Whether you're about to do your first deal or you're part of a bigger firm that's done hundreds, chances are you're using a combination of your own capital and outside investor equity to fund your deals. Certainly, there are plenty of funds that are investing captive equity (e.g. private equity), but most developers and real estate entrepreneurs are using a mixture of LP (limited partner) and GP (general partner) equity to fund their deals.
What is an LP / GP?
Private equity real estate is typically capitalized via a Joint Venture (JV) between a General Partner (GP) and a Limited Partner (LP). The two parties can be defined as follows:
The LP Investor is typically an individual or group that would like to invest directly in real estate, but lacks the expertise or infrastructure to do so. The LP investor is the "money partner" and in many structures contributes 90% of the required equity in a project.
The GP Investor is a Developer/Sponsor that has the required expertise and infrastructure to invest directly in real estate, but generally lacks the sufficient capital to do one (or more typically several) deals. The GP typically contributes the remaining 10% of the equity needed to fund a project, but also takes on the day-to-day management of the asset.
A sample JV structure is included below. While it accurately depicts the overall structure (The Property is owned by the JV, which is owned by the LP and GP), in most instances the structure is far more complex and has far more layers.
What are the LP / GP Responsibilities?
Ultimately, the structure is a matter of convenience. Neither partner has what the other does. Indeed, the LP either has equity or can easily raise it and the GP has the ability to execute on a business plan. Simply, the LP investor is passive equity and the GP Investor is doing the heavy lifting, which typically includes:
1) Deal sourcing / underwriting
2) Negotiating deals
3) Establishing relationships with brokers / sellers
4) Conduct due diligence and negotiate a purchase & sale agreement
5) Secure financing
6) Act as the guarantor of debt (typically personally with some degree of recourse)
7) Act as the property manager (leasing, maintenance, etc).
9) Execute the business plan (e.g. value-add redevelopment)
10) Focus on delivering superior investment returns.
How are the LP / GP Compensate?
With the GP doing "all" of the work to improve/manage the investment property, it is reasonable to expect the GP to earn a disproportionate rate of return than their pro-rata equity contribution would calculate. Remember, a GP i sputting in just 10% of the required equity - so why would they do all the work if they don't stand to benefit? What's more, the LP wants the GP to remain focused on creating value - keeping costs down, growing revenues, etc.
The disproportionate share of returns is typically calculated using an Equity Waterfall, which may be as simple as a cash flow split above a certain preferred rate of return, or as complex as several IRR hurdle rates.
Stay tuned for an example of an equity waterfall in a future blog post!