Preview 2) When to Jump From SFHs to Syndications?

Passive Investor Accelerator eCourse BONUS – Past Deal Webinars (On-Boarding Call Required for Access) Preview 2) When to Jump From SFHs to Syndications?

Buy the eCourse

See all eCourses

Below is a sample of the Full Syndication For Passive (LP) Investors eCourse

Check out free version here

Types of Syndications/Private Placements

Open-Ended Fund

Open-Ended Funds are typically offered as an ongoing vehicle where the Fund Manager is constantly buying and selling assets for the Fund. Often, these types of Funds offer redemption features so an investor can exit the Fund, after a stated lock-up period. New investors can come into the Fund over time as well. One significant advantage for the investor is that they automatically have diversification in their portfolio because their investment into the Fund exposes their capital beyond just a single asset and across all assets the Fund owns. A disadvantage is that the investor has no day-to-day control over the assets in the Fund and is relying solely on the fund manager’s discretion. Distributions to investors may be made monthly, quarterly, or at different intervals and come in the form of cash to the investor or may be reinvested back to the Fund, depending on the fund’s specific setup.

Closed-Ended Funds

Similar to open-ended funds, typically have multiple assets in them and therefore provide an element of diversification. However, there are typically no redemption options as the Fund is designed to have a finite shelf-life, both in terms of a fundraising period and an estimated deal lifecycle. The deals the manager selects for the Fund have an expected return which is generally distributed to investors once the deal is fully completed and then distributed to the investor at the close of the Fund. After the Fund is closed, no more deals will be done and hopefully all investors receive their principal and return on investment back at that time. Regular cash distributions may or may not occur depending on the type of assets going into the Fund. If the assets are long-term growth-related assets, such as a motel conversion to affordable housing, there may not be immediate cash flows until the project is completed and rent payments are collected.

Syndications

Syndications are generally structured for the purpose of raising capital to acquire a small number of assets and/or one single asset. These structures are very commonly used for larger value assets, such as multi-family apartment complexes. Generally, there isn’t the diversification, and like a closed-ended fund, it has a shelf-life based on the syndication sponsor’s belief about when the asset will be liquidated and principal returned to investors. The syndication may or may not offer cash flow over the life of the offering.

Direct Ownership

Direct Ownership provides investors the greatest control over their assets – in that they make all day-to-day decisions. With Funds and Syndications, the investor is relying solely on the manager to make ongoing decisions. With direct ownership, all of the investor’s capital has full exposure to the asset and therefore doesn’t bring the diversification element. Depending on type of asset, there may or may not be a current cash flow component. However, it gives the investor the control to fully position the asset to the specification of their portfolio.

These four access points can offer investors many benefits that advance their individual financial freedom objectives. However, the investor must carefully assess those benefits (and risks) and how much investment capital is allocated amongst these access points, in addition to the asset classes themselves, as well as the many other components when making private investments.

Understanding a Syndication Deal (PPM)

Syndications are not entirely passive, there’s a lot of due diligence to be done before you invest. However, after you send in that check, your work is essentially done.

What is a PPM?

A Private Placement Memorandum, or PPM, discloses everything an investor needs to make a decision to provide funding. This is going to be your “go to” document for everything.

These legal documents are required by the SEC when making an offering to the public.

(stocks have a prospectus while multifamily syndications have a PPM)

PPM Outside Structure: The Regulatory Side Of A Deal

In this first part of our series, you’ll learn about how the PPM outlines the regulatory side (or outside structure) of an investment vehicle.

When reading through a PPM, you see the following sections:

To properly understand the deal, you need to go through them all.

We’ll talk about the significance of each, one at a time, with examples.

* Note: every PPM is unique, so you may not see EXACTLY the same thing as our examples, but we’re highlighting big-picture items that are going to be covered one way or another on basically every PPM you’ll read.

The offering package. This offering includes a number of documents, all of which collectively comprise of the Offering Package. Each document provides you the investor relevant information about the opportunity.

Private Placement Memorandum or PPM

Tells the story of the investment

Legally this Memorandum is the disclosure document required by the Securities and Exchange Commission (SEC) and/or applicable State securities agency for a private placement offering.

Describes the structure of the company

Projected distributions to investors

Compensation to the manager

The risks of investing

Potential conflicts of interests

Business plan

And many other things.

The Company Agreement or Agreement

The agreement describes how the company will be run.

Legally, it is the governing document for the Company operations and describes in detail the rights and duties of the Members and the Manger.

How meetings and votes of the members will be held

How and when Cash Distribution will be made

Where the Company books and records will be kept

How disputes will be dissolved

The agreement is contractual and enforceable.

Succession plans

Subscription Booklet

This is where you the investor must complete

Cerify that you understand and agree

Protects syndicator/lead and investors

Summary of the Offering (Ground Zero)

Sometimes shortened to “Summary Offering”, this is your introduction to how the syndication company is being structured to manage the investment.

A typical summary offering includes:

Company Information and Objectives

The name of the company and clear objectives of how the company is planning to exit the property.

Classes of Limited Partnership and Equity Split

As the passive investor this is key to knowing where you fall into the structure of the deal. What are the different classes within the partnership and what to expect for payment? How the deal is split? Is it 70/30, 60/40, etc. This will depend from deal to deal and that is why it’s important to have a clear understanding, so you’re not surprised when the property is liquidated.

Use of Proceeds

This is imperative. As an investor, you’ll want to know exactly how the company or LLC plans to purchase the property, improve, operate, and ultimately dispose of the property.

Risk Factors and Conflict of Interest

This is so you know where General Partners and Limited Partners stand, as well as the risks associated with the property.

