In the commercial real estate industry, it’s common to see Co-GP models. The theory behind these models is simple. Less experienced operators join forces with a more experienced operators to learn the ropes versus going on their own. They help the primary operator with all aspects of a project from sourcing, due diligence, capital raising, acquisition, operations, investor relations, and disposition. In the end, they share in the manager side of the profits (ie. the promote) by taking a share of the Co-GP shares. The apprentice role is perfect. It’s a win-win for the experienced operator, the new operator and investors. No one loses. It’s like watching the perfect sunset.
The reality is quite different.
With interest rates rising, property values increasing significantly and investors pulling back, even experienced operators are struggling to raise all the necessary capital. The result is that operators view the Co-GP model as an easier way to raise capital by giving away a small share of their Co-GP shares. The goal of these structures is not to help a new operator learn the business. Its simply to have an additional network of investors to raise capital from for the offering. The experienced operator has no intention of enabling these “Co-GPs” to have any operational or decision-making control over the asset. Its simply to get them to raise capital and in return for a small amount of income.
Experienced operators, new operators, and investors should all be aware. This model is sold by many as the perfect model including some real estate attorneys. The model is not just less than perfect, it's like walking a tightrope over a pool of alligators. The alligators can be the SEC, state regulators, and sometimes even investors when the investment performs poorly.
Here Are Some Reasons Why
· Co-GPs are receiving a very small portion of the co-GP shares (<10%) for really doing nothing more than capital raising for the lead sponsor of the deal. They don’t have any real responsibilities from the acquisition, day-to-day operations through disposition. They don’t participate or make any of the major decisions and all they really do is report out to investors via “investor relations” or other artificial roles. Yet they position themselves as Co-GPs. This is just a commission model in disguise. Both the lead sponsor and the co-GPs are potentially breaking broker-dealer laws by taking Co-GP shares as a form of commission for capital raising.
· Co-GPs are going out and raising capital with no legal documents of their own and solely depending on the lead operator’s documents. They are not clearly disclosing their role in the operation to their investors. They are not disclosing the compensation they are receiving from the Co-GP shares. The lack of disclosures goes against SEC rules and the Co-GPs are likely breaking broker-dealer laws and investment adviser laws by raising capital this way.
· Co-GPs are marketing to their investors or potential leads that they have 1000 or 2000 doors under management or they have $50 million of assets under management. Again, this is completely false and misleading to their investors because they actually are co-GPs with no/limited real control of the doors or the assets. They are misleading their investors about their level of experience and control. This is opening themselves up for major investor litigation, SEC fines, and even potential jail sentences for investor fraud.
· In most cases, Co-GPs are not listed in the PPM. In many cases, they are not even on the operating agreement of the asset management company and just managing the relationship with a side letter agreement. They have no real proof they are co-GPs.
Additionally, they are not on the loan documents or any other documents that prove they have any skin in the game on the asset’s success.
Some investment portals are not only supporting this bad behavior but enabling it to scale. They create separate investor portals for the primary operators and their so-called “Co-GPs”. The question is very simple. If you are truly in business with someone, why do you need separate marketing collaterals and separate investor portals? This is just another red flag that says the relationship is not a true Co-GP operation and is only being utilized for capital raising.
A private fund structure or a Special Purpose Vehicle (SPV) structure with Exempt Reporting Adviser registration addresses the risks of the Co-GP model and enables a better, legal, and regulatory-compliant way to raise capital. Here is why:
1) These structures file a Form D with the SEC and blue sky filings with the states as exempt offerings.
2) These structures have their own PPM, Operating Agreement, Subscription Agreement, and other legal disclosures so investors understand that they are investing in an entity that is then investing in another entity.
3) The legal documents protect investors and inexperienced operators by ensuring the right level of disclosures is happening which reduces their risk of litigation.
4) The structures still enable an inexperienced operator to take Co-GP shares when they are actually participating in the operations of an underlying asset and clearly articulate the role to their investors.
5) When required, the exempt reporting adviser registration ensures that the new operator is following the necessary rules to avoid investment adviser registration.
In summary, investors, inexperienced operators, and experienced operators new to the Co-GP game should all be aware. Investors should be aware because many Co-GPs are not real Co-GPs and are marketing inaccurate data about their doors and assets under management. Inexperienced operators should be aware to avoid this trap as you are setting yourselves up to break both broker-dealer laws and investment adviser laws.
Finally, experienced operators should be aware in that you are jeopardizing your existing business by trying to find an easier path to raising capital in this difficult market. One mistake and you be off the rope and in the water.
