April 1, 2024

JF3496: The Experience Myth, Why Steady Deal Flow Is a Superpower, and Key Questions LPs Should Be Asking — The Due Diligence Show ft. Lance Pederson




Welcome to the Due Diligence Show, a new Best Ever series featuring deep dives into every aspect of the due diligence process. In this series, our host, Slocomb Reed, will interview expert guests to uncover their stories, tips, and strategies to give you the information you need to master the due diligence process. In this episode, Lance Pederson, co-founder and CEO of Passive Advantage, joins Slocomb to discuss due diligence for limited partners, including questions LPs should be asking GPs, the importance of deal flow, and the myth that experience equals better or more advantageous deals.

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Slocomb Reed (00:54.818)
Best ever listeners. Welcome to the best real estate investing advice ever show. I'm Slocomb Reed. And today we are joined by Lance Pederson for another episode of our due diligence mini series. We are focused on the process of vetting your deals after you have them under contract and all of the things that go into determining whether or not a project, a property, a business plan are viable. We have, uh, Lance with us.

His company is, he's the co-founder and CEO of Passive Advantage, which builds online software tools that help limited partners analyze real estate syndications. He has worked with a major private equity firm in the past, but currently has just 20 of his own LP positions in multifamily, class B industrial, and in real estate debt funds. Our topic for today is limited partner due diligence 101. How can limited partners be vetting the opportunities that general partners bring to them to make sure that their interests and their returns and their potential upside are protected? Lance, can you tell us a little bit more about your background and then we'll dive in.

Lance Pederson (02:13.84)
Sure. Yeah. Thanks for having me, Slocomb. Appreciate it. Yeah. So I think a bit about my background, you know, at heart, I'm an entrepreneur. I started my first company. It was an IT services business when I was 21. I sold it seven years later and I got into real estate in 2008 in the private lending business and really the private fund space as you sort of alluded to. So I was a principal of a real estate private equity firm.

You know, we started doing, you know, allocating capital as LPs and then later as sort of more co-GP type relationships, you know, into syndications or funds. And we, we had $0 in that strategy in 2011 and we grew it to over 300 million in equity under management. Uh, we also had an accidental business that, uh, it was a real state fund administration company.

We, we found out quickly that in running kind of a fund to funds type strategy, really reliant on the underlying sponsors to produce the information we needed. And we learned that wasn't necessarily many of them, their strength. So we ended up providing that as a service doing all the back office accounting and administration. And so I headed that up and kind of founded that company. And we ended up growing that to over three billion in assets under administration.

I worked a lot with, I mean, there's probably over 200 real estate sponsors helping them architect and launch discretionary pooled investment funds. And I still do that, you know, at any given time I got two or three clients that I'm helping, you know, put together a discretionary pooled fund. And out of all that, I guess I kind of had, you know, like all people want to write their memoirs or book.

I ended up creating a video online training course called the Empire Builder Formula that basically kind of teaches people all the things I've been teaching people over the years and helping them with on how to architect a fund and launch a fund and developing a capillary strategy and plan. So keep pretty busy, but yeah, I'm the co-founder CEO of Pass Advantage. And so we're now building out some software tools to help LPs just, you know, just kind of remove some of the friction on their side of the fence, so to speak, when it comes to conducting due diligence on syndications primarily.

Slocomb Reed (04:36.334)
Nice, yeah, so let's talk about that, Lance. You have a breadth of experience here. What is it?

Slocomb Reed (04:48.406)
Let's start here. Lance, where is it that you see limited partners most often get misled by the offerings or offering memoranda of general partners in this space?

Lance Pederson (05:04.12)
I'm not sure if it's like being misled, but I think that, and you know, being a syndicator, and I mean, and I know as we syndicated quite a few deals ourselves, it's just when you're putting together an OM, trying to make it presentable to LPs, a lot of it's you've got your financial model and then you're trying to shove it all into what amounts to a PDF presentation, right? And so I think it just becomes a bit overwhelming. Every one you get is in different order and has different information.