The Class A Limited Partners may have conflicts of interest with the Class B Limited Partner and the General Partner; who have interests in earning their own distributions and fees.

Liquidity

Here is where you will have a clear understanding of how liquid the property really is (which is typically ‘zero’).

A multifamily syndication is a great investment, but a drawback is its lack of liquidity. You should be prepared to stay in the property for the entire holding period. As there is typically no market to sell your holding to.

1031 Exchange

What is a 1031 exchange?

Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another.

Investors will not be able to 1031 exchange into the property. However, at the time of sale, the General Partner may call for a vote of the Limited Partners to approve exchange of the Property for another investment property under 1031 exchange rules

This would require a majority vote and you as the LP would generally be able to exit upon a 1031 exchange if you didn’t wish to proceed.

How to Review the Offering

There is where you will be able to understand the offer and ensure that you fit into the business model.

Look at the following:

Limited Partner Agreement

This describes how the Company will be run, and supersedes all previous agreements that may have been adopted by the Company.

Subscription Agreement

This contains the investor’s representations and warranties to their qualifications and suitability to invest in this Offering, the amount the investor is planning to invest, and the General Partner’s acceptance of the investor as a Limited Partner of the Company.

Investor Suitability Standards

In making a determination about whether to accept a prospective investor as a Limited Partner of the Company, the General Partner must comply with certain standards set forth in the Securities Act. Part of this is determining if the investment is suitable for the investor or not.

Type of SEC Offering: 506B vs 506C

Real Estate syndications have to be registered with The U.S Securities and Exchange Commission and fall under Rule 506 of Regulation D.

Under Rule 506(b), a “safe harbor” under Section 4(a)(2) of the Securities Act, a company can be assured it is within the Section 4(a)(2) exemption by satisfying certain requirements, including the following:

The company cannot use general solicitation or advertising to market the securities.
The company is allowed to sell to an “unlimited” amount of accredited investors and up to 35 non-accredited but sophisticated investors. A sophisticated investor is an investor who has a sufficient amount of capital and experience in these types of investments, but is not accredited.

Under Rule 506(c), a company can broadly solicit and generally advertise the offering and still be deemed to be in compliance with the exemption’s requirements if:

The investors in the offering are all accredited investors.
The company takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W2s, tax returns, bank and brokerage statements, credit reports, etc.

Regulations and Investor Qualifications

SDIRA Account Holders

For an entity such as an Individual Retirement Account (IRA) or Self Employed Person (SEP) Retirement Account, all of the beneficial owners must meet one of the above standards. The beneficial owners may be either natural persons or other entities if each of them meet one of the definitions above.

Unsuitable for 1031 Exchange

As mentioned before, a 1031 exchange is a tax deferment strategy for capital gains which is used by real estate investors.

If you were to exercise this investment strategy upon sale of a property or entity, one would have to declare a new property (typically within 45 days) one plans to invest in. Upon the sale of the original property those capital gains would be deferred to the next property.

However, it should be noted that this is an unlikely scenario and any investor who is looking to roll capital gains over into a new property probably shouldn’t invest in the syndication in the first place.

Any syndicator who promises to do a 1031 exchange in all likelihood lacks experience and should be vetted further before you proceed.

Is foreign investment allowed?

Disqualifying events are broadly defined to include such things as criminal convictions, citations, cease and desist or other final orders issued by a court, state or federal regulatory agency related to financial matters, Investors, securities violations, fraud, or misrepresentation.

It is up to the General Partners to know and check out all investors in the deal and make sure that they are in compliance with ALL regulations.

This is known as KYOC (know your own customer). The General Partners will validate investors’ information as they see fit.

Summary of the Company

The most important section here is the Company Purpose and Specified Offering.

Financing

The General Partner anticipates the use of institutional financing to acquire the Property and to finance capital improvements. The proposed lender’s term sheet may be available on request, however, the actual loan terms will not be known until the rate is locked and/or the Property is acquired.

The General Partner reserves the right to accept different commercially available loan terms or to change lenders as necessary to acquire and subsequently refinance or supplement the loan on the Property.

Funds raised from offerings will be used to finance the down payment, closing costs, due diligence expenses, General Partner’s acquisition fees, improvements and operating reserves related for the Property and to reimburse the General Partner or its members for any expenses they may have advanced related to acquisition of the Property. In addition, the members of the General Partner may act as guarantors on the acquisition loan for the Property.

This will vary from sponsor to sponsor and you’ll just want to familiarize yourself with the specifics of the deal.

GP Advances and LP Loans

Deferred General Partner reimbursements and fees, or General Partner loans, will be treated as a General Partner Advance and will earn a percentage of interest annually or the costs of the funds, whichever is higher, from the date of closing until repaid. However, Limited Partner or third party loans may earn any rate negotiated by the General Partner, and deemed by the General Partner to be reasonable under the circumstances.

Limited Partners

It is typical in the syndication model for the Company to sell Class A Limited Partner Interests to investors to raise capital for organization of the Company, down payments, due diligence, and closing costs necessary for acquisition of the Property.

Every deal is structured differently. Here is a hypothetical example of a deal:

Class ABC Limited Partner – Interests will comprise seventy percent (70%) of the total Interests in the Company, or such other percentage as may be agreed upon by the General Partner and the Limited Partners. The Minimum Investment Amount for a single prospective Investor is $50,000 or the purchase of fifty Class A Limited Partner Interests. However, the General Partner may lower the Minimum Investment Amount in its sole discretion.

