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The Beauty of the GP Co-Investment

Structure
By Ian Formigle On July 21, 2015, 4:57 p.m., updated Feb. 24, 2016, 3:33 p.m.

Private equity real estate is rooted in the underlying concept that

there is an inescapable positive linear correlation between risk and
reward when it comes to investment returns.

Private equity real estate is rooted in the underlying concept that there is an
inescapable positive linear correlation between risk and reward when it comes to
investment returns (i.e. the greater the returns the greater the risk and vice versa):

While this concept is true when holding all other assumptions static, in reality, the
relationship between risk and return is more uid and malleable. There is not simply
one plotted relationship in this universe but an in nite number. More importantly,
there are ways for individual investors to earn greater returns at each level of risk or
“jump” upwards to a superior risk-return line. One such way is through co-investment
in the General Partner side of a private equity real estate deal.
Private equity real estate is often capitalized via a General Partner / Limited Partner
joint venture or a “GP / LP JV”. Graphically speaking, it looks like this:

This structure is marriage of convenience between two parties: 1) Limited Partners

(LP’s) — groups that have money they wish to invest in real estate but are resource
constrained in identifying and acquiring it and 2) General Partners (“GP’s) — groups
that possess expertise in acquiring and operating real estate in a geographic area but
are resource constrained in capitalizing it. Deals that are capitalized under this
structure involve the LP putting up the vast majority of total equity, typically 90%, with
the GP putting up the remaining 10%.

Structuring a GP / LP JV deal commonly utilizes an incentive mechanism known as

disproportionate sharing of pro ts or in industry slang a “promote”. While GP’s may
only put up 10% of the equity they earn greater than 10% of the pro ts. LP’s tolerate
paying disproportionate shares of pro ts to GP’s because a) they rely upon GP’s in a
multitude of ways (see below) and b) they want to incentive GP’s to perform.

LP’s rely upon GP’s, among other things, to do the following in a JV deal:

1. Source and identify assets

2. Underwrite and discover hidden value
3. Pursue, negotiate and win deals
4. Develop asset business plans
5. Negotiate purchase and sale agreements
6. Conduct thorough due diligence
7. Secure nancing
8. Close deals
9. Manage assets
10. Execute asset business plans
11. Dispose of assets; and
12. Deliver investment returns
Considering that GP’s do most of the heavy lifting in a JV deal, it is fair and logical for
GP’s to earn a greater share of pro ts than their pro-rata equity participation would
otherwise suggest. In addition, because LP’s rely upon GP’s to execute upon the items
listed above, they want to incentive GP’s to keep their eye on the prize and there is no
better way to do this than to o er up the carrot of disproportionate pro ts
participation.

So how can individual investors bene t from the GP / LP JV relationship? The answer is
to invest directly into the GP’s entity and earn a percentage of its promote on top of
the standard LP pro t share. This is commonly referred to as a “GP co-investment”. By
receiving a share of a GP’s promote, the individual investor is able to move up to a
superior risk-reward line and earn greater returns than the LP when measured
against project-level returns as demonstrated below:

You might ask, “why would GP’s share their promote with me, an individual investor?”
The answer to that question draws back to the underlying reason why GP’s pursue
this structure in the rst place — they are inherently capital constrained.

Consider the following scenario: a $60 million private equity real estate transaction
that is capitalized by $40 million of debt and $20 million of equity. Under the typical
10% / 90% GP / LP structure, the GP provides $2 million to the LP’s $18 million to do
the deal. For the GP, whose business is to acquire and manage as many assets as
feasibly possible, $2 million is a lot of balance sheet capital to expend on a single
asset. For GP’s, the highest and best use of its capital is to scale its operations, not
heavily invest in each deal, no matter how attractive the deal may look.
To solve this problem, GP’s seek to reduce the amount of balance sheet capital they
invest in each deal in order to sprinkle capital into more deals rather than concentrate
it into fewer deals. At the same time, while LP’s always want GP’s to have equity
participation or “skin in the game” they often do not require it to be the full 10% of
equity (particularly when the deals become large) but, rather, an amount that the LP
deems as “meaningful” to the GP.

As a result, GP’s are often permitted by LP’s to nd other investors to help fund GP co-
investment requirements and those other investors often comprise high net worth
individuals. To attain the GP co-investment dollars, GP’s are willing to share a portion
of their promote since those co-investment dollars enable the GP to a) do the deal b)
enjoy the opportunity to earn a promote and c) preserve precious balance sheet
capital to fund the next deal.

The GP co-investment is that rare case when the little guy out earns the big guy in a
deal; the private equity real estate equivalent of David versus Goliath. And that is why
it’s beautiful.

Research the GP Acquisition Fund II o ered by Encore Enterprises, Inc. of Dallas, TX

(https://app.crowdstreet.com/properties/show/gp-acquisition-fund-ii/)

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