Bootstrap Capital for New PropCos

While innovations in how we design, build, and operate real estate projects capture headlines and venture dollars, innovations in how we capitalize these projects are the key to moving the real estate ecosystem forward.

While there have been several notable $100mm+ commitments by major players like Starwood and TPG to VC-backed OpCo-PropCos in recent years, getting to that point can be a challenge as earlier-stage PropCo capital is scarce.

Typically, a new real estate business model requires capital for both the operating company and the properties. Because the profile of risk/size/return are very different for OpCo than PropCo, there is no one-size-fits-all for this funding. OpCo funding has traditionally come from friends and family and venture capital, but venture capital is not appropriate for OpCos that are unlikely to deliver the 10x returns VC funds need.

PropCo investments, on the other hand tend, to be larger in size and lower in returns—a natural fit for real estate-focused investors. But, in the early stages of an innovative business, the checks are too small for a private equity real estate fund and the risks are high.

Now, there is a growing cohort of institutional investors providing "bootstrap" capital—the first $10–30mm—to emerging sponsors with innovative operating companies and/or niche strategies to begin proving out their track records.

This week we spoke with Sandor Valner, Co-Founder and Partner at PTB, a boutique investment bank serving innovative real estate companies. We discussed:

• The types of firms making bootstrap capital commitments;

• How these capital commitments are being structured;

• Three different sponsor profiles attracting bootstrap capital today;

• The importance of track record, and what to do if you don’t have it;

• The difference between joint ventures and service level agreements;

• Why the future of capital raising is moving online.

Read on for more…

1. What’s bootstrap capital? And what do these transactions look like in practice?

Bootstrap capital refers to the first $10-30mm of PropCo capital a sponsor – often an OpCo/PropCo – receives to acquire assets and begin proving out its track record.

Traditionally, this money came from friends and family, usually on a deal-by-deal basis. But now, given some of the unique OpCo innovations and niche investment opportunities in real estate, institutional investors and new dedicated funds are going downstream to fund the most promising sponsors in hopes of scaling the platform together over time.

Generally speaking, these transactions are joint venture structures between the investors and sponsors, where the investor puts up 90-95% of the equity capital and the sponsor puts up the rest. Investors use three primary levers to capture upside for investing early:

• OpCo warrants - typically a minority ownership between 2-10% depending on the size of the PropCo investment and impact on the OpCo business;

• ROFO/ROFR - the right to fund the next capital rounds of PropCo; and

• Reduced fees - sponsors can also compensate initial investors who are taking the bootstrap capital risk by reducing the fees and carried interests in the initial investments.

Additionally, to control the risks involved in a startup, many investors will only release capital in small increments at first as they get comfortable with the sponsor’s process and PropCo’s performance.

So a simplified, sample term sheet for bootstrap capital between a Sponsor and investor might look like the following:

• Joint Venture: The Joint Venture will be a Delaware LLC with Investor and Sponsor as Members.

• Capital Commitment: $[30mm] total from the Members where Investor commits up to a total of $[27mm] and Sponsor commits up to a total of $[3mm] (90/10 split)

• Capital Release: Investor will initially release $[5mm] for acquisitions. Subsequent releases are dependent on Sponsor performance to achieve Buy Box targets.

• Buy Box: Acquired assets must have a projected cap rate of [7.5]% and be in the following states: [Georgia, Texas, Florida, Arizona…].

• Management of Joint Venture: Day-to-day operations of portfolio will be the responsibility of the Sponsor. Investor will have the right to make all major decisions.

• Sponsor Fees: Investor to pay Sponsor a Management Fee of [1]% on invested capital and a carried interest of [15]% above a [10]% return hurdle.

• Investor Warrants: Investor will receive warrants for up to [5]% equity ownership in Sponsor’s OpCo.

• Investor Right of First Offer: Investor will have a ROFO on a subsequent $[50mm] of investment capital on the same terms except no additional warrants.

• Exclusivity: Each party shall work exclusively with the other party on the closing of the Joint Venture.

Note this is purely illustrative and purposely simplified. In practice a joint venture term sheet has far more terms, detail and complexity.

2. Who are the types of sponsors getting these initial $10-30mm checks today?

We’ve seen two general types of sponsors attracting bootstrap capital to date.

The first are OpCo-PropCos that are attacking new, potentially massive markets by leveraging an OpCo that owns certain legal and technological innovations.