Class XYZ Limited Partner – On startup of the Company, COMPANY LLC (or their members or Affiliates) will retain ownership of thirty percent (30%) of the Limited Partner Interests in the Company in the form of Class B Limited Partner Interests in exchange for a total Capital Contribution of One Thousand Dollars ($1,000) and for past services they have contributed to make this investment opportunity available to the Class A Limited Partners.

Key Principals and the Members of a General Partner

The syndication model is structured in a way where it has no board of director, officers, or employees.

There are however key principals and other members of the company who will act in roles similar to those of directors, executive officers, and employees of a corporation.

So how do key principals and the members get paid?

General partners and principals usually earn a compensation in the form of fees from the company, which are then distributed to its members based on the percentage of interest one has within the company (see table below).

However, it should be noted that every PPM attached to a syndication will look different. It’s imperative that you review, understand, and are comfortable with how the key principals and general partners are being paid out.

If you don’t understand, or have questions about the percentages of distribution, always ask the sponsor.

Investment Objective

Every smart real estate investor should enter into an investment with the end game (exit strategy) in mind, and syndicators aren’t any different.

Syndicators will often refer to the company’s investment strategy as the “investment objective”. This states how they plan to acquire, finance, manage, improve, and then sell the property.

So you need to understand how long the syndicator plans to hold the property and what the plan is for the exit strategy.

Typical hold patterns vary between three to ten years.

During the holding pattern your money is locked and you should be 100% comfortable with the allotted time.

Voting Rights

Limited partners are given limited voting rights and will not be able to vote on changes or handlings of the property’s operations.

However, the voting rights can be expressed if the limited partners would like to remove a general partner for good cause (as defined by the agreement), or to determine a new preferred exit strategy for the property.

This would typically require a majority vote and isn’t a common practice in syndications.

If you’ve vetted your sponsor carefully a coup will most likely not occur. It’s just something you should be aware of.

Depreciation Method to Be Used

In order for the company to maximize profits for investors it will typically use some form of depreciation, whether forced or not.

To optimize this process a cost segregation study is done to properties with a value over $1,000,000.

Depreciation should be passed on to limited partners, however not all sponsors do this. Depreciation deductions are one of the biggest advantages of investing in multifamily syndications. So investors should always ensure they’re getting their rightful share.

We highly recommend that all investors speak with their financial advisor to exercise and maximize these benefits.

* * *

Since PPMs are a bit dense, the average investor pays them very little attention.

Hopefully this article has armed you to become a more sophisticated investor, and to get the most out of your commercial real estate deals.

Key Takeaways:

PPM shows how deal is structured,
Who the partners are in the deal,
The type of offering.

But for part 2 in the series, we will explore the most attractive aspect of the PPM…

How you, the investor, get paid.

PPM Risks & Rewards: How You Get Paid

Now that we’ve established the regulatory side, we can jump into the meat and potatoes.

Part 2 is all about that money.

We’ll discuss how both you and the syndicator get paid, as well as the associated risks:

Sources and Uses of Proceeds

It’s important to understand how the money works within a deal so you are never blindsided as an investor.

For every syndication model, there is a minimum and maximum dollar amount to be raised in order to acquire the property, with corresponding expenses.

Minimum Dollar Amount

This will tell you the low threshold of the capital raise, in order for the GP to use investor funds.

It also describes what happens when only this amount is raised (generally includes the GP deferring fees, advancing funds, or even seeking a loan from a third party).

Note that, usually, a GP can reduce this amount at their discretion.

Maximum Dollar Amount

This is the high end of the offering; the GP will not raise more money than this.

The offer can be terminated at any point before the maximum is raised.

Below is a typical table that would be used to show the minimum and maximum amounts.

Closing Costs

This section talks about how some of the proceeds of the offering will be used to pay the GP back for costs they may have incurred during the acquisition stage.

It will usually tell you where to look (in a table or appendix) to see the estimated closing costs of the deal. If the amount or usage is not clear to you (or seems too high or too low), you should ask the sponsor to elaborate.

Of course, like so many of the other metrics, the actual closing costs may differ from the original estimate.

In that case, you’ll also find a provision that states the GP will advance funds to close (if only the minimum dollar amount is raised), and, if so, how much interest they will charge until repaid.

This is unlikely to occur when sponsors conservatively underwrite a deal.

But it’s a possibility that you should be aware of, and should be included in the PPM.

Working Capital and Reserves

Sometimes there is excess cash raised above that needed to acquire the property.

Here you will find a description of what happens in that case. Typically the proceeds are held in a bank account to be used as working capital/reserves.

On the flip side, there are also provisions if only the minimum amount is raised.

So the PPM will include a description of how the property’s cash flow would be used instead, and how that may affect distributions.

Deferral Of Fees / Reimbursements

Much like closing costs above, there will be a plan in place if only the minimum amount is raised. This particular section talks about how the GP’s fees will be handled.

Distributions to Limited Partners

This is THE hot section of the PPM, from the point of view of you (the passive investor / Limited Partner).

Everyone always wants to know “when are the distributions”, “how much will they be”, etc.

Here you will learn how your returns will be paid out based on the cash flow of the operation, and in what proportion based on your investment.

It will also contain an estimate of when the first distribution will be paid out, and how often thereafter.

During Operations

The distributable cash (from operations) will have an order in which it will go out, depending on the class of the Limited Partner.

Of course, no two deals are ever the same. So you should examine the payout structure outlined in each PPM.

