We buy multifamily projects in Austin and San Antonio. We spend all our time looking for deals in our hometown markets that we believe in—looking for assets we have conviction about. As we look for that next opportunity, we are constantly talking with investors who come to us looking for investment opportunities. In those conversations we want to understand why they are investing in real estate, what their return expectations are, and spend time educating them about what we’re seeing in the market. From our perspective, we want to be clear about who we are as operators, the types of assets we are pursuing and what our business plan generally is. We also want to keep a pulse on the appetite of our investors—to understand the types and sizes of deals that we can and should be looking at. After all, if you can’t raise the equity required for a deal, you shouldn’t waste your time looking at deals in the first place.
During those conversations, a common question that comes up asks whether we structure our deals “one deal at a time” or if we use “a fund structure”. Our answer is that we always do deals one deal at a time, and then usually talk about why. In today’s article, we want to highlight the two different approaches and what we believe the pros and cons of each approach are (and why we do it a deal at a time).
Using this structure, we as the sponsor create a fund that is going to own and invest in multiple deals. We are going to create deal parameters around the fund which become rules about what we can and can’t invest in and you the investor decide if you like those parameters. If you do, you will commit to the fund and then likely send us a portion of your commitment upfront. Over the next 12-24 months as we find other deals to acquire, we will call more funds due until we have received all of your original commitment and get it deployed.
As an example, if Wildhorn was to create a fund, we might set it up to be Austin or San Antonio specific, where we pledge to only buy multifamily assets of a certain vintage and say that no single asset use more than 25% of the fund and we’d be targeting a total return of 12%-14% IRR. We would cap the size of the fund to say $50 million. An investor would decide if they like that thesis and those guidelines, and then commit to us, where you’d review and sign the documents for that fund. Once we found the first deal, we would let everyone know the details of that asset and tell you it was time to send us in x% of your initial capital commitment.
The biggest pro here is diversification, as your dollars will be split into more than one asset through the fund. One deal may underperform, but another may overperform balancing out the returns and the risk.
Some investors also like the simplicity that a fund structure offers, as they only have to make one big decision upfront and then not worry about it. You are evaluating the sponsor and whether or not you trust them, their track record and their investment thesis—but once that is made you don’t have to evaluate each deal separately.
Investors are giving up a certain amount of control, as these are typically blind funds. You don’t know the asset(s) you’ll be buying, as the sponsor hasn’t gone out and found them yet. This lack of visibility into what you are buying into can make investors uncomfortable.
Lower returns. Typically a fund has lower projected returns than a single asset investment would. Along with diversification you usually see lower returns—which some investors are happy with and wanting. But a fund usually has lower marketed returns than a single asset would.
Future Timing: Once you commit to a fund, you need to keep capital available to send in over the next 6-24 months. You don’t have to (and often can’t) send it all in upfront, but you’re now committed. So even if your financial situation changes you’ll be responsible for this commitment and will need to be ready to respond when a capital call comes in.
Deal by Deal.
Using this structure, each and every time we find a deal we create a new entity structure (usually consisting of 2-4 LLCs), a new investor PPM and all of the other needed documents. They are all specific to that asset and are recreated for each and every deal. We typically try and name these entities using the address of the property for easy identification—but that also highlights the specificity of these documents. In this structure, the offering is only open until we close on the asset (or perhaps 30 days after that) so there is a small window in which you can invest.
The biggest advantage to this approach is that as an investor, you know exactly what you are investing in. The location, the business plan, the timeline, and most importantly the return profile for that investment. You can evaluate the investment on its own merit, assess whether this timeline works for you, your current cash position, etc—and then make a decision.
If you choose to invest, there is no presumption or requirement to invest with us again in the future. Maybe you turn out not to like us, or your financial situation or goals have changed. But you make the single investment and we move forward together. Future investments will be evaluated on their own merit.
The biggest—and really only—negative to this approach is that you don’t get the benefit of diversification. That investment is all going to be tied to the performance of that asset and how well we execute our business plan onsite.
Now to be fair, we always preach diversification and don’t ever advise anyone to put all their assets into a single deal. We recommend you spread your dollars out across multiple deals, and even with multiple sponsors across multiple geographies. But, for the sake of this single investment there isn’t any diversification.
As you read through this, our bias may be pretty apparent. We prefer the deal by deal structure—for many of the reasons listed above. But those are the factors from an investors perspective. As you think about it from a Sponsor’s perspective, keep these things in mind:
Each Deal On Its Own Merit.
When every deal we do gets evaluated on a standalone basis, the bar is high for us to find deals that are attractive. We have to present (and believe in) a compelling plan for that deal, and that deal alone. If the returns aren’t attractive, we will pass and keep moving along.
In a fund structure, the bar isn’t quite so high—precisely because of the diversification. An individual deal that might underwrite to a lower return is often times purchased by a fund as they bet they can find other deals to offset a lower return. The fund can become a vehicle to increase transaction volume and velocity rather than pursue assets on their own merit.
The timelines of funds can also be tricky. Most funds have a set timeline of 5-10 years, where they pledge to return capital in a certain timeframe. As that window starts to close, funds have to hustle to find deals to buy so they can get the money working. Often times that leads to buying less quality deals than a single asset structure would, just because they have committed capital and a clock in their head. This can also impact the timing of exits, as sponsors will want to close out a fund and may sell the last few assets a little early so they can earn their fees and move on to the new fund.
Fee Shop vs Deal Shop.
From a sponsor perspective the biggest difference we see in these two structures is often related to compensation—how we make money. As we’ve stated many times, we want to make sure we have strong alignment of interests with our investors. Our fees are low and our compensation is tied to investor returns—when investors do well, we do well.
In a deal by deal environment, it’s easy to keep that structure going. Again, we’re evaluating deals on their own merit—are they something we believe in? We live in fear of becoming a shop that just does deals to collect fees. Whether that’s an acquisition fee, an asset management fee or anything else.
Many times once you start down the fund structure path, the compensation changes. The way you think about deals shifts from upside to simply getting money deployed so you can generate fees.
You also see funds prevalent with really big shops. Those shops have lots of people employed, and lots of overhead. Fees start to run the process so you can make sure to collect fees to feed the beast. We never want to be a fee-driven shop and work hard to stay streamlined and efficient. Heading down the fund path can feel a little like you’re giving up your soul.
Overall, we know plenty of friends that operate with a fund model, and we don’t think they are bad people at all. It’s a philosophical approach and deserves conversation as much as anything else. Clearly we feel good about our approach however and the feedback we’ve gotten from investors is that they feel the same way.
If you’re an investor and you agree or disagree, we’d love to talk it through with you.