Full cycle exits or the deal that broke: which one tells you more about a sponsor

Question

Diligence on a sponsor raising a value-add multifamily deal and I've hit a fork I can't reason my way out of.

Their realized record is six exits, all between 2016 and 2021, averaging low 20s IRR. Clean, verifiable, LP references confirm the wires. Their current book has one deal that's been sideways since the rate cap expired in 2023. Distributions paused seven quarters, no capital call yet, and they've sent a two page memo every quarter through it, including one that said outright they underwrote exit cap too tight on the way in.

The realized record was built entirely in a period where cap rate compression covered a multitude of sins. I can't separate skill from tailwind in those six exits. The broken deal is the only piece of evidence I have that was generated under stress, and it's a sample of one.

So the question. If you had to weight one at 70% and the other at 30%, which way do you go? The case for the realized record is that returning capital is the only thing an LP actually buys, and lots of people write good memos while losing money. The case for the broken deal is that any allocation targeting the 7 to 12 range only fails through the downside, and that's the only place I get to observe it.

Poll below. Interested in how the people with more positions than me have actually weighted this.

aaron_fitz10 · Accepted Answer

I'd stop trying to weight the two and go get a third data point, because the choice as posed is between two weak signals.

The realized exits are contaminated by cap compression, you already know that. The broken deal is one observation and you're reading it through documents the sponsor wrote about himself. Both are things he chose to show you.

What I'd do instead: get the names of LPs from the broken deal specifically, not from the six winners. The sponsor will offer you references from the deals that worked. Ask for two from the one that didn't. How they react to that request is itself the test. A sponsor who hands them over without friction is telling you something the memos can't.

Then the questions to those LPs are narrow. Did the quarterly memo arrive before or after you'd already heard something was wrong. When you emailed with a question, how long. Did the story change between quarters, meaning did the projected recovery date keep sliding by exactly one quarter each time.

If you can't get those calls, then I'd weight the broken deal heavily, because the exits mostly tell you he was in the market at the right time. On the mechanics, @keystone's reserve question is the one that separates a sponsor who planned for this from one who's stalling. Get the answer in writing. And whatever you conclude, this is one position in a book. If the answer to it changes your 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

@wren usually it accrues, but you have to read the document because it varies deal to deal.

@windlass on your actual question, from the construction side, the memo that says we underwrote exit cap too tight is the single most useful sentence in your post. In twenty years I've watched maybe four people say a version of that out loud before they were forced to. Everybody else discovers a reason it was somebody else's fault. Even so, an accurate diagnosis in a memo doesn't fix a capital stack, and I've also known guys who could describe exactly why the job was over budget while it kept 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 @windlass'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

@solder 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.

Full cycle exits or the deal that broke: which one tells you more about a sponsor

9 replies