A sponsor's realized exits versus the one deal that broke, which tells you more in diligence

Question

Take a sponsor raising a value-add multifamily deal with a realized record of six exits between 2016 and 2021, averaging low 20s IRR, clean and verifiable, LP references confirming the wires. Their current book has one deal that has been sideways since a rate cap expired in 2023, distributions paused for seven quarters, no capital call yet, and a two page investor memo every quarter through it, including one that stated outright the exit cap was underwritten too tight going in. The realized record was built almost entirely in a period where cap rate compression covered a wide range of underwriting mistakes, which makes it hard to separate skill from tailwind across those six exits. The broken deal is the only piece of evidence generated under real stress, though it is a sample of one. Weighted 70 and 30 one way or the other, the case for weighting the realized record higher is that returning capital is the only thing an LP actually buys in the end, and plenty of sponsors write good memos while losing money. The case for weighting the broken deal higher is that any allocation targeting the 7 to 12 percent range only fails through the downside, and a stress event is the only place that failure mode gets observed directly. Worth polling the room on how LPs with more positions on the books have actually weighted this tradeoff in practice, because the honest answer probably depends on how large a position is being sized against either signal.

aaron_fitz10 · Accepted Answer

The choice as posed is between two weak signals, so the better move is to stop weighting them against each other and go find a third data point. The realized exits are contaminated by cap compression, and that is already understood. The broken deal is a single observation, read through documents the sponsor wrote about himself. Both are things he chose to show you. The stronger approach is to ask for LP names from the broken deal specifically. A sponsor will offer references from the deals that worked. Ask for two from the one that didn't, and watch how he reacts to that request, because the reaction is itself the test. A sponsor who hands them over without friction is telling you something the memos can't. The questions to those LPs should be narrow. Did the quarterly memo arrive before or after they had already heard something was wrong. When they emailed with a question, how long did the reply take. Did the story change between quarters, meaning did the projected recovery date keep sliding by exactly one quarter each time. If those calls can't be arranged, weight the broken deal heavily, because the exits mostly show he was in the market at the right time. On the mechanics, @samantha_ruiz's reserve question is the one that separates a sponsor who planned for this from one who is stalling. Get the answer in writing. And whatever the conclusion, this is one position in a book. If the answer to it changes the outcome much, the position is too big.

brandonlee36 · Answer

The 2016 to 2021 exits aren't worthless, they just don't measure what you want them to measure. What they do prove is that this sponsor can close, operate, refinance, sell and get money back out the door through a full legal and lender process. That's not nothing. Plenty of people raising today have never actually done the back half of a deal. What those exits can't tell you is behavior under stress. So I wouldn't weight 70/30 either way. I'd treat the exits as a pass/fail gate and the broken deal as the actual scoring.

samantha_ruiz · Answer

Seven quarters paused with no capital call is the number I'd pull on. Either they had reserves sized properly at close, or they're deferring something to avoid the conversation. Ask for the current loan terms, the rate cap replacement cost when they bought it, and what the debt service coverage is right now. If they had reserves and used them as designed, that memo is worth a lot. If they're just riding it and hoping the refi window opens, the memo is prose. Both look identical from the outside.

paulgrant17 · Answer

What does distributions paused actually mean for the LP in the meantime? Does the preferred return stop, or does it pile up somewhere and come back later?

gregpowell66 · Answer

@paulgrant17 usually it accrues, but read the document, because it varies deal to deal. @luis_carrera on the actual question, from the construction side, a memo that says we underwrote exit cap too tight is one of the most useful sentences a sponsor can write. Very few sponsors say a version of that out loud before they're forced to. Most discover a reason it was somebody else's fault. Even so, an accurate diagnosis in a memo doesn't fix a capital stack, and plenty of operators can describe exactly why a job went over budget while it keeps going over budget.

Rena Guide · Answer

A few definitions for anyone reading this thread who's newer, since the terms are doing a lot of work here.

A preferred return is a rate the LP capital earns before the sponsor takes a share of profits. Whether it accrues when cash isn't distributed, and whether it compounds while accruing, is set in the operating agreement. Two deals with the same headline pref number can behave very differently on this point, so read the distribution section and ask the sponsor to walk you through it.

A capital call is a request for LPs to send more money into a deal that already closed. What happens if you don't participate is also in the document. Common mechanics include dilution of your ownership percentage or a preferred position for the LPs who do fund. This is a place where a lawyer reading your specific documents is worth the fee.

Full cycle means a deal was acquired, operated and sold, with capital returned. A sponsor with no full cycle deals has never demonstrated the exit half of the process.

On @luis_carrera's actual fork, both pieces of evidence are answering different questions. Realized exits show whether the sponsor can complete a process. Behavior in a distressed deal shows how they treat LP capital when the outcome is already going to disappoint. Neither substitutes for the other, and a sponsor with only one of the two has a gap you should be able to describe in a sentence before you commit.

mitchell_ray4 · Answer

Sample of one on the broken deal, sure, but you've also got a sample of six on the good ones and every single one was pulled in the same conditions. That's arguably a sample of one too.

ryanmck27 · Answer

@mitchell_ray4 that reframing is the sharpest thing in the thread. Six exits in one regime is one observation repeated six times.

jessreyes12 · Answer

The last line there is the part I'd have been embarrassed to ask about. I've been treating each deal like the decision is whether the sponsor is good, when the actual decision is what fraction of my capital I'm willing to put behind a judgment I can only half verify. Those are different questions and I've been answering the first one and pretending it settled the second.

A sponsor's realized exits versus the one deal that broke, which tells you more in diligence

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