And I think that it's challenging to make sure you've checked all the boxes as an LP. Right? Like, have I looked at all the information? It's not necessarily that syndicators are omitting information intentionally. Right? But, I mean, let's face it, they're kind of putting their best foot forward. So I think that's the big thing. I mean, I'm just a big believer in, you know, this is what I teach LPs is just, it's okay to ask for the actual financial model that the sponsor put together that came up with much of what amounts to the OM.

And because then you have the real information, you've got the data that you can look at, you can see how their assumptions worked. And so, I mean, I think that's the big thing, right, is just getting their minds wrapped around what assumptions were made. How do they arrive at these conclusions? Why did they choose this exit cap rate as an example? Right. What were the rent growth assumptions and why?

And, you know, just, just those sorts of things, which a lot of times just OMS just don't necessarily answer those questions directly per se. I mean, some do, some don't, but I think it's just for me, it's just more of having a method to your madness when you're underwriting these deals and make sure that it's, you know, you're kind of checking all the boxes is the big.

Slocomb Reed (06:53.482)
Yeah, that makes sense. And misled was the wrong word. I think I should have said something like misunderstood. Um, but, but yeah, totally. So let's, let's dig into that. Um, as a limited partner, I imagine you receive, uh, opportunities from a lot of GPs, what are the first, when you open that O M or you get into the webinar, uh, to be presented the opportunity, what is, what are your template questions that you're planning to make sure you get answers to?

Lance Pederson (07:29.784)
Well, for me, the first thing that I look at are the fees and the waterfall, just to see, are they sort of in line with what I think is market? Acquisition fee, is there a disposition fee? What's their asset management fee? Are they vertically integrated? If so, what's the property management fee that they're charging? I just wanna figure out how is the sponsor being compensated? I mean, really what I'm...

what I'm looking for, right, is that do I feel like the way that it's structured, are we aligned? And I think it was the same thing I did when, you know, helping all these guys architect their funds, the same thing. It's like, I want you to get paid for the value that you, you know, you as the sponsor, I want you need to be compensated for the value that you're bringing. I mean, I had sort of, you know, like, the way I, my philosophy with it is like, put the money where the work is.

Right. So when you're adding value, then you should be compensated. And obviously, if you're able to execute the business plan, then you should earn, you know, a big chunk of that upside. Right. But that's the first thing that I go after is, is just trying to figure out is, is there good alignment here on, on its face? Um, that sort of step one, I mean, and then I guess what could probably be, you know, that's one a one B is just, do I think that the sponsor's team has what it takes to execute the business plan that's being put forth. Right?

Like, have they done this before? Do they have people in each critical position to execute that strategy? Especially if they're like a really deep value-add strategy, then I'd expect to see someone's name pop up that has lots of construction experience and who's going to run that kind of project. Whereas WIF is a core, kind of a core plus sort of play, then that just wouldn't be as important, right? I wouldn't expect that they'd have someone with that, you know, on the asset management team that would have that kind of pedigree. But that's kind of what I'm looking for. Does the business plan, does the team match the business plan and vice versa?

Slocomb Reed (09:41.486)
Thinking about our listeners who are newer to this space, Lance, and don't have the experience that you do to know necessarily what the answers to those questions need to be, what are the roles that need to be filled out in the team? What are some questions that LPs can make sure they get answers to with regards to the general partnerships structure experience who it's comprised of to make sure that they know that they're putting themselves into a position where the business plan they're buying into literally as well as figuratively can be successfully executed upon?

Lance Pederson (10:29.176)
Yeah, I mean, to simplify it, right, like I think there's sort of four things that I'm looking for. One is like, who's in charge of acquisitions, right? Like, who's the one that's digging up opportunities and who gets up every day and is trying to find new deals? You know, and who's the person who's negotiating sort of those deals in the asset acquisition side? So that's one. And then two, kind of alluded to like, once the deal is closed, who's responsible for executing that business plan?