Many of these are in the housing and lodging sectors, including single family rentals (SFR), single family leisure (SFL), and small multifamily operators who have built a small portfolio of 10-20 assets using their OpCo’s balance sheet capital–sometimes from VCs and other seed stage investors–to prove out their model.

The second are seasoned sponsors with a track record investing in adjacent, more traditional asset classes who are now entering an alternative space, like multifamily developers moving into coliving. Sometimes these groups have built an innovative OpCo as well, but more typically they are looking to partner with an innovative OpCo(s) as their preferred third party manager(s).

Both types of sponsors ultimately need to meet investors targets for unlevered yield (typically 6% and above in the current market environment) and IRR (high teens and above), while demonstrating downside protections if their business model doesn’t perform (e.g., ability to convert a vacation rental home to a traditional long-term rental if necessary).

3. There have been a lot of headlines over the past few years related to joint ventures between large private equity real estate groups and VC-backed opco-propcos. Are these the same groups providing bootstrap capital?

There are good and notable exceptions but usually no.

The groups we’re seeing invest today are small- and mid-cap private equity real estate groups focused on value-add and opportunistic strategies who like alternative investment strategies and can write smaller checks.

This also includes family offices with dedicated real estate arms and the wealth management arms of large VCs, both of whom can creatively invest in both the OpCo and PropCo.

These groups are looking to invest in these early-stage platforms for two reasons: because they provide yield and return profiles that cannot be found elsewhere in the market due to high interest rates, and because they present opportunities to deploy significant amounts of capital over time if their model is proven successful.

Platform investors are another type of bootstrap capital provider. They look to own the OpCo alongside the sponsor plus provide the bootstrap capital to the PropCo, with the eventual goal of bringing in larger LPs from their network to scale the PropCo over time. We have recently seen an increase in these types of investors.

4. Tell us more about how these bootstrap capital joint ventures are different from the joint ventures structured between larger PERE players.

While there are some typical joint venture agreements for bootstrap capital, candidly, most of the "joint ventures" that have been announced with the large institutional players are not traditional joint ventures, and instead are structured as service level agreements (SLAs).

Typically joint ventures, including these bootstrap capital deals, are arrangements where an institutional investor and sponsor agree to both contribute capital to a new venture to buy real estate together, whereby the Sponsor is responsible for most of the day-to-day decisions. Together the two parties participate in the upside of the deal, and the sponsor receives a promoted interest (or "carry").

In SLAs, like most of the OpCo/PropCo deals you’ve seen announced to date, an investor signs an agreement with an OpCo to acquire and manage real estate on its behalf, sometimes loosely committing a certain amount of money it might invest over time if the investments are successful. But the OpCo in these arrangements has minimal control over investment decisions, does not put in its own capital, and if it receives a promoted interest, it is usually smaller than it would be in a traditional joint venture. It’s only paid fees on the capital it deploys.

5. It sounds like some track record, even a small proof of concept portfolio, is necessary to point to in order to get investors comfortable. What can a sponsor do if they don’t have a track record?

Yes, track record is one of the key elements that get investors comfortable with deploying capital with the sponsor. The fastest path to get a track record is to partner with a larger sponsor in a win-win structure to add value to their deals.

This oftentimes means helping to originate deals for that sponsor and receiving a fee in return.

For example, a new SFR Opco-PropCo might partner with a large SFR investment platform to help them source and close new deals leveraging their unique OpCo structure. They can be paid an acquisition or origination fee for these deals.

This can also mean managing assets once their sponsor partner has acquired an asset or assets, and receiving a property management fee. But it is always helpful if the new OpCo-PropCo has a role in originating or underwriting the deals, as investors will want to see they have the ability to find and execute on acquisitions.

Another option is to explore solutions from groups like Cherry Lawn and ReSeed who provide alternative financing options for OpCo-PropCos and early stage sponsors.

6. What further innovations do you see happening in the capital markets to make this capital more accessible?

The format and structure of these bootstrap capital deals is becoming established industry-wide. But as appetite for these deals grows, better access to these investors will be necessary – as they aren’t easily accessible today.

So over the next couple years we expect to see a lot more of these relationships between investors and sponsors develop online, which is something we’re currently working on. We also expect to see more dedicated capital to fill the current void in the bootstrap capital space.