Here is an example of a possible payout structure:

First, to the Class A Limited Partners, an annual, non-compounding, cumulative Preferred Return of eight percent (8%) (the Preferred Return) calculated against their respective Capital Contributions.
Second, to the Class B Limited Partners until they have received an annual, cumulative non-compounding cash distribution (the Class B Catch up Distribution) of 3.43% calculated against the Unreturned Capital Contributions of the Class A Limited Partners.
Note that this is equivalent to a 70/30 split between the Class A and Class B Limited Partners as shown below:
70 / 30 = 8 / 3.43
Third, to the Class A Limited Partners and the Class B Limited Partners, 70/30 to be allocated amongst them pro rata.

Things to Look For

In my experience, it’s good to ask for the following on any opportunity:

The numbers (What is the sponsor’s ownership of the property? What is the expected return? What is the minimum investment on the project? What is the projected income on the property?)

Financing (How much debt + equity does the project require? What is the acquisition cost?)

Timeline (What is the expected time to return on investment? If it is a rehab, what is the construction timeline?)

Market Overview (What makes this area unique? How is the current state of the market? How do similar properties compare?)

The Sponsor (What is the team’s experience? Have they done projects like this before? What were the returns on past projects?)

What is a Preferred Return in a Real Estate Syndicate?

According to Mark Kenney over at ThinkMultifamily, a preferred return is “a return that investors received BEFORE the general partners receive a return.” In essence, after the investors receive their initial capital back, they received a preferred rate of return before the general partners get any payout at all.

Mark, an investor and real estate coach who owns over 2,000 doors in Tennessee, Georgia, and Texas, says that he doesn’t like to use a preferred return but has in the past on deals that didn’t expect any distributions for 12 or 18 months. The preferred return would accrue and give incentive for people to invest in the deal.

Andrew Campbell, the co-founder of Wildhorn Capital, a multifamily operator based in Austin, Texas has a different opinion. He said he likes to have an 8% preferred return for the majority of his 450 door portfolio. It “gives some certainty to investors about their overall returns. Plus, 8% also happens to beat the historical stock market return of 7%.”

Analyzing the Proforma

I have seen proformas that show an interest rate of 5 percent that changes after 5 years, yet the proforma assumes the rate will be fixed for 25 years. Of course, that is revealed in the fine print. Is the philosophy to pay down debt and then distribute money? Or is there a teaser return that can change after 5 years? Is there an interest only loan?

Other Items

Take the proforma with a grain of salt. Even more importantly, jump down and look at the FINE PRINT in the proforma FIRST. Literally, go to the bottom of the page and read the assumptions that they are trying to hide from you. Make sure you know what the management fee is. To paraphrase a risqué supreme court judge, I don’t know how to find an inappropriate management fee, but I know one when I see one. 5 percent is too high. 1-2 percent might be reasonable. Most investors don’t pay attention to the disposition fee. That is the fee the sponsor gets when the asset is sold. Is it a reasonable 1.5 percent, or is it 5 percent? Ask for any lease agreements between the tenant and landlord. Have fun reading that, if you know what I mean. The lease is about as entertaining as studying the proximal convoluted tubule and loop of henle. Ideally, discuss the prospectus with a colleague who is also thinking of investing. The creators of these deals are often talented salesman. They will use every trick in the book (flattery, using your name, inflating your ego, scarcity principle, reciprocity etc…). As a skillful salesman once said, “It’s not what you sell ’em, it’s what you tell em.” Another tip is to track down the competitor of the outfit that you are buying from. That competitor is more likely to provide you with what you really need to know than the syndication outfit you are purchasing your shares from.

Researching the Deal Continued

Find out info about GP

– Search LinkedIn and Facebook and contact mutual friends to get references

– Are the syndicators just raising money or are they operators?

– Have they ever had to make capital calls on past deals?

How to know if a deal has good returns.

– Equity multiplier should 1.8-2x over 5 years, or at least 80% return in 5 years

– 5-8% cash flow a year is about average

Multifamily deals

– Do they have in-house property management or are they using professional property management?

– Find out if the rent comps are good.

– Call and get pricing sheet from competitors.

– Ask people you know about the areas and/or complexes.

– What are the fees? There are generally 3 fees, before (acquisition, percentage of purchase price), middle (asset management, percentage of revenue), and after (disposition, percentage of sale price). They should all be 1-3% each.

– Debt service coverage ratio should be 1.25 or higher.

– Rent increase after rehab should be 10-15% or less.

– 2% stabilized annual rent increase is a good, conservative number.

– Expect to see 15-20% vacancy if bumping rents more than 15%.

– Stabilized economic vacancy should be 10-12% conservatively.

– Amount spent on rehab:

– $2-4k per unit is a basic upgrade. It will get you basic stuff, paint, carpet, flooring, etc.

– $4-8k per unit is a high-end upgrade. It will get you kitchen countertops, backsplashes, appliances, etc.

– Estimate an exit cap rate of 1% higher than current cap rate to account for market changes.

– Find out if loan is recourse or non-recourse loan. Not something to worry about as an LP. Usually loans are non-recourse.

– General partner usually puts in 5-10% on the LP side.

– Longer term debt is better than bridge debt to ride out economic cycles.

– 7 years is the sweet spot for term.

– Too long and has large pre-payment penalties.

– Too short and may have to refinance at a bad time economically.

– Verify rent rolls match proforma.

– Are the expenses going up similar to rent increases? Generally they should be the same percentage or close.

– Make sure preferred return is cumulative so it’s caught up if underpaid some months/quarters.

– What is the frequency of distributions?

– What is the communication frequency?

– Expense amount of $4k per unit is normal for a stabilized property.

– In a small value-add deal, should be $55k-85k per unit in purchase price.

