Key Takeaways
- Institutional real estate investors are placing greater emphasis on “sponsor risk” during the due diligence process.
- Across the CRE industry, capital stacks are becoming more complex, creating administrative challenges for sponsors.
- Sponsors that demonstrate strong processes and vendor relationships designed to mitigate operational risk are lowering barriers to securing funding.
The clients we typically partner with are middle-market private equity real estate investment firms, and the managers behind these firms often, and understandably, aspire to grow. For many, the ultimate goal is to institutionalize the business. Succeeding at this is a major step forward because it unlocks new and larger funding sources, which in turn allows the sponsor to entertain a wider range of deals and take down larger deals.
Two emerging themes are central to these growth objectives and are having a significant impact on middle-market private equity CRE sponsors. Specifically, institutional capital providers are focusing more intensely on sponsor risk and the growing complexity of capital stacks across the industry. Middle-market sponsors should understand the nature of each, how institutional capital providers are thinking about them, and how to prepare for due diligence when sourcing institutional capital.
Sponsor Risk Has Become a Focal Point of the Due Diligence Process
One of the most discussed topics in the PE CRE industry today is “sponsor risk.” Institutional investors are placing much greater emphasis on evaluating the risks associated with the sponsor leading the deal. This shift in focus means that even a high-quality asset may be overlooked if the sponsor is believed to have skill gaps or lack experience that could jeopardize investment performance.
Investment committees at larger capital providers are quickly coalescing around the view that sponsor risk as a non-negotiable pillar of the due diligence process. Factors like the sponsor’s tenure in the industry, level of familiarity with the asset type, and experience managing similar deal types (e.g., value-add) are critical in the decision-making process. For many institutions, these elements can make or break a deal. In fact, firms that are in the business of underwriting debt and equity placements are showing a preference toward investing in lower-quality assets managed by highly experienced sponsors rather than taking on the risk of funding underqualified sponsors marketing high-potential offerings.
Complex Capital Stacks Create Operational Strain
Another important challenge facing sponsors is the growing complexity of capital stacks and the resources needed to manage the administration of the debt and equity capital. With bank lending activity slowing in recent years and institutional equity providers showing restrain, sponsors have become more creative in securing funding. It’s increasingly common to see deals financed with multiple layers of capital, including first-lien loans, senior and junior mezzanine debt, preferred equity, and common equity.
In addition to the focus on a broader set of funding solutions, middle-market sponsors often manage a larger pool of investors centered around high-net-worth individuals and family offices. The average check size committed by these limited partners is, on average, smaller than those placed by institutional equity investors. As a result, it is not unusual for middle-market private equity firms to manage investor bases consisting of dozens or even hundreds of investors. This can create a resource crunch as these sponsors typically have limited staff available to handle investor management activities.
Successful Sponsors Partner with Experienced Vendors to Enable Scale
Coupled with the growth objectives that many middle-market private equity firms target, two dynamics—sponsor risk and capital stack complexity—are prompting many mid-sized sponsors to reevaluate operational procedures. If not addressed at the beginning of the growth cycle, sponsors can find themselves unprepared for an institutional due diligence process, while simultaneously managing an unexpectedly large and complex investor base.
What many middle-market sponsors don’t realize is that a basic disadvantage (limited internal resources to drive growth and manage complexity) can be turned into an advantage in the eyes of institutional capital providers. All it takes is establishing partnerships with the right vendors.
As scrutiny of the sponsor increases and as fundraising and capital assembly becomes more involved, sponsors can benefit from partnering with a fund administrator or fractional CFO firm to ensure that critical activities are being handled properly. These vendors specialize in managing the investor base and mitigating key risks associated with capital stack complexity, such as allocations of capital call and distribution events, tax reporting, and the management of sensitive general and limited partner information. As an added benefit, many institutional investors prefer to place capital with sponsors that engage experienced administrators.
Final Thoughts
Many of the middle-market private equity real estate sponsors we meet and partner with are looking to grow and ultimately attract institutional capital. It is important to understand that institutional investors have become more attuned to the sponsor risk and are performing more intensive due diligence on the sponsor’s track record and experience with the deal type under consideration. Simultaneously, capital stacks have grown increasingly complex, and middle-market sponsors need to be prepared to meet these new demands. By partnering with the right vendors, sponsors can position themselves to secure funding and build lasting relationships with high-quality capital providers.
Lexcraft Advisors is a fund administration provider that serves middle market real estate investment funds and syndications, typically with equity under management between $15 million and $150 million. Our team takes pride in providing general partners with reliable fund administration solutions often reserved for large, global investment firms. To learn more about our services, schedule a complimentary meeting with one of our Managing Partners.