And I just always use that sort of parlance like, who's waking up in the morning and that's all they care about, right? Like that's the first order of business is our, because when you think about a value add strategy, especially, I mean, there's a plan, right? Like we're buying it because there's a problem with it and we're gonna do this to it to add value to get out the other end. So you wanna be looking for signals that says like, how are they adding value?

If they're saying that they're gonna buy it and they're not doing any kind of rehab or rehabbing the units or whatever the case may be, but it's all operational, then I want to see like there's somebody on the team, even if it's not necessarily a VP level person, but like who's the person that's, you know, responsible for increasing, you know, revenues and decreasing expenses, you know, like who's filling that role, who's going to make sure that happens. And then the third thing, you know, I always want to like, who's in charge of like investor relations or fundraising.

Like, so I'm an LP, I mean, who's going to make sure that I get information or when I do have questions, it's going to be there to respond to it and make sure that, you know, all that kind of stuff is being handled and that this group can actually raise capital at velocity and, you know, handle that function. And the fourth function I think is just back office in general. Like who's responsible for producing financial statements? I mean, I alluded to it earlier, right? That that was, seems always be the missing piece where they just don't have enough competency in that area.

But as an LP, it's super important because the financials are what it's all about. Right. I want to see those results. I have no say in what goes on day to day, but ultimately I want to see, you know, the numbers will tell me the story. Uh, so just making sure that there's somebody that's competent that can, you know, prepare that kind of information. Cause they could be a great, they can be really great at X, great to find a deal is great at executing, um, the strategy, but if, if I'm never getting updates and I don't really know what the score is, so to speak, you know, that's going to be a problem.

And, and, and I think as, as operators, the sponsors who are listening, I mean, just understanding that when you, when you're in no position, you have no control over what goes on, you can, your mind can quickly get away from you. Right. Like you can start thinking the worst. I didn't hear anything. Whereas the sponsor's thinking, man, I'm crushing it for you. I mean, I don't have time to go and tell you how it's going because we're just killing it. Um, but then the perception could be completely mismatched.

So that's that's those are the questions that I think you just want to figure out, like, who are these team members? Who's, who's filling those four critical roles is, is a big piece of it. I think my opinion is that sometimes we put too much, too much emphasis on like track record or experience, you know, a lot of guys, we got over 120 years of experience, like, okay, maybe, maybe you do, but you know, we found as, as kind of professional LPs is that some of the best deals we ever did were with emerging sponsors, you know, guys who maybe used to work at a, you know, CBRE or something like that.

And they struck out on their own. So they don't have much principle experience, but they're just hustlers, right. And they can get after it. So, I mean, track record matters obviously, because you can look at the past results and see, you know, it's somewhat indicative of the future, but of course not entirely.

Slocomb Reed (14:15.542)
Lance, I've heard some people say that you always want to get into Fund One, because Fund One for a newer syndicator, not necessarily brand new to real estate, but a newer syndicator is the one where they feel the most compelled to outperform their projections because they need to create a track record for themselves. Does, I've heard a few people whose, whose opinion and perspective I really trust and respect here say that. Do you feel similarly?

Lance Pederson (14:51.952)
We did that was really our entire thesis, you know, when we were investing in that manner, was that we weren't going after the guys who had super long track records or super well established, because what happens is they kind of earn the right to, you know, take more of a promote and charge more fees. We did just that. Like we looked for people who were super hungry and who had something to prove and loved what they did, right? They had passion, they had conviction about their strategy.

And, you know, they checked all the other boxes and I think the thesis proved itself that was, you know, because you can lose money with someone who's got a lot of experience. This is easy. You can lose someone who doesn't have as much of a track record. And I think, you know, as we record this, that's sort of playing out right in front of us. So, yeah, I'm a huge believer in that.

