In this episode, Hunter Thompson shares how you can utilize the Fund of Funds model to scale your business.
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TRANSCRIPTION
Joe Fairless: Welcome to another special episode of The Best Real Estate Investing Advice Ever Show, where we are sharing the top sessions from the Best Ever Conference 2021. This year, the Best Ever Conference is back in person, February 24th through 26th. Come join us in Denver, Colorado. You’ll hear all the new keynote speakers, you’ll meet some new business partners, you’ll learn some insights from the presentations and from the people you meet, that you can apply to your business today. Here is an example of a session from last year that is still relevant today and will be beneficial for you.
Hunter Thompson: Alright. For those of you who don’t know me, we are about to dive in deep into the details. Buckle up, get your pen and paper ready, and make sure to write down questions as they come up. Because I definitely want to get into the Q&A and just burn through as many questions as possible. It’s likely that a lot of things will come up during this conversation. If you’re not yet familiar with this concept, let’s talk about what this is. Why listen to this presentation?
Before we get into the details of what this is all about – this presentation is going to outline a concept, a structure, a model that’s going to allow you to provide your investors with access to operators with extremely large minimums. It will allow you to act as a capital raiser while avoiding challenges associated with becoming a registered representative under a broker-dealer, which I am; it’s kind of a pain, but you can avoid that by doing this. You can also provide economies of scale if you’re just getting started.
So if you just want to be a capital raiser, for example, it usually doesn’t make sense to do that and go through all that process and compliance unless you can raise, let’s say, five million dollars in a year. This will allow you to start with raising half a million, raising a million, raising two million. And if you want to continue to just be a capital raiser, perhaps at that point, you can go and be a registered representative.
Also, if you’re an operator – this is so key; I know a lot of attendees are operators here – it will allow you to create structures that attract fund of funds managers. This is how you can get someone to write you a check for two million, three million, five million dollars, such as my firm, Asym Capital; we’ve done this many, many times. And if you’re an operator and you’ve got a lot of capacity to invest or raise capital, but your deal flow slows down, you can actually create your own fund of funds and invest in someone else’s deal. Lastly, and potentially most importantly, there’s nothing better to do. Everything’s closed down, so you’re stuck with me for the next 20 minutes. So let’s rap about it.
So this is what a traditional real estate partnership looks like, and this is something that has been going on for hundreds of years. You have a capital partner – it’s very common in the real estate business to have a delta between a capital raising partner and the operating partner. One person focuses on operations, the other person focuses on the placement of capital. Those people get together, they form a management company, and that management company purchases real estate. We’re very, very familiar with this.
So as the Jobs Act happened, and as podcasts such as Joe Fairless, as in my own, and many, many others started taking place, people recognize “Wait a minute. I have access to half a million dollars through my friends and family. Perhaps I can be a capital partner in one of these deals.” So what ended up happening is a lot of people in the industry took this co-GP model that’s been proven over millennia and turned it into something that looks a little bit different.
Now it’s like this – a capital partner is here, they’re going to raise money for a deal; we’ve got the operating partner, and they’ve created this management LLC. But the capital partner can’t come up with 100% of the capital because the deals are getting bigger and bigger… What happens is they invest in this deal, but maybe it takes this capital partner, this capital partner… They’ve added all these capital partners in, and the SEC is basically saying, “Look, you can’t just have a bunch of people raising money for a deal, each of which is getting compensation basically exclusively on how much capital they raised. They’re basically acting as a placement agent, but they’re not doing so under a broker-dealer.” I know this is super, super common, and I’m not really saying, morally, there’s anything wrong with it. I’m just saying from a guidance perspective going forward, I would say that this is not ideal, especially the more people you have. If you have 30 capital raisers for a deal, the SEC would really have a problem with that.
So this enters the conversation of the special purpose vehicle. These two terms, SPVs and fund of funds are used interchangeably. That can actually create a lot of confusion, so I’m trying to get in front of that really quickly. The SPV, of course, it’s short for special purpose vehicle; it’s considered a pass-through entity. This is the part that causes a lot of confusion; just because we say a fund of funds does not necessarily mean there are multiple assets. When I say fund of funds, it’s a structure that I’m about to outline, but it doesn’t necessarily mean you’re investing in mobile home parks, self-storage, you’re investing in Florida, Texas, etc. It just means the structure itself; they’re used interchangeably.
