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Should Sponsors Offer Discounts?
May 23, 2020
I am often asked by aspiring sponsors whether they should lower their fees and/or promote in order to attract investors. While I do think it makes sense to have an attractive deal structure so as to not create a roadblock for investors, the benefit of lower GP economics only marginally weigh on net investor returns while dramatically reducing profitability for the sponsor. Here is an example to illustrate this point: A hypothetical, 3-year value-add deal with a robust project-level IRR of 19.5%. In this first example, the sponsor is offering a 7% preferred return (IRR Hurdle) and is taking a 30% promote.
In this case, the 30% promote amounts to $214,460, which may sound like a lot, but isn’t tremendously impressive considering how hard it can be to earn at all. In any event, imagine that you were nervous about attracting investors with this typical structure and wanted to offer something that looked more attractive. You could trade down to a 20% promote from 30% (generally these mark the high and low end depending on deal type and structure). Below is the return summary for this scenario:
Investor IRR goes up to 15.1% from 14.2%, which is certainly meaningful. The sponsor’s promote, however, takes a massive hit to deliver this gain, falling from $214,460 to $142,973. Basically, the sponsor has given investors a 6% increase in projected returns while cutting his or her own expected profits by 33%. This should tell you as a sponsor that there are better ways to attract investors than by caving on your desired partnership structure. The caveat is of course to offer a structure that is within market norms and not demand unreasonable terms that stick out amongst comparable investment opportunities.
The other point that hopefully this example makes is that it is extremely difficult (and unprofitable) to try to make an average deal look good via a cheap partnership structure. Said another way, you can’t make a bad deal good for investors just because you’re cheap. Furthermore, I believe an unusually investor friendly structure draws attention (not the good kind) and may raise more questions about why the sponsor would offer such terms. For example, a sponsor solely concerned about transactional fees and less invested in the outcome of the deal could offer a lower promote to endear themselves to investors.
Another reason why trying to attract investors with below-market structures is not fruitful is because investors (on the more sophisticated / institutional side) are generally underwriting deals on a project basis first before they ever begin to think about working out a deal structure with you. Investors want to know they have a solid deal on their hands before they look to potentially negotiate any fee alpha for themselves. This is similar to how we always evaluate unlevered return metrics to understand the merits of an investment before overlaying various financing scenarios which will result in obviously more favorable levered returns (i.e. real returns vs financial engineering).
Another way to tweak partnership structure is via the preferred return. I believe this is the better lever to pull as a sponsor to entice sophisticated investors, since smart investors are always focused on downside protection. By offering a higher preferred return, you give investors more peace of mind about their investment, which may even let you be more aggressive on promote. The principle is pretty evident in secondary hurdles, or IRR lookbacks. For example, many investors will have no problem giving a sponsor a 50% promote over a 15-18% IRR because they are happy receiving such returns and see increased promote as a strong incentive for sponsor outperformance that nonetheless protects their downside. Let’s examine how a 7% vs 10% hurdle affects investor returns and sponsor compensation. Below is the same hypothetical deal as above but this time we have a 10% preferred return with the original 30% promote.
These terms result in investors sitting pretty at a 15% IRR (compared to 14.2% in the 7% pref scenario). To emphasize again, investors are not only receiving higher projected returns here, but they are also better insulated from underperformance. Viewed another way, although the 7% pref and 20% promote scenario has a slightly higher projected return (15.1%), I’d be willing to bet that 99% of investors would take the 10% pref option (I mean who doesn’t like a 10 pref?). Offering a 10% pref isn’t free though! Higher pref lowered sponsor promote to $154,167 versus $214,460 in the 7% pref scenario. The obvious answer is to charge higher promote when offering higher preferred return. For example, raising promote from 30% to 40%, brings carried interest back to $205,557, almost equaling the 7% pref / 30% promote scenario. Of course, these figures are not specific advice, but simply help to understand the effects that deal structure can have on investor returns and sponsor promote.
In conclusion, I don’t believe selling your services on the cheap is a winning strategy to get deals done, especially if a sponsor is doing so in order to compensate for less than adequate project-level returns. Investors won’t invest in a bad deal just because you are giving it away. Moreover, while investors may appreciate discounted fees / promote, it isn’t going to make or break the deal for them since it only modestly raises their returns while drastically cutting your sponsor compensation. Partnership structures should emphasize alignment of interest and skin in the game, while encouraging the sponsor to outperform and rewarding them if they do.