Multifamily Investor Expo - Feb 15th
On August 18, AltsDb co-founder Jimmy Atkinson hosted Andrew Doup, securities counsel at Kegler Brown Hill and Ritter, to present a live one-hour webinar for financial advisors. The webinar detailed six of the most common pitfalls in passive alternative investments (and how to avoid these pitfalls).
This podcast includes an audio version of the webinar, including a short introduction by Andy Hagans.
Watch On YouTube
- The first steps in evaluating any private placement offering.
- Why offering documents are the only way to review an offering from a legal perspective.
- A summary of the regulatory framework that governs certain private placement offerings.
- The importance of verifying that a sponsor itself is advised by securities counsel.
- The specific documents that should be included in any “batch” of offering documents (and which of these are considered enforceable contracts).
- How to evaluate sponsor terms and fees (including some surprising variations in how fees, preferred returns, and other metrics are calculated).
Featured On This Episode
- Official Webinar Replay Page – includes downloadable deck (AltsDb)
- Alts Resources For Advisors – includes upcoming CE credit webinar schedule (AltsDb)
Today’s Guest: Andrew Doup, Kegler Brown Hill + Ritter
About The Alternative Investment Podcast
The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.
Jimmy Atkinson: Welcome to today’s AltsDb webinar, “6 Pitfalls To Avoid In Passive Alternative Investments.” Today’s webinar is sponsored by Kegler Brown, and our presenter today is Andrew Doup, attorney at Kegler Brown. And Andrew is counsel to founders of new and emerging businesses, real estate developers, fund managers and private investors.
And he specializes in corporate and business law, mergers and acquisitions, real estate. And I know him from opportunity zones, he’s also an opportunity zone specialist, as well. And he comes to us today from Columbus, Ohio. Andrew, welcome. Thanks for coming on, today. We’re going to get to you and your presentation momentarily. But first, I just want to let everyone know that, first of all, yes, this webinar today is being recorded.
We’re going to circulate a recording of this webinar to everyone by tomorrow. Also, this webinar has been accepted by the CFP Board for one hour of continuing education credit. So, if you hold a CFP designation, and you’d like to receive your CPE credit, we have a quiz for you to take at the conclusion of today’s webinar. And we’ll let you know how you can take that quiz at the end, but we need to have you stick around to the very end, please.
Finally, we want this program to be somewhat interactive, so if you have any questions for Andrew throughout the course of today’s presentation, please use the Q&A tool in your Zoom toolbar, it should be at the bottom of your screen typically. We’ll save some time for questions at the end of the presentation. But with that said, Andrew, welcome, and thank you for joining us today.
Andrew Doup: Thanks for having me, Jimmy. And good afternoon. Really happy to speak to your audience about this topic, as you and I have discussed, alternative investments are becoming increasingly accessible to private investors. And that’s as a result of regulatory changes by the SCC, facilitating capital formation for business ventures in the middle market.
So, more and more, we’re taking on investors as clients who are presented with exciting opportunities to place their capital in these private investments. And so, I thought, well, how relevant and how timely it would be to cover some of the most common pitfalls that I see when we’re conducting due diligence.
Jimmy Atkinson: Yeah, we want to avoid those pitfalls, right, and conducting due diligence is really key before making any investments in passive alternative investments. So, well, let’s dive in, Andrew, feel free to share your screen and take it away, the stage is yours. And again, for those just joining, we are going to save some time at the end for some live Q&A.
So, if you have any questions throughout the course of the presentation, please do use that Q&A tool in your Zoom toolbar. We’ll be sure to save those questions for the end, and we’ll get to as many of those as we can. Andrew, I can see your screen just great, looks fantastic. Go ahead.
Andrew Doup: Awesome. Great. Okay. So, you know, I think the best place to start this conversation is, you know, say, Jimmy, you know, you have a friend or an acquaintance who is talking to you about the opportunity to invest privately into their business venture, whether it’s a real estate project, or an operating company, they’ve sent you a pitch deck, and you’ve reviewed the pitch deck.