Break: [00:05:31] – [00:07:10]
Hunter Thompson: Here’s how this typically works. You’ve got a bunch of investors and they invest into a fund of funds or a special purpose vehicle, and that entity then invests in an investment opportunity, let’s say a typical deal with Spartan Investments. But there is a manager of that fund of funds. In this instance, this would be the placement agent that’s sole duty is to create the entity, identify the operating partner, pool investors together, and then invest into that other person’s deal. This overcomes a lot of those challenges with third-party compensation, because your compensation is being derived at the fund of funds level. Now, when you look at this and you’re an investor, and you’re attending Best Ever and you’ve got a bunch of friends that you know, from this conference or otherwise, you’re like, “Why would I ever invest in a special-purpose vehicle that then just invests in someone else’s deal? Clearly, I’m getting a middleman-ed.” That’s a lot of what we’re going to talk about today.
Why would this ever happen? Most importantly, I’m going to give you the tactics and the strategies, but this is a very important slide here. Your clients desire your expertise; I cannot overstate this enough. Price is not the determining factor. The difference between a 16% IRR and a 14.9% IRR is not the difference between investors moving forward. The reason is that your clients desire your expertise, they trust you, etc. Now, it may also give them access to operators that otherwise aren’t available. So you can come to them and say “I formed the relationship, I did all this due diligence, I provide access to this relationship through the structure.” It may also create a situation where they have access to an operator that has a very high minimum investment. We did a deal a year ago where the operator has a two million dollar minimum. Well, our investors can’t reach that minimum individually. But if we pull them together in a special purpose vehicle, then we can invest in an operator that’s extremely high quality, a billion dollars under management, etc.
And lastly, as I mentioned, your dream clients – they’ve been attracted to you. And if you’re not focusing on your dream clients and specifically creating your marketing to attract those people, you’re leaving money on the table and you’re not working with people that you love. You want to work with investors that you love, and the way to do that is to focus on attracting them.
Of course deferring to your due diligence, most investors are not like you. As fun as we like to spend our whole weekend going to these virtual events that Ben has done such a great job putting together, most people don’t want to spend their time attending conferences. They just want to go about their business, live their life, work their W2, etc. And of course, as I said, price is not it, that’s never the answer. If you’re struggling, it’s not because of price, it’s because you haven’t increased the value in your customer’s eyes enough for them to want to move forward. So the economics is not necessarily the reason, but it is not even the case that through the structure, they’re less favorable. I’ll give you a quick example.
So you can actually negotiate that your SPV itself gets a favorable treatment that can make up significantly for the fact that there is an intermediary in the deal. Here’s how that would work. Operators want to focus on implementing the business plan. Remember the original example I gave where there’s an operating partner and a capital partner? This is the same concept. They want to focus on actually doing it, not talking to investors. If you’re a capital raiser and you like talking to investors, you feel like, “Oh, that’s clearly the best and funnest part of this whole space.” I tend to agree with you, but that’s not what most people want to do that is focused on the operating side of the business. They want to focus on management, they want to focus on implementing the business plan. So you can leverage what you’re bringing to the table as a negotiation tool to get favorable treatment for that. And you can even get things other than just economics – you can get voting rights, and all these things; transparency, additional reporting, etc. This all results in operators willing to forego some of the economics, to receive larger checks.
How many times have you heard about institutions that have 80/20 or 90/10 splits? The reason they’re able to negotiate that is that they are going to write a $20 million dollar check or 100-million-dollar check. This is the same concept at a smaller level, and this is how it typically plays out. By the way, if this is the first time you’ve seen this concept – watch me; there’s going to be more and more. Not because I had anything to do with it, but it makes a lot of sense, and we’re seeing the industry flow this way. So you can create different classes of shares based on the investment amount.
Now, if you’re an operator and you’re not doing some version of this, you’re going to be so excited when you start. Here’s how this works. Class A minimum is a $50,000 investment. Then there’s a Class B minimum with a $500,000 investment. And the $500,000 investment can have slightly or significantly more favorable preferred return, waterfall structure, voting rights, transparency, etc. This is typically done by creating these different classes of shares, but it can also be done through a side letter agreement. And when it comes to side letters, the issue with those is that it’s a secret kind of agreement. I don’t like to do secretive things in my real estate deals, so I prefer doing these clear class of shares delineations that says, “Hey, look, you want to invest half a million? You get favorable treatment. If not, no problem. Class A is for you.” And by the way, when you do this in your documents, which is pretty much free to do, you’re going to find that random investor that’s going $50,000 investment here, $100,000 investment here… All of a sudden, it’s a miracle; they find half a million dollars and they want to get what everyone wants to get, which is a good deal. So just simply having the opportunity to do that makes a lot of sense.