– Post-close liquidity should be at least 10% or at least $250/unit.

– Have you used this property manager before? If not, how did you choose them and what references did you get for them?

– The rent-to-value ratio should be 1.2-1.5% for class B and C multifamily housing.

Funds

– How much of the capital is invested in cash, short-term investments, long-term investments?

– 10-20% of cash and short-term investments is good.

– Below 5% is bad

– Is the fund always open? If not, liquidity of your funds will be more difficult.

– If they’re doing hard money lending, are the points shared split with investors?

– Can you reinvest distributions in the fund?

– If fund is open, ask for last quarter returns and trailing 12 months of total return.

– How does the fund find deals?

– Network driven or marketing driven?

– What types of deals does the fund invest in?

– Debt, equity, asset type, deal size, location, value-add or performing.

– How good are the deals? Risk/reward, target ROI, downside protection.

– What is the fund transparency? Will you show the assets and performance in the fund?

– What percent of deals get reviewed (ideally less than 25%) and what percent get funded (ideally less than 10%)?

– What’s the underwriting criteria?

Capital Transactions

But what happens if there is a refinance or the property is sold?

You’ll get a payout structure for this as well.

Just like the operational distributions, the LP (Class A) typically gets money first, and then the GP (Class B) gets some, and if there is anything left, the cash keeps getting split until the payouts reach a threshold.

Pay attention to all the numbers and return limits, and how they are affected by your original capital contribution.

Dissolution And Termination

This will tell you what happens to the company after the final settlement is made on the property.

Company assets will be distributed as outlined here.

It will usually refer to the next section about the GP’s fees as well.

What are Common Syndication Structures to Expect and What Should You Look For?

Here are the two major investing players in a syndication deal:

General Partner / Sponsor / Operator
Limited Partner

The sponsor will find the deal and pull together the necessary documents to form a syndication. There are endless ways to split profits and fees / costs in a syndication, the split is known as the syndication structure. Below highlights the fundamental profit splits of a syndication deal and the common fees associated with the deal.

Return of Investor Capital– The payment/return back to the “capital owners,” in this case the limited partners that is not taxable income. This is when the limited partners receive a portion of his/her original investment, which is not considered incomexceeds the growth (net income / taxable income) of a business / investment.
The Preferred Return– A return that investors receive before the general partners receive a return.
The Catch-Up– Sponsor gets 100% of the profits after the preferred return until the pre-determined split is met.
Carried Interest– Profits for the sponsor based on an agreed amount (80/20 split or 70/30 split). It is a performance fee rewarding the manager for enhancing performance.

Profits generated above any preferred returns are generally split between the limited partners and the general partners (e.g., 70% to limited partners and 30% to general partners). While most individuals would like to intuitively understand this first, it’s important to understand all of the fees that may be hidden into the deal that may make or break your profits.

Have You Heard of a Waterfall in a Syndication?

A waterfall refers to the overall distribution of funds and tiers but it is often explains how profits are split after the preferred return (e.g., 70% limited partner and the 30% general partner split). Some deals may have “additional waterfalls” where after a certain IRR % is reached, the split will differ (e.g., 50% limited partner and 50% general partner).

Now that you understand the basic terminology of how a syndication can split profits and fees, I’d argue the most important of all is understanding the incentives behind all the splits of profits and fees.

High Preferred Return and High Fee Deals– This incentivizes the sponsor to close more deals instead of maximize cash flow.
Waterfall Distribution Based on IRR– Deals with large incentive levels to sponsors once certain IRR%’s are achieved may incentivize the sponsor to find ways to artificially increase the IRR in order to trigger the agreed upon waterfall distribution.

High Returns for Sponsor– The deals that are tied to the performance of the investment with a large incentive for the sponsor will create more incentive to produce high returns.

Preferred return means that 100% of the cash flow goes to the investor until such time as the hurdle has been met. So let’s say that you have an 8% preferred return, and in year 1 the investment throws off 4% in distributable cash. In year 2 it throws off 8% and in year 3 it throws off 12%. Up to this point the investor has received 100% of the cash flow because 4% accrued from year 1 and didn’t get caught up until year 3.

As to waterfall structure, hurdles can be based on IRR or Cash on Cash. In the case of an IRR hurdle, return of capital has to happen by definition in order to hit the IRR hurdles, so effectively all cash goes to the investor until they not only receive the preferred return but also have received all of their capital back. This rarely happens during a hold period, so this means that all of the sponsor’s promote comes out of the sale.

A cash-on-cash based waterfall can be structured such that the hurdles can be met from cash flow alone, with return of capital happening only at capital events such as a cash-out refinance or sale. Sometimes you’ll see distributions first classified as a return of capital and the preferred return second…this is done to reduce the preferred return by constantly lowering the investor’s capital account. Nevertheless, in the case of a CoC waterfall you CAN hit the hurdles during the hold period and collect promotes prior to the sale. But you’re unlikely to see it for 3-4 years because accrued pref usually sucks up the cash in the early period as income is increased from renovations or churning the rent roll.

On the topic of making a living, it is in everyone’s interest that the sponsor be compensated and keeps the lights on. This is why it’s tough for new sponsors to break into this business. You don’t earn a lot along the way, but you have to earn something. Somewhat of a catch-22.

FAQ:

How will I know I’m ready for a syndication?
What are some red flags to watch out for?
How much excess income should I have before investing in a syndication?