You’ve talked to the sponsor, and you like what you’re hearing. So, you know, the question is, what do you do next? What are those next steps? And, you know, my response would be, well, you want to be 100% sure that you know what it is you’re buying.
There’s only one way to do that, and that’s in asking the sponsor for the offering documents. And the reason why is because the offering documents are the instruments that create that legally enforceable contract among the sponsor, the investors, and the business entity, which is referred to as the issuer in a securities context. And so, that issuer is who is issuing a passive ownership stake in exchange for your investment.
So, while the pitch deck may look great, and the sponsor has given you assurances about the investment, the offering documents are actually the only way to verify whether your expectations as a passive investor are legally enforceable. So, my practice is to summarize the key terms of the offering into an investment abstract.
And for anyone who’s viewing this webinar, feel free to reach out to me, I will send you an example of what an investment abstract looks like. But it’s basically a summary that contains columns for you to review the offering documents and summarize the key terms that we typically outline.
Okay, so, you know, taking a step back, what is the regulatory framework for these alternative investments? These aren’t public registered or publicly traded securities. However, there is still a regulatory framework that these issuers and the sponsors need to comply with. The general rule is that the offer and sale of passive equity interests are governed by federal and state securities laws, meaning sponsors have a legal obligation to disclose to prospective investors the terms of the offering, as well as any risks that are material to making an informed investment decision.
So, sponsors that provide information whether it’s a pitch deck or a business plan, or an email, for that matter with misrepresentations, misleading statements or material omissions are subject to civil liability and criminal prosecution. So, this underscores the importance of verifying that the sponsor itself is advised by securities counsel. So, when you ask the sponsor for the offering documents, you may receive one or all of the following materials.
The first one is what’s referred to as a private placement memorandum or a PPM. This is the legal instrument that’s used to disclose the terms of the offering and also the risks that are material to making an informed investment decision. You may have already received a business plan, this may come in the form of a pitch deck, or executive summary, or financial projections.
This is not a legal instrument, so it’s not an enforceable contract. But you’ll want to ask for the most current financial projections if they’re in there, because underlying assumptions can change during the term of an offering. The subscription agreement, in contrast, is a legal instrument that is used to close on your investment, but also to allocate the risk of securities liability away from the sponsor and onto you as an informed decision maker.
The subscription agreement will contain investor representations and warranties, including that you as a purchaser are an accredited investor, that you’re purchasing for investment and not a view for resale, and that you’re making an informed investment decision based on your independent evaluation of the PPM. Finally, the operating agreement, this is also a legal instrument, it governs the relationship of the sponsor and the investors as business partners, as well as their respective duties and rights to the issuer and to each other.
So, of these four deliverables that you may receive when you ask for the offering documents, the business plan is the only document here there’s not a legally enforceable instrument. And of the legally enforceable instruments, the operating agreement is the most important because that is a contract that actually governs the terms of the partnership.
Okay, now, you may be thinking, “I’ve seen offering documents, and they can be a stack of papers that easily exceed 100.” Don’t be discouraged, a lot of it is boilerplate, but there is also a lot of information in there that needs to be analyzed and synthesized, and that’s where the investment abstract will prove useful for you.
So, don’t be discouraged. What we’re going to do for the remainder of this webinar is just break down the important terms that you should be focusing on when reviewing the offering documents. And we’re going to break those down like this. All right, so you’re going to be primarily looking for three key terms. Those are terms that govern money, power, and responsibility.
Okay, so first, money, right. As a passive investor, you are primarily interested in verifying whether the operating agreement is consistent with your economic expectations. Economic rights are governed by provisions on cash distributions, tax allocations, and guarantee payments, or otherwise put, fees that are paid to the sponsor.
Okay, so, let’s talk about cash distributions. If you’re investing for cash flow, then you want to locate provisions in the operating agreement that govern how net profits will be shared among the partners. Typically, the sponsor will reserve discretion on timing of cash distributions for when the project can afford it, and only after payment of expenses and budgeting for contingencies.