Slocomb Reed (16:04.47)
So the vetting that you're putting syndication opportunities through, it feels like it falls into two primary categories. Again, keeping in mind, you know, I'm an owner operator. I'm vertically integrated. I am the property manager. Everyone who touches the property, literally or figuratively, has been hired by me, reports to me.

So keeping in mind the perspective of someone who is not an expert in this field, not in operations of real estate or acquisitions, but also not necessarily a professional LP. Lance, it sounds like the things these LPs need to be focused on when considering an opportunity fall into two categories. One is the general partner's compensation, and the alignment of interest in that compensation with the LP and their end of the compensation model and the other is making sure that the general partnership has the expertise and the experience may not be the best way to put it but the bandwidth necessary to execute on their business plan. Is that a fair summary thus far?

Lance Pederson (17:23.416)
Yeah, that's how I look at it. That's certainly how I assess it.

Slocomb Reed (17:31.41)
Let's dive into the bandwidth question here. You identified four key points. These should not be, these may be new to some of our listeners, but you're certainly not the only person who divides a general partnership into these four categories, acquisitions, operations, investor relations, and back office or administrative, or financial reporting and underwriting, depending on who you ask.

When it comes to what you're looking for from an acquisitions specialist, what is it that you want to see within a general partnership, Lance?

Lance Pederson (18:12.54)
So the ability to generate deal flow, I think, is the first half of it, right? It's just, do they have a method to their madness, like a strategy for going direct to owners or a strategy for developing deep relationships with brokers? Once again, like I don't care so much what it is. I just want to know that they could articulate it and that there's a system or a process in place that generates deal flow.

It just tells me a lot because to me, if they're generating a lot of deal flow, then that means that it is far easier for them to be conservative about the deals that they do. They can be picky. Whereas if they're sort of just, I mean, we all do this we're human beings, right? We can trick ourselves into thinking like, well, I've only got five deals to look at, and you can just somehow fall in love with one of those five deals. I'd rather know that you've done something to where you got like 40 of these things, and I'm being a bit dramatic here, but, you know, like it just sounds like you're in the flow.

And I also look at it like, you know, how, how far are you spread out? Right. I, I always liked when guys are like, I put a fence around this area, right? Like the deal won't hit the market in this particular area that I won't know about. I mean, I'm just looking from, I want to hear things like that. And then on the flip side, you know, the other part of what I think are part of asset acquisition, then is that due diligence and underwriting.

So I want to hear that once again, they've got, they've got checklists. They've got, there's ways that they sort of then take the deals that come through and screen them and kick things out that don't meet a certain criteria. So their box is a little smaller. You know, they're very particular about what it, you know, what it has to be. I just want to hear stuff like that because it's the same thing that I know. Like they know what they're hunting for. They know how to figure out whether it meets that criteria or not. And, and I just want to know that they just like me as an LP, I want to check all the boxes on my due diligence checklist.

I want to know that they have something similar.

Slocomb Reed (20:13.366)
That makes a lot of sense. When it comes to the person who wakes up and the first thing they think about is operations or asset management, what is it that you're looking for from them?

Lance Pederson (20:27.488)
You know, I think there's got to be some amount of like, you know, leadership and management ability, you know, higher levels of organization, right? More of a planner and a, you know, kind of a plotter, someone who's just going to, I mean, what I'm looking for is like a conductor type person, right? Someone who's going to keep the trains on schedule. Mainly, like I said, mainly when I know there's just more, it's a deeper value add type of situation.

I mean, whereas like industrial as an example would be you know, it would be different. They don't necessarily have to have that, but they've got to be super connected and know they've got tenants they can put in. So it just depends upon the strategy that they're executing. But just to use deep value add multifamily is a good example. I just want to know that they're highly organized because I know that it's a lot of work and there's a lot of moving parts. I mean, you've got tenants that are vacating and you've got, you know, all sorts of things that are taking place. And, you know, once again, if you tell me what the business plan is, then I'm just want to see that there's another, there's a person who I think has a skill set, experience and competency to actually be able to do that.