*Usually I see investors place no more than 5% of their networth into any one deal

Are there any other associated costs aside from the investment I should know about / watch out for?
What are common pitfalls to look out for?
What is the best type of % split between GP / LP? What is the best syndication structure there is?
Where can I find syndications to invest in?
What kind of return should I be looking for, Financing, Timeline, Market Overview, The Sponsor, Type of Partnership
Communication with Investors
Can I save on taxes if I invest in a Syndication?
Do I need to hire a lawyer to look over a Syndication structure?
How can I protect myself if a Syndication goes sideways?
Does the due diligence vary between deals? How can I be sure I’m considering everything I need to consider?
How do I know if the assumptions in my model are correct?
Where can I find sample diligences to model after?

What Are the Technical Aspects of a Syndication (Legal, Taxes)?

Intro To:

Group Ownership Entities
Securities Laws
Income Tax and Accounting Issues
Private Placement Memorandum
Summary Chart of Exempt Offering Alternatives
506B and 506C
Filing Requirements

This allows you to take over the existing LLC which greatly minimizes the chance for the taxes to go up. Typically when a property changes hands the State really likes to reassess the value of the property. Normally you can spot check this as a LP and look for a new tax assessed value 95% the sale price which can surprise a lot of inexperienced leads. High growth areas like Dallas is very aggressive. Often even if the taxes go up there are a few loopholes to petition the amount lower with a clever petition specialist.

What are the X Things to Complete in Your Syndication Due Diligence?

Summarize Due Diligence Checklist – Lane’s google doc
Initial Review, Meeting, Marketing Material, Legal, Other, People, Operational and Investment Process, Performance – Lane’s google doc

Diversification Equals Less Due Diligence

A recent prospectus that came across my desk asked for a minimum investment of $75,000. If the astute investor wants to give syndications a try but does not want to do due diligence (pardon the pun and alliteration), a good trick would be to purchase smaller units in larger quantities. Three different syndications at $5,000 each may be more palatable and more educational than one syndication for $15,000. As the investor develops confidence in the provider, additional syndication projects could be purchased.

To answer these questions investors must gain a deeper understanding of all of the following: (a) the strategy, (b) the investment process, (c) the people involved in the fund, (d) the ‘business’ operations of the fund, and (e) the performance track-record.

Initial Review

Typically, the DD process starts with an initial document review to glean the basics and see if its worth taking the meeting. I generally start with the tearsheet, presentation, and recent investor letters. Every investor has their own limiting criteria, but depending on the investor some will pass right away due to factors such as:

Size of the fund. Some investors want the sense of ‘safety’ from a large fund, while others prefer smaller funds due to their higher return potential. (My diligence is generally focused on smaller funds, which may have higher operational risk, so the research burden tends to be higher.)
Undifferentiated strategy or an unfavorable strategy for the market environment.
Lack of a track record. Many institutions and investors require 3 years of track-record or a ‘portable’ track record from a manager’s previous firm in order to get comfortable with their historical ability to perform. Again, I have some investors who are comfortable being ‘day-1’ money which raises the due-diligence threshold.
Poor relative or absolute historical performance.
High volatility or large drawdowns.
Poor quality of investor communication. The only thing that differentiates a ‘black-box’ from a transparent fund is communication. If the communication from managers is sparse or uninformative it is tough to get comfortable with a strategy. We generally like to see monthly performance updates with quarterly commentary. Anything more frequent may mean the manager is spending too much time writing, and anything less means we are in the dark for too long.
Lack of credible third-party service providers (auditor, independent fund administrator, prime broker, legal counsel.) Third-party service providers are the checks and balances on a manager’s operations. Investors do not get compensated for taking on unnecessary operational risks, so if we don’t see auditors, administrators, and prime brokers in place we will pass immediately.

Meeting

If the manager passes our initial document review we’ll take a meeting. The first meeting(s) are usually the standard pitch, a walk-through of the presentation, and a high-level Q&A. Though we’ll have an idea going in on what we want answered and what we’d like to discuss, we let the manager start with their pitch and always end up free-forming after a while. The idea is to get a sense of the manager, personality, and to probe on different areas of interest or concern and get a sense of whether it holds up.

If the strategy, performance, fund structure, and people all pass the initial smell test and merit further interest, due-diligence begins in earnest. An initial document list is requested which generally includes:

Marketing materials:

Investor letters since inception. These give us a sense of the quality of communication, investment ideas, research, and insight into the manager’s personality and approach.

Relevant PR such as interviews, press releases, and published articles.

Due-diligence questionnaire aka the ‘DDQ’. This is a key document that asks 100+ detailed questions about the fund. The AIMA (Alternative Investment Management Association) version is the most common DDQ. We review the DDQ provided by the manager and compare it with the AIMA DDQ to see if the manager deleted any questions from the list. Usually, when a question is missing from a DDQ it’s because it was irrelevant to the strategy, but sometimes a deleted question can be HIGHLY relevant and show what questions the manager doesn’t want to answer. (Here’s a random completed DDQ off Google in case you’d like to get a sense of what that document looks like: Page on opcvm360.com)

Research samples. Again these give us a sense of the depth and focus of the investment process.

Legal:

Private Placement Memorandum. This is the legal doc outlining key terms of the fund. This is generally where all the nuances on fees and fund structure are found. See How do you describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds? for more detail on nonsense to be aware of surrounding hedge fund fees.

Subscription documents. We review to make sure everything is consistent with the PPM.

Partnership agreements. These detail terms of the business structure and can also detail nuances of the fund structure.

State certificate of organization/LP certificate/state registration doc, IRS W-9 tax ID form. These are mostly just confirmatory documents.

Other:

Audits since inception. The independent auditor’s report is of critical importance, as it will reconcile assets, portfolio balances, performance, and often provide insights on portfolio construction, liquidity of underlying assets, and back-office protocols.

