From LP to GP: A Path to Elevated Return

When investing in a real estate project, investors consider different parts of the capital stack as an entry point, from senior and mezzanine debt, to preferred and common equity (see our Capital Stack article to learn more). Investors who prefer to reap the benefits of a levered return and potential upside generally seek to invest in the common equity, which has traditionally been bifurcated between equity investors or limited partners (“LPs”) and real estate sponsors or general partners (“GPs”).

This article takes a look at the relationship between LPs and GPs and outlines the risk-reward dynamic of LP and GP equity investments.

Two Sides of Equity – LP & GP

Most traditional commercial real estate transactions are a joint venture of two parties: the sponsor or manager (GP) and their equity investors or limited partners (LPs). The relationship between the parties is often regarded as a “marriage of convenience,” whereby each party is providing something the other doesn’t have. The GP/LP structure may provide symbiotic alignment, whereby the sponsor identifies the opportunity and provides management expertise to execute the business plan while the LPs are able to participate in the fruits of the investment by providing the bulk of the capital needed to consummate the transaction.  

In this traditional LP-GP structure, the LP contributes capital to help fund the deal presented by the sponsor and, in return, seeks to participate in cash flow and profits without actively managing the real estate. On the other hand, the sponsor, or the GP, is expected to do the “heavy lifting” and manage the day-to-day. Not only are the GPs putting in significantly more work throughout the investment cycle, they are often taking additional risks as they must fulfill responsibilities that come with debt capital, and provide various types of guarantees required by the lender. To compensate for the execution work and liabilities, an incentive structure is created such that the GP is motivated to maximize returns for all parties. That is, the GP is entitled to receive a disproportionately larger profit once the LPs receive a preferred return and return of contributed capital.

Consider a hypothetical deal in which the LP investors contribute 90% of the equity and the sponsor (GP) contributes the remaining 10%. The sponsor and the LP investors agree on the following distribution structure:

1. First, 100% distribution goes to ALL equity investors (LP and GP) pro-rata until they receive an 8% preferred return.
2. Second, 100% distribution goes to ALL equity investors (LP and GP) pro-rata until they receive their capital contribution.
3. Third, 100% goes to the Sponsor until they receive 25% of all profits distributed in clause (1);
4. Fourth, 70% distribution goes to ALL equity investors (LP and GP) pro-rata, and 30% goes to GP until LPs achieve a 13% IRR.
5. Thereafter, 60% distribution goes to ALL equity investors (LP and GP) pro-rata, and 40% goes to GP.

Note: Please note this is a hypothetical illustration of a real estate transaction.

The structure above is typically referred to as a waterfall. The illustration below shows that at different tiers of the structure, cash flows are distributed between the LP and GP in accordance with the returns hurdles achieved. 

Such a distribution structure allows GP investors to participate in a significantly greater amount of profit relative to capital contributed when the investment is exited successfully because the distributions of profit after certain hurdles are more favorable to the GP than a pro-rata split – an arrangement known as the “carried interest” or “promote”. In the above example, the GP contributed 10% of the equity but is entitled to receive more than their pro-rata allocation of the profit once all equity investors (including the GP) receive the return of contributed capital and an even greater share once LP investors achieve a 13% IRR target. The more successful the investment, the greater the profit for the GP.

Investing alongside the GP

Given the incentive structure, if an investment is able to outperform its targeted hurdles, then the GP can earn a considerably outsized share of the overall profits. So why would a sponsor allow investors to share in these economics? The answer is simple: diversification and capital allocation. As noted above, depending on the arrangement a GP has with their LPs and lender(s), the contribution required of a GP could be anywhere from 5-20% of the equity.  This capital requirement can prevent capital-constrained sponsors from pursuing multiple opportunities concurrently. If a GP is seeking to scale their expertise across a number of investments in a focused sector, a co-GP investment vehicle, such as a GP fund, allows them to diversify beyond a single investment. 

Similar to LP equity investors, investors in a co-GP structure, or GP fund, can passively participate without having to deal with the day-to-day management of the investment while potentially earning outsized return usually reserved for the GP.

Considerations for Co-GP, GP Fund Investments

Co-GP/GP fund arrangements are applicable to all real estate asset classes and can potentially benefit investors in many settings. However, considering that outsized profit to co-GP/GP fund investors are primarily generated from sharing the promote, value-add and opportunistic investment strategies with larger upside potential make the best use out of such arrangements.

The co-GP arrangement allows the sponsor to contribute less of their own equity (“skin in the game”) than they would otherwise have to. As such, it is all the more crucial to ensure the sponsor has a well-formulated business plan and the requisite experience to execute on the project. 

With an experienced and capable sponsor, co-GP investment structures may enable investors to achieve enhanced economics through participation in GP promotes.