Compensation of General Partner
In this article we are discussing the basics of determining a fair compensation of general partner.
The sponsor is the single-most important player in your property evaluation, but the sponsor is not the only player to consider. Take a closer look at the level of compensation in order to evaluate a prospective general partner.
The parties who create and sell an investment opportunity deserve some kind of compensation for their work. As an informed investor you should know what this compensation is and how and when it gets paid. Sponsors earn their income by putting deals together. The nature of those fees and how those fees compare to what other potential sponsors have to offer should be considered.
All investment documents should be transparent for the type of fees that will be paid to a sponsor, as well as the exact timing for these payments. Some fees are paid up front, while others are paid over time such as asset management fees. There are also fees that might be applicable during disposition or refinancing of a property. There should be no surprises and fees should be agreed upon upfront.
If there is a promote included in the deal structure, which would allow a sponsor to receive additional cash flow in excess of the required return as a fixed percentage, you should understand whether and to what extent a sponsor is entitled to these fees. In addition, what fees are they entitled to if they do not deliver the required returns and even worse what if they lose any part of the invested principal? If there are any third parties involved in the deal, such as outside property managers, affiliates of a sponsor, or other JV partners, the offering prospectus should also shed light on how they are compensated. Make sure there are no conflicts of interest between all involved parties.
Below is a list of common fees and entitlements to a sponsor, though any of these and their size depends on negotiation.
Upfront Fees:These are the fees paid to a sponsor for organizing and entering the deal in general, called acquisition fees. These are separate and an addition to other acquisitions costs encountered during the purchase process such as legal fees, lenders, inspectors, title insurance etc. This money is meant to compensate sponsors for time and money they spent during finding and vetting the deal, securing a loan, and structuring JV/Syndication with investors.
Asset Management Fees:These are the fees charged for keeping the investment process running successfully on a strategic level, which includes keeping the relationships with the bank, reporting operations and finances to investors, managing the company holding a property including tax considerations, accounting, and so on. In addition, the Asset Manager, or in some cases a sponsor, manages a Property Manager who is in charge of daily property operation.
A sponsor has a choice of either performing property management internally or externally through a third-party property management company. Either way you as an Investor should be well informed about the process and respective fees. Asset Management fees are usually a percentage of a capital base or annual revenues and are most often paid on a quarterly basis. If Asset Management fees are paid on some capital base, consider whether they propose to include only the capital which will be actually contributed to the deal, or committed but not yet delivered. If the fee is based on the committed but not yet delivered capital, this would result in much higher quarterly payments.
Profit Splits: These are the moneys a sponsor would receive for participating in the deal. Profit splits are determined simply on a pro rata basis or through agreement of a basic waterfall structure. The profits from a deal include both the ongoing cash flow and the proceeds from an asset sale. When the profits from a deal are split pro rata, a sponsor receives exactly a percentage of the profit in accordance with what they invested. For example, if they invested 5% into the deal, they will be receiving 5% of ongoing net cash flow plus 5% of the net proceeds from the sale. The issue becomes more complex when there is a waterfall structure in place.
The general purpose of the waterfall is to incentivize a sponsor, similar to a promote structure. There is no standard for a great waterfall structure; it all depends on negotiations. The goal is to set a structure in place so that a sponsor receives a higher proportion of a profit after a certain return threshold is achieved. For example, while a sponsor invested only 5% into the deal, after the required return of 10% is achieved the net cash flow is split as 20/80 with 20% to the sponsor. Once the return goes above 15%, the split is 40/60 with 40% to the sponsor.
Some Sponsors are looking for much higher fees for their services. Compare the proposed terms to the market and make sure the price for the services reflect good value for money.