Independent prime brokerage report as of last completed audit. This allows us to see even more detail on the portfolio from the time of last audit and allows us to reconcile the audit with the actual portfolio. If anything doesn’t line up with the audit it means either we or the auditor are missing something.

Reference list. They will all obviously be glowing references, but the choice of references can be very important. Who they leave out of the reference list is often more instructive than who is included. That being said, sometimes good information can be found through the references.

Service provider contact information. We verify the relationship with each service provider, and perform due-diligence on the service providers to get an understanding of the terms and length of the relationship with the fund.

Any external or internal risk reports. These give us a sense of how they measure risk, what risks they control for, and how they fall within those parameters.

Regulatory registration documents such as form ADV for advisers. This is more confirmatory information but can also show critical pieces of information such as assets under management as of a particular date, key principals, number and type of clients, and compliance with the law.

Once the document review is completed, you’ll likely have a better understanding (and many new questions) about key issues surrounding the 3 P’s: people, process & performance. The next step is to dig on areas of interest or concern to learn more on each of these three areas.

People

One of my favorite stories on manager due-diligence came from a well-known investor who passed on a hedge fund because of a raincoat:

The investor wanted to get to know the manager better, so they agreed to go on a hike. Halfway up the mountain it began to downpour. Unfortunately, the manager hadn’t checked the forecast and spent the latter part of the hike completely drenched. The (dry) investor realized at that point that the manager was a little too focused on the adventure ahead of him and not at all focused on managing the predictable risks along the way. The investor passed due to concerns over risk management.

We haven’t passed on any managers over rain gear, but I think the point is relevant. In poker, you must observe everything about a player; betting patterns, style of play, tolerance for risk, and personality. You piece together an understanding of the person from the data in order to get a sense of their tendencies. The same applies to due-diligence on people. Fortunately we have a lot more data to work with than at a poker table:

Background checks. We use a service that looks for criminal, regulatory, and civil infractions, including Anti-Money-Laundering checks on all principals and key employees of a prospective firm.

Regulatory checks. The Financial Industry Regulatory Authority (FINRA) has a very comprehensive database of brokers and investment adviser firms that shows whether individuals or firms have had any regulatory infractions, their registration status, whether they’ve had any arbitration awards issued against them, and the full employment record of registered individuals (among other things). It also ties into the SEC database which is often relevant for larger firms. All of this is obviously extremely valuable background information. One little trick we use is to match up the employment record of the principal with the bio in their marketing materials. Often they will leave firms out of their bio if they had a bad experience there, though they’ll include it on their regulatory filings. It may bring up points that require further digging: BrokerCheck: Research Brokers & Investment Advisers

Back-channel reference checks. This is probably one of the hardest things to do effectively, particularly for industry outsiders, but this can be a source of absolutely critical information. This is the scuttlebutt; the “I’ll talk to my guy who worked in this manager’s Deutsche Bank division when he was a portfolio manager…” This approach is often how you get the ‘real’ story behind a manager.

Regular ol’ reference checks. You have to cut through the glowing praise and ask the right questions to really get a sense of the truth, but these can be helpful.

Direct interviews with the manager. This doesn’t have to be a cross examination but during the meetings there should be a component of confirmatory questions along with getting a sense of the manager’s personality, background, and approach.

Google. (Never underestimate!) I was asked by a family office to diligence a manager and I googled the manager before anything. Past investors had posted on a forum that the manager lost 90%+ of their money by making risky bets then doubling down when the original bets didn’t work out.

Skin in the Game

Also worth noting is that it’s incredibly important to know that the manager has invested in their own fund, and that they are risking their assets alongside yours. Most investors want to know what percentage of the manager’s liquid net worth is in the fund, and will often request documents to prove it.

Operational and Investment Process

Now that you understand more about the people you’re working with, you want to understand the structure and processes that constrain them.

A hedge fund, like any other business, creates a product (a portfolio). In order to generate consistent portfolio performance you need to understand the sausage factory, including both the investment process AND the operational processes in place.

I know what you’re thinking—operations are boring. The sexy stuff is how people come up with their brilliant investment ideas. Unfortunately, the operations and business side of the fund are not trivial matters; research has shown that over half of all hedge fund blow-ups occur due to operational issues that have nothing to do with the investment process. As unappealing as it is to try to figure out the nuances of how Net Asset Value is calculated and reconciled with the fund administrator, it’s even less appealing to lose a billion dollars because you didn’t take the time. (Yes, turning over every stone means turning over the ugly ones too.)

I’ve seen institutional investors pass on funds for reasons which may not be immediately obvious problems to a new hedge fund investor. Below are some examples. If you can think through the issues or potential issues with each real-life scenario below then you are off to a good start:

A small fund required a single signatory on cash transfers.
A fund had legal entities for their marketing, deal sourcing, and investment divisions of the firm.
A large, well-known fund has used a big-4 firm as their auditor since inception, and worked with several offices of the firm over the course of their relationship.
The same fund in #3 managed their fund administration internally.
A fund was down 3% one month.
A fund had rehypothecation agreements in place with their Prime Broker, a major, well-respected Wall St. bank.

I imagine some of the above might not even sound like English. So what does it mean and why were these all problems for the prospective investors?

