JF1933: When To & When To NOT Work With Private Equity Institutions | Syndication School with Theo Hicks
After you’ve done a deal or two, you may have the opportunity to work with private equity institutions. Joe and Ashcroft Capital choose to not work with them ever, but that doesn’t mean you shouldn’t. Theo will cover why we do not work with them, and when it might make sense to work with them. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I’m your host, Theo Hicks. Each week we air two episodes of the Syndication School series on the best real estate investing advice ever show on iTunes, as well as in video form on YouTube, and we focus on a specific aspect of the apartment syndication investment strategy.
For the majority of the series, especially our earlier series, we offer free documents. These are PowerPoint presentation templates, Excel calculator templates, PDF how-to guides, some sort of resource for you to download for free, that accompanies the episode or the series. All of these past series and these free documents can be found at SyndicationSchool.com.
In this episode we’re gonna talk about when to work with and when not to work with private equity institutions. First I’m gonna define what these are, and then we’re gonna go over what to think about when you are considering raising money from private equity institutions.
Private equity is an asset class composed of pooled private and public investments in the property markets. That’s the textbook definition. What that means is that private accredited institutions such as pension funds and non-profit funds and other third-party asset managers who invest on the behalf of institutions will invest in these private equity real estate funds that are then used to buy real estate. One way that it could be used to buy real estate is to invest with an apartment syndicator of some sort, whether it’s a developer, a value-add syndicator, distressed syndicator, turnkey syndicator, or whatever.
A caveat would be that this is really only gonna be relevant to people who have done deals before, so you’re not going to be able to get a line of credit or funding from a private equity institution if it’s your first deal or your second deal. You’re gonna wanna have a track record, because they’re going to base their funding on the deal, but then also on you. But if you’ve done some deals, then you can consider working with institutions. We’re not gonna talk about exactly how to work with institutions here, but we’re gonna talk about when it makes sense to work with them and when it makes sense not to work with them.
Joe does not work with private equity institutions because of the way that his deals are structured. It really depends on how your deals are structured to determine if it makes sense to work with them.
We’re gonna go over the reasons why Joe doesn’t work with then, and then we’re also gonna talk about reasons why if his deals were different in this way, then this is how he would be able to work with them.
The first thing is that the private equity institutions are only going to review a deal that’s under contract. Once you’ve got your PSA signed with the seller and you already have your relationship with this institution, it’s only at that point that they’re going to actually perform their due diligence on the deal to determine if they’re going to provide funding. So they’re not going to do due diligence and let you know that they’re gonna fund the deal before you put it under contract. So you’re doing all of your upfront due diligence, underwriting, and then once you determine that the deal makes sense, only then will they actually look at the deal to see if it makes sense to them, to determine if they’re going to provide you funding.
This could pose a pretty big problem, especially if you’re working in a pretty competitive market that requires a non-refundable earnest deposit… Because generally, if you’re raising money from just regular passive investors and not a fund, you don’t have hard commitment, but you have an idea of how much money you’re capable of raising beforehand; it’s what we recommend, at least – you wanna have the money before the deal. So you wanna have verbal commitments, you wanna have a list of investors, and then know how much money that they are capable of investing, and then based on the summation of that list, you can determine what size deals you can look at. If you’re capable of raising a million dollars, then you can assume that you’ll probably have to put down between 30% to 35%, so you can look at deals that are three million dollars and lower.
When you’re working with an institution – sure, you might have an idea of the line of credit that they’ll give you, how much money they’re willing to fund in total, but since you don’t know if they’re actually going to fund the deal or not beforehand, and you put down a non-refundable earnest deposit, if they don’t fund it, then you’re gonna lose that earnest deposit.
Obviously, it’s possible to lose the non-refundable earnest deposit by raising capital from a group of individual accredited investors, but the probability is going to be lower, because as I mentioned before, you already have an idea of how much money you’re capable of raising, plus ideally you’re not going to push that ceiling. Obviously, it’s good to push yourself, but if you’re capable of raising a million dollars and you only need to raise 500k, well you’ve got a lot of options to raise money from people. Only half of the investors need to actually invest the amount they said they would invest in order to hit that threshold… Whereas if you’re doing it with a fund, it’s just one entity that’s investing… And if they say yes, then you’ve got the money; if they say no, you’ve got no money. And then obviously, if you are able to close, then you’re gonna lose that non-refundable earnest deposit. So that’s one thing.
If you need to go non-refundable, it might not make sense to use private equity. If you do go refundable, then the next thing to think about is this next point, which is that private equity institutions typically will not approve their funding until a minimum of 30 days after contract. So you put the deal under contract, they do the due diligence – they’re not gonna instantaneously come back to you in one day and say “Oh yeah, we’ll fund this deal” or “Nah, we’re gonna pass on this deal.” It takes a while to do due diligence, so expect for it to take at least 30 days for them to approve or deny funding after the deal is placed under contract. And of course, this is an issue if you don’t have a long contract-to-close time period. Typically, it’ll take anywhere from 60 to 90 days to close on a deal; so PSA-to-close, 60-90 days.
Well, for Joe’s deals, the formal funding period usually will begin a few weeks after placing the deal under contract, so say day 14. And then the goal is to secure all the money that’s required to close by at least 30 days prior to closing. So if it’s a 60-day close, then day 14 to 30 hopefully they get all the money at that point, or at least the majority of the money.
