Traditional Co-GP Syndication vs Fund of Funds

Syndication remains an effective way to raise capital, however in recent years due to growing asset prices and a challenging capital environment, we have seen the emergence of syndicators operating in a “gray area” in terms of compliance.

Where there used to be just one or a small handful of Co-GPs there are teams exceeding 10+ just to be able to raise enough equity to close on their deals. It is becoming harder and harder to justify and delegate necessary and substantive duties to each member of the team and some simply don’t want anything to do with the operations of the asset. Some are outright ignoring the rules and doing things that are downright illegal such as paying finders fees to unlicensed broker dealers or only raising capital and not helping to manage the assets.

This is problematic because the SEC wants to see that each team member has a reason to be on the Co-GP team other than simply raising capital. The term “capital raiser” is taboo among the legal community because it opens you up to SEC violations if that is all you do and you are participating in a normal syndication. There is a right way and a wrong way to co-gp and this is an example of the over-extended Go-GP model.

This model is also problematic in that out of desperation, newer syndicators may be willing to partner with inexperienced, less than stellar operators just to be able to say they’re a GP in X number of doors. This can easily lead to loss of capital and reputation very early on in one’s real estate career and even be a career ender.

Luckily there is a solution that largely solves these problems. It’s called the fund of funds model. This is a specific setup that allows you to stay in compliance with the SEC while raising capital for other deals without material participation in the operations of the deal as long as you are investing as an LP. However there are some caveats and special requirements to remain compliant.

1. There must be some material benefit to your limited partners who invest with you rather than investing directly with the operator who’s deal you are investing in. These benefits might include something like:

   • Adding an additional layer of due diligence on the deal and the operators to further mitigate risk to capital. This includes

     1. Finding and underwriting the deals.

     2. Flights to meet with teams and visit properties.

     3. Doing background checks on operators.

     4. Checking references/performance vs pro forma in different market cycles.

   • Negotiating better terms and/or preferential treatment (like preferred return position and better splits) due to the larger check size.

   • Opening up deals and share classes that the investors might not have access to at the 50K level.

   • Diversity of risk across multiple assets and operators rather than putting all the eggs in one basket.

2. You are limited to 100 investors per fund of funds without meeting additional SEC guidelines. Most attorneys will only let you go to 99 just to be safe and you must include yourself in the number. If you are starting a fund of funds simply to invest in another fund of funds (not to be confused with another syndication) and you are investing all in the same fund (or 40%+ of your capital is going to the fund of funds), your investor count, count’s against their 100.

3. You are subject to the same Reg D 506b and 506c rules to maintain your exemption.

4. It is highly recommended that you hire a third party fund administrator responsible for the bookkeeping of your fund as well as calculation of waterfall distributions, assisting CPA with data for K-1s, etc.. as fund of fund accounting can get complicated quickly.

5. The fund must receive all compensation and then you can calculate splits/distributions. No side compensation just for the fund managers. If your fund takes a share of the GP it must go to the fund as a whole so the LPs can participate in the added profits. If you are Co-GP the material participation in the asset management rule still applies and you must be engaged at the asset management level.

Now that you know the caveats, here are the primary benefits for the GP of the fund of funds model:

1. Risk mitigation by working with only Top-Tier operators with many years of experience and dozens of full cycle deals rather than a newbie who just completed a training program and is putting their first or second deal together. Learn from the best in the business.

2. Diversify risk across multiple assets and operators.

3. Be the most interesting person in the room of top-tier operators. When you can write large checks, all of them want to be your friend and partner with you.

4. Focus on raising capital rather than being bogged down with operations. Lately raising capital has been the hardest part of the commercial real estate business and if you can solve this problem for people it will pay you handsomely.

5. Larger profit margins if done correctly.

6. Raise millions of dollars and build relationships with investors who are achieving on a high level.

7. Stay compliant with the SEC.

8. Raise capital for your own deals and for others all the time rather than going through "The Scramble" when you have a deal.

What are your thoughts on the fund of funds model? Did I miss anything?

*** Legal Disclaimer, This is not legal advice as I'm not an attorney, please defer to Mauricio Rauld or your SEC attorney legal questions.