Slocomb Reed (21:41.77)
And with an operations expert, you know, we've, you've referenced the amount to which experience is necessary for success. Specific to operations specialists, are you finding that people who are newer to asset management or newer to operations within their asset class are able to see similar levels of success as people who are more seasoned veterans. Uh, when it, when it comes to the, uh, business plans they've been able to execute on and the assets they've operated within that asset class already.

Lance Pederson (22:26.424)
No, I mean, I think that could be the chink in the armor, right? Oftentimes that's why I think that the. I mean, I just think that's why it's so important to bring others alongside you. Right? Like in some capacity, even if it's not you, but if you can point to like, Hey, our general contractor sort of has that, I mean, some way to augment it, right. Even if it is just a mentor who's doing something else, I mean, just something to give you a sense that there's a patch here.

And oftentimes they might have something that comes from another industry that's translatable. Like I said, just those skills of, you know, cause that's where even guy, I used to have guys like, well, I, I've renovated and re you know, I've, I've flipped 200 single family homes. I don't have a track record of multifamily, you know, and I'm, you know, I would encourage them and say, yeah, but you, you flipped 200 houses. Like, like that's, that's a lot of work too. So don't, don't get too hung up on that. I think that it's, it's, you know, that's relevant experience.

And if you have a gap on your GP team, that's what I mean. Like, that's what I love. This business is that it. It's a team sport. I think we all know that. And so go find someone, right? Go find someone. Don't, don't be afraid to dilute your position in the GP or whatever. I mean, bring them in for these very reasons, because it only increases your chances of success. You know, and I've done a lot of financial modeling with guys over the years to kind of show them like, Hey, if you did what you thought you could do.

Do you even fully appreciate what the economic, what the numbers would look like, right? Like do that math, like it's worth building a strong team. I have a whole module on this in my course. I mean, because I'm just like, build your rockstar team. Like it's a team game. If you try to do it on your own, I just don't think you'll find anywhere near the level of success that most people are after. It's more about increasing the size of the pie.

So, but yeah, I think people have never done it before, especially, I mean, it's one thing if you're doing, you know, rehabs, value add plays with three grand a door versus 15 or 20. Right. I mean, I think that you got to crawl before you can walk and walk before you can run. Right. So that's the kind of stuff I'm looking for is it's sort of like, are they, are they a bit out to lunch on what their capabilities are? I mean, they get, you know, what are the chances they get over their skis on this deal?

Slocomb Reed (24:51.078)
Yeah. In the interest of time lands with the questions I still want to ask you same question. What is it that you're looking for from, uh, investor relations and also from the, uh, backend specialist or financial analyst who's producing statements? What is it that you're looking for from those two?

Lance Pederson (25:12.496)
I think with the investor relations seat more than anything, you just know that it's occupied. Like there's someone who doesn't have six other jobs, but is like, that's their job. Once again, I just want to know that someone's going to be like waking up and thinking about like, Hey, we need to communicate with our LPs. I mean, I'm a bit more of a snob probably on the back office function, but I mean, I just want to know that there's somebody that actually does have some demonstrable experience that isn't just, we've outsourced our bookkeeping to the Philippines. It'd be no offense. I had a whole team in the Philippines.

But it just, I just want to know that once again, there's someone that's gonna provide some leadership and oversight to the function and do it right.

Slocomb Reed (26:02.634)
Returning to the topic of compensation and alignment of interest - let me start by making some of my own assumptions and sharing some of my own perspective, Lance, and then just getting your response to it. Feel free to disagree with me, uh, for the sake of the listeners, but also for the sake of me, I want to hear your, uh, your take on this. Um, of the ways that general partners are compensated, you have, uh, as you said earlier, acquisition and disposition fees, um, and then you have, uh, the waterfalls upon sale.

