Private Capital, the Great Equalizer

“How do I grow my business to the next level? I've been successful in creating value, but the capital requirements of opportunities available exceed my resources and those of family and friends.”

Successful owners and developers across the industry voice that question frequently. From lifestyle shopping center developers to buyers of garden apartments to office turnaround specialists, many seasoned players who share a track record for creating value find themselves in need of a capital infusion to grow their businesses, but to whom should they turn?

One answer to that dilemma is to form a strategic alliance with a provider of institutional capital. Pension funds, endowments, and wealthy individuals now see commercial real estate as the tallest midget in the investment forest. They are allocating a higher percentage of their capital to our industry.

The managers of this capital, particularly those with value-added or opportunistic strategies are searching for local partners with a proven track record of creating value in a specific product type, or in a well-defined geographic area. What these local partners all have in common is an ability to create value in ways that managers cannot do on their own.

Finding the ideal structure

Partnerships between investor and local partners can take several forms. The most common structures are equity for a single transaction, or a strategic alliance where an investor will fund a series of transactions. What is always essential is an alignment of interests, usually achieved through some co-investment, generally about 10% of the equity required.

Leverage usually ranges from 60% to 75% of cost. With 70% leverage and a co-investment of 10%, the local partner is only investing 3%. The institution is investing the other 27%.

Investors generally seek a leveraged internal rate of return (IRR) for value-added deals ranging from 13% to the low 20s. The range is based on perceived risk. In a typical structure, all capital generally receives a preferred return of 8% to 12%.

After the preferred returns are paid, the local partner receives a disproportionate share of the profits. For only investing 10% of the capital, the partner might receive 25% of the profits after the institution has achieved a 13% IRR, and 50% of the profits after an 18% IRR.

Another key component is agreement upon an exit strategy. The desired hold period is three to seven years. Many owners do not want an investor who will force a quick sale just to maximize the IRR. However, almost all investors require the right to force a sale, while providing their partners the choice to make a first offer or match the agreed-upon selling price.

A strategic alliance provides quick closings. Instead of raising equity one deal at a time, the partner will have the financial backing to grow his business in a more systematic and opportunistic way. This means more time can be devoted to buying property, attracting tenants and developing, instead of raising money. In some instances, the capital provider will allow funds to be used for land acquisition and pre-development expenses.

Be patient and realistic

Raising private capital is generally not a quick process. A proper search generally takes three to nine months before money changes hands. It's just unrealistic to arrange a strategic alliance where the first investment must close in 30 days. However, once arranged, subsequent closings can take place expeditiously.

Private capital can either be accessed directly or through an intermediary. Using an intermediary enables the company to focus on its primary business and let the intermediary run the “auction” to obtain the best terms and partner for its client. A typical assignment involves three stages:

  1. preparing an investment proposal/business plan with an emphasis on the client's track record;

  2. identifying the appropriate capital sources and contacting each of them;

  3. monitoring the investors, negotiating the best possible terms and analyzing the economics of each proposal.

Even as transactions get larger and more sophisticated, the entrepreneurial owner/developer can compete and grow his business. Institutional capital does allow owners to move beyond financial dependence on friends and family and to level the playing field with even the largest companies. It is a strategy which all developers and owners desiring to grow their business should explore.

S. Douglas Weil is director of equity finance for NorthMarq Capital's San Francisco office. He can be reached at [email protected], or at 415-433-0132.

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