Don't budge on return of capital

Why return of capital matters in LP investments

We recently discussed the three pillars of LP (Limited Partner) investing:

• Execution - track record and counterparty risk

  • Read the article here.

• Alignment of Interests - coinvest, waterfall, and fees

  • Read the article here, preferably before continuing.

• Property - valuation and business plan

  • Coming soon!

Before moving on to Property, I wanted to touch on return of capital since it was a big topic in last week’s Alignment of Interests article (I recommend reading this before continuing, or at least read the “2) Waterfall” section)

First, some definitions in case you’re tuning in for the first time:

• General Partner - the person or fund making day to day decisions. They found the deal and are raising capital from you, the Limited Partner

• Limited Partner - typically silent investor contributing capital only

Why is return of capital important:

At the outset, a GP/LP relationship is one that is off-balance, since the LP typically contributes ~90%+ of necessary equity capital (and therefore has more to lose!)

To offset this, there are two main tools that are used to "realign" incentives at the outset:

1. Coinvest & Preferred Returns - I discussed both of these extensively in last week’s post.

2. Return of capital - LPs get their capital back before GP is taking their profit share

Return of capital isn’t talked about enough, in my opinion, and is often overlooked by LPs or even their attorneys.

I believe this is true because return of capital matters less during good times .. and we’ve had a nice run up over the last decade. The returns were so good that the return of capital clause barely moved the needle.

During bad times, however, return of capital is extremely important and as an LP protecting your downside is paramount - especially in an investment that has fairly limited upside like real estate (2x isn’t unlimited, so you have to limit the probability of capital loss). I will write about this specific topic more in the future.

For now, back to return of capital.

At this point, I have seen numerous cases where the GP is making substantial amounts of money while the LP hasn't been paid back (i.e. still has capital at risk). There are certainly circumstances where this is acceptable, but in the vast majority of cases this isn't market (to put it lightly).

Let’s run through an example so that we can all understand why this is such an important topic.