And you have the prospect of additional fees being paid to vertically integrated general partners. And examples like mine, general partners who are also the property management company and the general contractor. So when it comes to acquisition and disposition fees, acquisition fees are not, I get where the GP is coming from, that a lot of work has been done before the, before the property is purchased and that they want some sort of compensation for it.

But that is compensation received by general partners before limited partners receive any sort of returns from a property. So kind of hard to say that an acquisition fee is necessarily aligned with an LP's interest, a fee paid when the property sells regardless of the amount it sells for the returns generated for the LPs. Again, it's not necessarily going to be aligned with the interests of the LPs because it doesn't rise and fall with the returns of the LPs experience.

When it comes to the waterfall structure or the split on profits above a preferred return, then uh, it makes a lot more sense there to, there are ways that you can set up a deal to make sure that the general partners, uh, are reaping the greatest reward when the limited partners are as well. And then with, uh, vertical integration, I think it has a lot to do with whether, uh, whether or not the fees being charged are reflective of the market of the moment or whether or not there is some sort of, I don't like to use the word discount, but is the general partnership charging below market because the fees are being provided in-house and they are one of the benefactors and owner of the property?

I just threw a lot of stuff out there. We also, you didn't reference preferred return at the beginning, but a preferred return is one way that you can make sure that an LP's interests are maintained within a deal.

Everything I just threw at you in the interest of time, what are your reactions?

Lance Pederson (29:17.52)
So I have no problem with an acquisition fee. Like I think once again, put the money where the work is, it's earned. It's a ton of work. And I think that if people fully appreciated and understood what guys had to do to find deals worth doing, which is your job to demonstrate to me that it's a deal worth doing and you're worthy of doing it, no problem with it. Don't like disposition fees because, unless you're gonna forego your promote. Property management fees, as long as they're market. I don't even, market's just fine with me, right? I want you to do a good job. It's a separate business.

You gotta make sure that you can, you know, hire the right people and all that. Always a preferred return. I mean, there's gotta be a hurdle. That's how you protect LP's downside risk. And, you know, and, you know, then if you'd, and obviously if you're overseeing a property manager and you're not vertically integrated, I expect you to charge an asset management fee because I want you to be on top of those guys to make sure that they're doing the job. So I always apply my philosophy to it is just, is the money being put where the work is? And is that amount of money commensurate to the work being done? And if yes, then I'm fine with it. I just need you to defend it.

Slocomb Reed (30:27.542)
That makes a lot of sense. Uh, quick take to end the episode. Lance, uh, what are you seeing? It's, it's, it's the first quarter of 2024. What are you seeing as market standard for, uh, preferred returns fees and waterfalls right now?

Lance Pederson (30:47.164)
It seems like it was 8% for a long time, I think we're at, depending upon which risk band we're in, core value add or opportunistic, it's going to be anywhere from 9% to maybe 11% on the preferred rate. On the PREF, yeah. And then on the promote, if you're getting it straight from 50,000, $100,000 investors, the 30% promote, 70-30 split above the PREF, acquisition fees and the I have no problem with.

Slocomb Reed (31:17.138)
Is that on the promote is that 30% of the LP or the GP?

Lance Pederson (31:22.36)
No, to the GP. Yeah, the 30% promote to the GP. Yeah. So 70, 30 above a nine or a 10, you know, something like that. It just seems like that's sort of where we've shifted. But I mean, yeah, those, that's kind of what I would expect to see. And I think that that's fair given where interest rates are at and where we're at in the market. And, um, you know, it makes it, makes it tough. It's a tough environment right now as we record this, just given the higher interest rates and, it just looks like it's gonna be a bit before we start to see him ratchet down.

Slocomb Reed (31:53.986)
That makes a lot of sense. Lance, thank you. Best ever listeners, thank you as well for tuning in. If you've gained value from this episode, this conversation on due diligence for limited partners in commercial real estate syndications, please do subscribe to our show. Leave us a five star review and share this episode with a friend you know we can add value to through our conversation today. Thank you and have a best ever day.

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