations about answering reasonable questions about the deal, including how they will get paid. I understand some investors may be reluctant to ask about sponsor compensation, but if you are investing $1 or $100k, you deserve to know where it's going.
Another aspect of transparency worth asking about is the frequency of communication. There is no "right answer" on how often they should be communicating with investors, but you certainly know when it's too much or too little. Once the deal is underway, monthly is common. During unforeseen challenges (say, like a pandemic), the frequency is likely to increase. Talking through your expectations and ensuring they align with the sponsor is part of the process.
An illuminating exercise can be to ask them to recount an experience when something went wrong in a deal and ask how they dealt with it and communicated it to investors. This would show how flexible they are in dealing with adversity and hopefully give an indication if investors were told engaged early and often when things went wrong. I make sure to emphasize my motto on the subject, which is, "bad news doesn't get better with time."
Alignment of Interest
Besides being an indication of transparency, knowing how your deal syndicator is getting paid will also illuminate if there is an alignment of interest. If you're not sure what I mean here by alignment of interest, then I'll give you a quick example. Just a few months ago, Elon Musk was able to unlock $1.69B (yes, that's a B) in stock options as part of his tiered compensation package. This treasure chest was made available to him because Tesla increase in both sales and profits, and for each goal of the tiered compensation package, he gets another treasure chest.
The key takeaway here is that if Tesla shareholders make money, then he makes money. His success is inextricably linked to that of the company and the shareholders, so there is clear alignment of interest. While such an arrangement may be overly complicated for a real estate syndication, it is certainly possible to ensure deal sponsors are getting paid on the success of the deal and not just getting the deal done.
Many investors also like for the deal sponsor to have "skin in the game." There is no better indication of alignment of interest than the syndicators having their own money in the deal. Don't be too overzealous on this one through. Keep in mind that many sponsors are doing many deals a year, and they likely won't have the capital available to put significant amounts in every deal. They are putting substantial amounts of time into putting the deals together, and that can be viewed as an investment as well.
Thought leadership platforms are likely how you are introduced to potential deal sponsors. These platforms can be a blog, podcast, or just being known as someone who provides reliable answers to questions on sites like Bigger Pockets. While this is not necessarily an indicator of trustworthiness, you will likely be able to determine if this is someone you like and should provide an indication of their expertise.
You may have a relationship with one person, but you are investing with the entire team. For this reason, you need to understand who they are and what their areas of expertise are. Sometimes you will see team members with similar backgrounds, but more often than not, you will see a diversity of experience. It is this diversity that will often be the strength of the team, providing a depth of knowledge in important areas.
I have seen CPAs, engineers, management professionals, and others become apartment syndicators. What's important is that they have found a way to leverage their skills in support of the deal. If you're not sure how a team member's experience is relevant to their role in the deal, ask!
There is no replacement for the emphatic recommendation of a close friend or colleague when it comes to investments, but it is incumbent upon each of us to do our own homework. You will notice this issue was not about vetting the deal. That, I assure you, was by design. Vetting the deal sponsors is far more important than the deal itself. Even the best deal can crash and burn if not managed effectively, and a marginal deal can perform beautifully with the right team in place.
Now that you know what to look for, get out there and start vetting sponsors and their deals so you can make your money work harder for you.
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Ready to start passively investing in multifamily real estate and want to see if our opportunities might be a good fit for you? Click here to visit our website to learn more or reach out to me directly at Tim@ZANAinvestments.com.