Let’s talk about what this will look like. I’m sorry to say this is really, really complicated. I couldn’t remove this slide from this presentation, this is the only way to explain it. I will let you know after the fact how to get access to the slides. So I’m going to just run through this really quickly. Let’s say there’s a typical deal that’s an eight pref with a 60/40 split. Let’s assume that the property level average ROI is 22%. That’s prior to the waterfall. Here’s what a typical investor would receive if they did this. 22%, take away the pref, multiply the remaining balance by 60%, add the pref back in, you get 16.4% ROI, just an average return on investment.
Now, let’s assume that you create an SPV and get favorable treatment. Rather than an eight pref with a 60/40 split, you get an eight pref with a 70/30 split for investing half a million dollars or more.
Break: [00:13:49] – [00:16:45]
Hunter Thompson: I know we’re probably losing some people but bear with me for a second. We’ll show you structurally what this looks like in a moment. The same exact calculation with a more favorable treatment. 22% property level, take away the pref, multiply the remaining balance by 70%, add the pref back in, and you get 17.8%. That’s what the SPV would receive; not the SPV investors, but the SPV.
Now, as an SPV manager, you want to make some money for putting all this together, for doing the due diligence, for pooling investors, etc. And let’s assume that you basically pass through an 8% pref with a 90/10 split to the SPV manager. Now, some of you probably see where this is going, but you’re basically taking a 90/10 split on profits above the pref. Here’s what this would look like.
The SPV itself receives a 17% return. What do we do? The same formula. 17%, take away the pref, multiply that number by 90%, with 90 going to the investors, put the pref back in, and a 16.82% ROI net to the SPV investors. Holy cow, they’re getting a better deal than those that went direct!
Now, there’s a lot to go into details here, there’s all these fees that we can do, and this is just back of the napkin math. I’m trying to show you that it works, and it’s not necessarily less favorable. Here’s what the structure looks like from a structural standpoint. You’ve got the investment opportunity, sending out 17.8% into the fund of funds, you got the eight pref at the fund of funds level with a 90/10 split, investors receive 16.82. And you, the fund of funds manager, all you’ve done is create an LLC, done the due diligence, and put in a ton of work, obviously, but you’re getting 0.98% every year based on capital raised, as long as the deal performs as projected. So here’s what this means. If you raise a million dollars and you operate a fund like this for 10 years, you make $100,000. That’s my favorite way to make $100,000. I’ve done this, and made $100,000 many, many times over. So there you go. This is a wake-up call, both if you’re an operator or a capital raiser; this is a really good way to do this.
I do want to say though, just because this is possible, just because your investors can get a similar deal, or the same deal, or even a better deal, don’t let that goal be a limiting factor in your deal flow. What I mean is, you’ve probably heard the concept of 20 plus two; this is a private equity split. This is far better. I just gave you an example that was a 90/10 split. The two is an asset management fee, the 20 is the carry that these firms like Goldman Sachs implement. Price is never the deciding factor. We’ve implemented the structure alongside groups that have had investors where there was like a 60/40 split at the SPV level, and their firm has a billion dollars under management, which mine does not. So how is that the case? It’s because they’re people that know, like, and trust them, they’ve got more of them, they positioned themselves in such a way to be able to successfully do this… And you would recognize their names. This is not country bumpkins or family offices that don’t really know what’s going on. These are elite players.
As an example, Goldman Sachs doesn’t have a real estate firm. They’re not operating real estate, yet they’re making billions on real estate, because they’re doing this 20 plus two. I’m actually going to skip that just for the sake of time. But here’s a quick note about compliance. I’m trying to give you all the tools. This is not so much the fun part but this may be the most important slide I’m going to share right now. And the industry has not yet caught up to what I’m talking about, but this is really, really important. Get your screenshots ready for this. This is the $100,000 idea. When you create an SPV and you invest not into real estate but into someone else’s deal that’s a security, this has significant implications in terms of the Investment Company Act of 1940, and the Investment Advisors Act of 1940. These are not acts that most of your attorneys specialize in. I know this, unfortunately, because this is a realization that I had to make up on my own.
So here’s what the idea is, if you’re going to go this route – make sure you hire or consult with an attorney who specializes in what they call the 40s Acts; not issuer-focused attorneys. That’s all you got to say, “Do you specialize in the 40s Act?” “No.” “Do you have someone at your firm that does? Great. Can I get an introduction?”
I want to do the key takeaways but you guys already know it, I blitzed through it. Here’s what I’m going to do really quickly. If you want the slides, go to raisemasters.com/FOF-slides. This will allow you to download everything. In fact, there are far more downloads. Raisemasters is our Mastermind, and you just got something super, super valuable that people have paid quite a bit to get some access to, so go there. If you don’t find the URL or it doesn’t work, check me out at the booth and I will see you there.
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