Single signatory. Like any other business, embezzlement can be a problem for hedge funds. Requiring a single signatory to move cash, particularly for a small fund, means that a founder/key employee can potentially loot the place without limits. It’s not unheard of for a business owner to get served divorce papers then decide it’s time for an early retirement in a tropical, non-extradition friendly country. On a less major scale, an employee may embezzle smaller amounts systematically over time. Hedge funds generally have much higher asset liquidity than traditional businesses, and therefore cash stewardship is of utmost importance. For these reasons, institutions usually require double signatories on cash transfers, often with one signatory being a credible, independent fund administrator.
Multiple legal entities. Separate legal entities are put in place to limit liability (and potentially transparency) between entities. Whenever a manager puts legal shields in place between different operational aspects of a fund the investor should have a very clear understanding of why that is the case. In this case the reasons didn’t pass the smell test, and were likely in place to obscure important information for investors.
Using several offices of the same accountant. Accountants understand the concept of multiple legal entities all too well. For example, each office of PWC may have its own separate legal entity which protects the greater organization and other offices from shared liability. In other words, working with 3 different offices of the same firm can be like working with 3 completely different firms. Another fact about accountants: If they find a problem with a fund (or a company) they will often resign rather than report their suspicions. In this particular example, 3 offices of the same accounting firm resigned over the course of the life of the fund. Unfortunately, most investors just thought: “Well, the manager has used a credible firm since inception, therefore it’s all kosher.” Wrong.
In-sourced administration. Approximately 90% of all hedge fund frauds would be eliminated through use of a credible outside fund administrator to manage valuation, NAV reporting, subscriptions/redemptions, and the back-office functions of a hedge fund. Madoff (again) in-sourced his administration. He couldn’t have reasonably pulled off his fraud had he used a credible outside administrator.
Fund down 3% in a month. This by itself isn’t a problem. Some funds have high volatility and +/- 5% or more in a month isn’t unusual. The problem was that this particular fund’s investment strategy was expected to generate a slow, consistent half percent a month. A drawdown in one month of 3% in the context of that strategy was a red flag. The next month the fund was down 9% and subsequently lost another 20% before shutting down.
Rehypothe-what?? Rehypothecation is when the fund lends their securities to their prime broker. The broker can then use the securities as collateral to lend against, and will generally pay the fund a small fee in return, which helps lower the fund’s brokerage expenses. Here’s bottom line: When Lehman Brothers went bankrupt, this small distinction determined who ‘owned’ the assets. It was the difference between blow-up or solvency for many funds. (Literally billions were lost or saved over this nuanced operational detail.)

In addition to operational processes, the investor must understand the investment processes in order to get a sense of how the fund’s portfolio is constructed. How does the manager source ideas, and what does their own research consist of? What kind of risks does the fund take? Risks such as currency, security, sector, market, interest rate, volatility, and countless other risks can be a part of the portfolio construction process. How does the manager make sure they are adequately compensated for those risks? How do these risks fit into the investor’s broader portfolio? Professional portfolio managers must account for all of these factors with the funds they invest.

Performance.

On every disclaimer on every document you will read from a hedge fund it will say: “Past performance is not indicative of future results.” I’m generally not a fan of legalese but this bit should be taken as gospel. Historical returns are in the past, and without understanding them in the context of the strategy, the risks taken, and the changing nature of the strategy in the market then those returns are meaningless. Statistics lie. At the very least they can mislead: Did you know that the Vatican City has 5.9 Popes per square mile? True fact.

Lets go through another quick example. If a manager tells you “we returned 100% last year.” Are you:

(a) Excited

(b) Interested

(d) Overwhelmed by feelings of inferiority over your own lousy returns

If the answer is anything other than lots of ‘c’ with a little bit of ‘b’ then you need to learn more about what performance means. (If your answer is ‘d’ I suggest yoga.)

Performance needs to be understood in context. What risks did you take to make 100%? What is the volatility an investor can expect on those kinds of returns? (No matter how great your returns are, you only need to lose 100% once to wipe it all out.) Statistics like Sharpe ratios, maximum drawdown, correlation, and volatility can only really be helpful in the context of the market and the strategy that contributed to that performance.

I once met with a manager who returned 142% in 2009 and 55% in 2010. Those were eye-popping returns, and they had all the right service providers and statistical ratios to ‘prove’ how credible and great they were.

The manager told me that their whole strategy was to analyze momentum price signals, because “when you focus on one thing all day you get pretty good at it.” They were a complete black box as far as their model and their investment process, but the manager shared one aspect of the model: “When the market goes up we are able to capture those returns, but as soon as the market starts to drop, the model shuts down in order to mitigate any losses.” Classic baloney. (Explanation: Unless you know whether the market will continue to go down or up you can’t determine when to turn the model on or off. He was basically implying that they could perfectly predict the direction of future price action in the market.)

I passed on the fund, and it literally blew up the next month. (To be fair, I didn’t realize it would blow up so soon, though I did know that it would inevitably blow up with those returns coupled with no credible explanation of how they produced them or why they would persist.) The moral is that it’s hard to find an edge and generate consistent returns, and historical performance (whether good or bad) has to be understood in full context.

How come I have to do this third party certification for this Reg D 506C investment?

Answer: It all matters what the syndicator does to market the deal.

506C allows for open marketing but the SEC wants to protect average Joe from doing something dumb so only Accredited are allowed. Thus the 3rd party check.

506B is not marketed and thus a little less scrutiny from SEC. But as the syndicator I have to act responsibly because if I make the wrong call you could get all your money back. Of course this is all predicated on the deal going south and as in sports… winning (a good investment) covers up a lot of things.

How guaranteed is my investment?
How do you know what your doing?
What if I want to back out after a certain time?
How many of these have you done?
How much experience do you have?
How many other investors are there?
How do I know I can trust you with my money?

Previous Topic

Back to Lesson

Next Topic