Good Partners vs. Bad Partners: What To Look For
Look at the chart below. What kind of conclusions can you draw from it?
In a nutshell, the above chart boils down the differences between public and private offerings by comparing the returns of public mutual funds with those of private equity funds.
Private equity is a fancy word for investments in private companies – usually in partnerships. When you invest in a private equity fund, you are essentially partnering with the promoters to invest in an asset or venture for your mutual benefit. Investors bring the capital, and the promoters (i.e., General Partners, Managers) bring the sweat equity (i.e., knowledge, experience, time, labor, infrastructure, and personnel).
The chart above explains why savvy ultra-high-net-worth individuals (UHNWIs) and institutional investors prefer private investments. Private investments offer a higher ceiling – 40%+ average annual returns on the high end. But you’re thinking; you also stand the chance of losing more money as well – with the possibility of losing an average annual return of nearly 30% in some cases.
Based on the popularity of private investments among UHNWIs and institutional investors, the potential risk of loss compared to safer public mutual funds hasn’t deterred these investors.
What sets the funds on the high end of the return spectrum apart from the low end?
Despite the higher risks of private investments, sophisticated investors have learned to mitigate these risks by separating the good partners from the bad ones. After all, the skill and experience of management is the #1 factor in determining the success of private investment. You have everything to lose in the wrong hands, but you have everything to gain in the right hands.
How do you separate good partners from bad ones? You ask the right questions!
Here are the main questions to ask when screening potential partners. Remember that only detailed responses are acceptable.
What is your investment strategy?
The investment strategy will be outlined in the offering document (Private Placement Memorandum) if prepared correctly. Still, it’s a good idea to have management articulate it to see if they have clear in their minds the direction they plan to take the fund. Are they targeting income? Income and growth? Just growth? It’s essential to know the fund’s investment goals to determine if they align with your own goals.
What infrastructure, processes, and personnel do you have in place to execute your investment strategy?
Does the potential partner have a solid foundation for executing their business plan, or will they be building everything from the ground up with your and other investors’ investment capital? A potential partner with a solid foundation in place who’s not just winging it will prevent delays in operations that could delay a return on your capital.
What is the fund’s exit strategy?
A clear and defined investment strategy should include a clear and defined exit strategy. What is the end game? How do you, the investor, cash out? Through a sale or refi of the asset? Through a merger? Acquisition? An investment shouldn’t be open-ended.
What is your track record?
Here are some related questions. How long have you been investing in this particular asset class for which you are raising money? For example, if the fund is raising money for multifamily, ask them how long they’ve been investing in multifamily.
What’s the value of assets currently under management? What has been the total deal volume of the principals? Have they raised money through a private placement before? If so, how many separate funds have they managed in the past or currently manage?
Answers to these questions should give you a good idea of the experience and knowledge of a potential co-investment partner.
What is your educational and professional background?
Most real estate investors didn’t start in real estate, but it helps to know their background to see if there were any complementary or transferable skills ideal for real estate investing. A background in which the manager exercised the ability to negotiate, analyze, and execute transactions – no matter what field – is a valuable skill in any setting.
What are the major risks?
Be cautious of a potential partner who claims there is no risk. There is always a risk. A manager who understands the risks, articulates them and explains precisely how they intend to mitigate those risks is the type of partner you want in your corner.
What are the principal financial terms of this venture?
Know the financial terminology, so you know what to ask. What is the expected average annual cash-on-cash return? What is the expected IRR? Do you have proformas to back up these numbers? What is the distribution schedule for cash flow from operations? What about cash flow from an exit?
Make sure management has the data to back up their numbers. Be sure to scrutinize the spreadsheets with a fine-toothed comb.
Do you have skin in the game, and how will you be compensated?
A potential partner with skin in the game gives you the confidence that they will protect your investment as much as theirs because you’re all in it together. The more skin they have in the game, the more incentivized they will be to achieve a return of investor capital and their capital.
Be cautious of front-loaded management compensation through excessive fees in terms of compensation. The majority of management compensation should be tied through performance in a share of profits. Reasonable management fees consistent with industry standards should be expected. The key term is reasonable.
Separating the good partners from the bad partners will differentiate between making and losing money with private investment. Know the right questions to ask and know what to look for. Any potential partner should have a clear vision for the fund and articulate every aspect of the proposed investment. Accept only focused answers to your questions. Remembering these key tips will help you find the right partners and sleep at night.