Let’s talk about one of the most critical - and overlooked - topics in investing: managing emotions and incentives. As deal makers, the pressure to close is immense. Time, money, reputation, and investor expectations can all cloud our judgment and push us into deals that don’t make sense.
Let me lay this out in an orderly format - all the ways in which pressure heaps upon the shoulders of deal people.
You invest money and time (and hope) into deals. This can be a lot of money. Theoretically you don't go hard until you're certain you want to do the deal - but either way, you are out quite a bit of capital even just doing inspections and your robust due diligence process
You invest your reputation into this. The selling brokers are usually people you do work with a lot. You don't want to look bad. The broker really wants you to close.
As a syndicator, you may have a lot of potential fees riding on getting a deal done. Sponsors can often resemble glorified brokers, and their compensation can look the same. You may have pressure to make money and need to get a deal done just to keep yourself out of the poor house
You probably feel pressure to do a deal because that's the purpose of a sponsors existence. We do deals. Your investors expect you to find great deals. Your entire reputation and brand is built on being "the guy or gal" who finds deals. So if you find "the" deal, and tell your investors, you have a lot riding on taking it through to conclusion. After all - what does it say if you get people all excited about the deal, and then you ultimately don't do it. Were you just being naive in the first place?
Actually, this article should be about all the massive incentive issues that sponsors deal with each and every day of their lives. I'll save that for later, though.
Right now - let's talk about "managing" these emotions. Or shall we call them these "incentive" problems.
First - I think highlighting the incentive issues is a VERY important first step. To solve a problem, we must first acknowledge that there is one. And there's a huge problem of incentives in this business. But just acknowledging them does not make them go away.
The best solution, in my opinion, is to have somebody who doesn't have these incentive problems review your deals. The issue here is that even with this in place, you can still choose to go forward. You can fool yourself into believing you found "the" deal and it just has to be done.
You can likely - if you have a good relationship with your mentor or advisor - also convince them that it's still a good deal.
Thus ...
ENTER THE INVESTMENT MEMO.
Yes - the humble investment memo.
Short of a truly institutional organization with a voting committee on deals, smaller sponsorship groups absolutely need to be writing and preparing investment memos. Better yet, they should write them, prepare them, then share them with their mentors or advisors or anybody affiliated with their company. I think it's a good practice to also share it with the LPs.
The Memo needs to challenge your dearly held assumptions. And you should fill it out on every deal before you advance to GO (GO being releasing DD Funds and going for it full force - because once you've gone hard on a deal, I think it's asking way too much of most sponsors to sacrifice their earnest money to back out).
Why do you want to make this investment? How does it compare to other options you've seen in the market? Is it better or worse than other alternatives?
What needs to go RIGHT for your deal to work?
What COULD go wrong? Can you survive if it goes wrong? More importantly, what happens to your LPs capital if it goes wrong?
Evaluate various stress test scenarios - what's your break even rate? What happens if rents drop? What happens if cap rates rise further? What happens in the event of a major disaster - does insurance cover you?
The reality is that a lot of deals just don't stand up to this level of scrutiny. Now - it's totally possible that a deal has some negatives. honesty - they all do. But on balance, does it win out?
You can still fool yourself through this process, but I find it to be an intellectually rigorous way to manage incentive problems.
Transparency is crucial - people should know your thought process beyond the pitch deck. Have you thought through the really gnarly issues? Are you still convinced it's a good place to put yours and your investors capital?
When is the right time to prepare this?
I think it's way too much to prepare this every time you go into contract on a deal. But I think the Memo should be completed during the due diligence phase, before you release your earnest money deposits.
Get your free copy of our investment memo process here.