Now, what happens if you raise money from institutions and you have a 60-day contract-to-close? Well, you do all your due diligence, you’re preparing to close, and then they don’t get back to you until day 30, and they say “Oh, we’re not gonna close on this deal.” Now you only have 30 days to fund your deal from your individual passive investors, whereas on the other hand, if you raise money from individual people, you would have 45 days to raise money. So that 15 days is gonna be pretty important. If they decide to obviously fund the deal, then no problem, but… There’s also the possibility that they won’t fund the deal.
If that’s the case, well then you have a condensed timeline to raise money from your list of private investors. And hopefully you can get it done, but again, the probability is lower of getting it done in that compressed timeframe. If you’re unable to raise money, you can’t close on the deal. If the earnest deposit is refundable – great, you get it back. If it’s non-refundable, well then you’re going to go ahead and lose that non-refundable earnest deposit.
Now what happens if “I have a refundable earnest deposit, so I’m not really worried about any of this, because even if they say no and I can’t raise the money, I’ll just get my money back.” Well, that’s not necessarily the case, because there’s more than just the earnest deposit that’s on the line. There’s other money on the line, but your reputation is also on the line. So when you are 30 days or more into the due diligence process – again, it takes 30 days for them to approve or deny it; or at least 30 days, maybe even longer. It could take two months. You might not get an approval until you’re supposed to close. But let’s just say on the fastest end 30 days. Well, at that point you’ve done inspections, you’ve done appraisals, different surveys, and these things aren’t free. These things cost money. And if you close, you’re gonna reimburse yourself if it comes out of your pocket, but you’re probably gonna be 5k, 10k, 20k out-of-pocket depending on how big the deal is.
You’ve also got legal costs as well, putting together PPMs in other contracts, creating the LLCs… Those aren’t free. And if you fail to close on the deal, even if you have a refundable earnest deposit – sure, you’ll get that back, but you’ll also lose all of that upfront due diligence costs and legal costs if you’re unable to close. There’s really nothing you can do about that at that point. That can happen in general if you don’t close, you’re unable to raise money… But as I mentioned before, the probability of raising money from your pool of investors is higher than raising money from one specific fund, because only one entity is making the decision on whether or not they’re gonna fund the cost of the deal.
But again, it’s not all just money that’s on the line as well. Your reputation is gonna be also at stake. If you were to pull out of a deal because you couldn’t raise enough money – either the private equity people back out and then you can’t fund the deal from your passive investors – well, your reputation is gonna take a hit, first of all, with the seller, so the person that you’re buying the deal from. And if that seller owns multiple apartments in that area – well, if they go to sell another deal in the future, you’ve reduced the likelihood of being awarded that contract, because the last time you weren’t able to close.
Also, if the seller is pretty involved in the local real estate market, knows a lot of real estate professionals, other investors, brokers, things like that – well, your reputation might also take a hit in the eyes of those other professionals of the greater real estate community in that area, because you’re gonna be known as a person who can’t close on deals. Even if it happens just one time, the word gets around.
Additionally, your reputation is going to take a hit from the listing broker as well, for very similar reasons. This could potentially be even worse, because the seller might own maybe five deals, so you’ve kind of lost on those five deals, but the broker might be listing hundreds of deals in their lifetime… And if you’re unable to close on one of those deals, you’ve reduced the likelihood of being awarded another deal that is listed by that broker, because similarly, you didn’t close, and they think of you as someone who wasted their time and was unable to close on the deal.
And then similarly to the seller, the broker also has a relationship with other brokers in the area, other investors in the area, and it’s kind of like a domino effect where you also might have issues getting deals from other brokers as well. Not all brokers, obviously… But again, the entire point of this is that if you do not close on a deal that you put under contract, at the very least you’re likely not going to get awarded another deal by that broker or that seller, if the reason why was because yo could not follow up on your commitment. If you had to back out because there’s a problem with the deal, that’s different. But if you could not qualify for financing and you couldn’t raise enough money, that’s different than backing out because of some environmental issue or something like that.
So if you’re unable to raise money, which is more probable if you’re raising money from a fund, then it’s a double-whammy. You’re gonna lose your earnest deposit, unless it’s refundable. But even if it’s refundable, you’re gonna lose all the upfront due diligence costs, and your reputation is also going to take a hit.
So when should you work with a private equity institution? The main factor would be if you have a long contract to close timeframe. You’ve got a lot of time before you close, so you don’t have to worry about waiting a month or two for the institution to get back to you and let you know if they could fund it. And if they say no, you have plenty of time to raise money from your list of private investors; ideally you have that, and you’re not just relying solely on private equity. But again, since you’re likely experienced, you’ve raised money from people before so you do have a network of passive investors that you can tap into, if you’re unable to quality.
So the main thing would be if you have more than 90 days, so like 120 days plus maybe a few 30-day or 15-day contract extensions, that would be good time to use the private equity institution. If you don’t need to go non-refundable on your earnest deposit, similarly, because if you’re unable to secure the funding from the private equity institution because they denied funding, and you’re unable to get money from the passive investors, then you could at the very least get your earnest deposit back… But again, you still have the issues with the upfront due diligence costs, as well as the reputation. So ideally, you have a long timeframe, so that if you’re denied funding, you can raise money from your passive investors.
Overall, the three reasons why Joe personally does not work with institutions is 1) they don’t review deals unless they’re under contract; 2) they deny funding until at least 30 days after the deal is under contract, and 3) if you’re unable to close, you lose money and reputation. So that is when to work with and when not to work with private equity institutions.
Until tomorrow, check out some of our other Syndication School episodes on the how-to’s of apartment syndications, make sure you download the free documents we have available as well. Both are available at SyndicationSchool.com.
Thank you for listening, and I will talk to you tomorrow.