How Important is “Skin in the Game”?
One of the most common questions I get asked in various forms from both SBRE entrepreneurs and investors is about the idea of “skin in the game”. Investors will frequently ask a fund manager or syndicator (let’s call them “Sponsors” for purposes of this blog) how much skin they have in the game, meaning how much of their own capital do they have in their fund or their deal. Sponsors in turn frequently ask me, either during a fund creation or other advisory engagement, or perhaps when we are considering an investment in their fund or deal, “how much skin should I have in the game?” What is an appropriate enough amount for a Sponsor to co-invest in a deal or a fund to align interests and inspire investment confidence, but not so much as to tie up much needed operating capital to run your small balance real estate business in the first place? Although there is no one absolute hard and fast answer, there are some good rules of thumb, basic best practices, and, increasingly, some innovative ways to improve the amount of Sponsor “skin in the game” and therefore improve your ability to raise capital from LPs (investors).
An excellent resource on this subject, as well as many other core concepts on structuring and operating pooled real estate investment funds, is INREV, an acronym for Investors in Non-Listed Real Estate Vehicles. This association, even though European rather than U.S. based, offers the single best tool I have found offering extensive, thorough and well-reasoned ideas on corporate self-governance and what constitutes good, average or sub-standard practices in a wide variety of important areas. Here is a link to the Self-Assessment Tool http://bit.ly/1oOY3aN for your reference. The tool is very much geared toward institutional funds and investors and therefore, like much of what I find in studying more institutionally oriented material, to effectively utilize the ideas, concepts and recommendations in the SBRE world requires an understanding of critical differences between the two different universes and an ability to filter and translate that material rather than apply a literal interpretation of it. Yet if Sponsors can do this, there are some very relevant lessons to be applied that can help you improve your SBRE business over time in multiple key areas.
One of the Self-Assessment Tool’s sections directly discusses the topic of Sponsor “skin in the game” and provides some of the best, most practical and appropriate guidance I have found anywhere on the subject. Not everything that constitutes “good governance” in this section is possible in an SBRE fund, in my opinion, as the realities of running smaller than institutional sized funds and syndications are simply too different. But much of the material is absolutely applicable. Let me quote some select material directly from this section (highlights are mine):
Does the manager co-invest in the vehicle? Co-investment in the vehicle could be done by key personnel or individuals employed by the management company, the management company, or a sponsoring investor which owns all or part of the management company. The amount of co-investment should be meaningful to the individuals, management company or sponsor, so that poor investment performance would have a major impact on the financial position of the individuals running the vehicle. Investors should also understand the origin of the co-investment of the manager. Personal co-investment (from the individuals who run the vehicle) is preferable to co-investment from a sponsor as it individually links the personnel to the performance and so is more likely to be effective.
It goes on to say that “…good governance is demonstrated by: Key personnel and other individuals running the vehicle co-invest their own money directly in the vehicle, and have a meaningful amount of co-investment, relative to their basic salary and net worth.” This to me is an insightful and fair assessment for both Sponsors and investors alike. It necessarily means that the amounts being co-invested by one Sponsor vs. another will likely be very different in size, but would be equally as meaningful and impactful to each Sponsor based on their relative financial condition and capability. This means that even newer and smaller Sponsors with less relative net worth are, by this measure, able to co-invest much smaller dollar amounts than some arbitrary minimum and still create alignment of interest with investors that is meaningful and important to the deal. Not all investors will react the same, of course, to smaller co-invests by less financially well-heeled Sponsors. Some will want big amounts of co-invest no matter what, while some do not care if there is any co-invest at all if they trust the Sponsor. In fact, sometimes the lack of Sponsor’s ability to co-invest represents a good opportunity for an investor as the Sponsor may be more generous with the splits. The disparity in opinion and reaction to this “skin in the game” dynamic is far wider with high net worth individual investors than it is with institutions who tend to all have very similar mindsets and requirements. When an investor asks you how much skin you have in the game, this definition gives Sponsors an excellent baseline measurement with which to answer the question. Hopefully you can say “I have invested an amount in the deal which, relative to my net worth, is meaningful and important to me.”
As other comments in the INREV material I quoted above infer, there are also ways for Sponsors to significantly increase the amount of “skin in the game” through bringing in strategic capital at the management company level. Far fewer Sponsors seem to be doing this effectively, yet it can be a very good solution to putting “skin in the game” that helps to align interests with LPs and to facilitate capital raising amongst them. By creating a structure where the active Sponsor (the person or people who are doing the work to originate, underwrite, acquire, manage, operate, and dispose of the actual assets) partners with a strategic capital source at the management company level, the Sponsor can co-invest larger dollars into each deal (and even do it programmatically by using a fund structure at the management company level). We are currently working on several engagements – some in an advisory capacity, some in an investment capacity, some in both – to help Sponsors, including fund managers, create structures whereby they are able to co-invest regularly and significantly and thereby systematically improve their ability to raise LP investor capital.
Much of that structure depends on the individual situation and objectives of the Sponsor. There are multiple variations on the theme depending on the average size of the deal, whether or not debt is available at the asset level and to what degree, the Sponsor’s deal flow relative to their existing capacity to co-invest as well as raise capital from LPs, and several other factors. The point to make here is that “skin in the game” is in fact important to many investors and that there are ways to do this effectively, even if the Sponsor does not have extremely large amounts of personal cash to co-invest (which is often the case). The amount of co-invest can and will vary from one situation to the next, but any Sponsor that is serious about raising capital from LP investors is wise to accept that “skin in the game” is going to be a continuing factor that will arise when doing so and therefore to also develop an approach as to how to handle the issue. My general experience is that there are more options available to Sponsors to create meaning skin in the game than most of them think about.
Matt Burk is founder and CEO of Fairway America, LLC, and SBREfunds.com, and Chief Investment Officer of Fairway’s two proprietary nationwide small balance real estate (SBRE) asset based pooled investment funds, Fairway America Fund VI, LLC, and Fairway America Fund VII LP. Fairway is the nation’s premier consulting, advisory, and investment firm in the SBRE private pooled investment fund space, providing a full spectrum of practical, real world products and services (including capital) needed for true success for SBRE entrepreneurs all over the U.S. Matt is a highly regarded adviser, consultant, and mentor to dozens of SBRE fund managers and author of a widely read blog followed by serious SBRE entrepreneurs and investors. For over 20 years, Matt has led Fairway’s deal underwriting as well as capital raising efforts in Fairway’s seven proprietary funds and individual trust deed investments, resulting in more than $250,000,000 in capital raised from accredited investors through more than 1,000 SBRE deals. He is currently working on multiple SBRE fund consulting engagements nationwide, authoring a book on how to raise capital for and effectively manage pooled investment funds, and dedicating his efforts to create greater awareness and drive more capital to the many high caliber and deserving SBRE entrepreneurs around the U.S.