The surplus is then distributed pursuant to typically a distributions waterfall, it may be pro rata in proportion to percentage interest. But if there’s a distributions waterfall or if the pitch deck promises a preferred return of some annual percentage to investors, followed by return of investor cash, then that is a distributions waterfall, ultimately ending in some sort of profit share between the sponsor and the investors as a class, or one or more classes.
More complex waterfalls will include one or more hurdle rates with adjusted profit splits as well. Okay, so staying on the topic of money being a key term, after economic expectations, you’re going to want to take a look at provisions that govern tax allocations, especially if you’re investing for passive tax losses, which in and of themselves have a lot of value for investors who may have high, you know, taxable income through W-2 wages.
You’ll want to make sure that you locate these provisions and identify how profits and losses are allocated among the business partners. Typically, items of profit and loss are allocated proportionate to cash contributions. However, this isn’t always the case, for example, if the sponsor is taking a promote or a share of upside as incentive compensation for services performed.
So, you know, pro tip number one here, if your expectation… Well, let me backpedal a little bit, there’s one more we need to cover, that’s sponsor fees. A sponsor will perform certain services to the issuer, that the issuer would otherwise need to pay a third party for, but for those services being provided in house, examples include an annual asset management fee based on the amount of investor equity under management.
If it’s a development project, maybe a developer fee based on the amount of the development construction budget, or even a guarantee fee based on the amount of debt guaranteed to a projects lender. So, if such fees are paid by the issuer to the sponsor prior to cash distributions to the investors, it is crucial for investors to be fully aware of the sponsor’s authority to pay yourself from amounts otherwise distributable to investors, because that can affect your ROI expectations.
Okay, so pro tip number one, we’re ready for this now. If your expectation on money is to receive a preferred return, then make note of when the preferred return will begin to accrue. Sometimes it begins to accrue on the date that you contribute your cash.
Sometimes it doesn’t begin until the project has been titled, sometimes even later, maybe when the project has completed construction. So, just do yourself a favor here and make note of when your pref begins to accrue. All right, pro tip number two also involves a topic of money here.
If the sponsor is taking a promote, then verify that profits and losses are allocated in proportion to cash contributions and not percentage interests. Otherwise, the sponsor is going to be taking a portion of taxes and losses that they’re going to be earning proportionate to the amount of their promote as well, so, you want to make sure that you’re receiving your fair share of profit and loss allocations.
Maybe a good idea if it’s a real estate project, for example, to also ask the sponsor whether they plan to accelerate depreciation deductions, and developers can do that by commissioning a cost segregation study, and so that accelerates the value of pass-through depreciation deductions for those investors who are tax sensitive.
Okay, and then pro tip number three, verify that the guarantee payments or sponsor fees are fully disclosed. Of course, you want to protect yourself as an investor against any hidden fees. You want to make sure that those fees are paid for actual services performed. And then finally, that they’re no less favorable than would be available at arm’s length from a third-party service provider.
And those fees, you know, from a sponsor’s perspective, you know, again, their goal is to fully disclose to you as a prospective investor the terms and risks of the offering. So, they’re going to be very willing to clarify any of these points that are in their offering documents. Okay, so, those are the pro tips.
Those are the issues that we flag on the topic of money. We’re going to switch gears to the next key term, this is what I refer to as power. And what I mean by power is that if the key economic rights that we’ve outlined are consistent with your expectations as a passive investor, then I would say the most next important category of REITs involve issues of control.
In a passive alternative investment, the bargain is fairly straightforward, the sponsor is primarily responsible for a day-to-day decision making as the general partner or GP, also referred to as a manager in the case of a limited liability company. And the investors are passive investors, whether they’re referred to as limited partners, or LPs, or, you know, a class of preferred members.
Passive investors, you know, typically not interested in approval rights on operational decisions, but it’s not uncommon for investors to have an approval right on certain major decisions that could have a material effect on any individual investor or on the investors as a class. And so, one example of, you know, an area where investors may want an approval right is on guaranteed payments or sponsor fees that are, you know, on terms less favorable than would be available from an unrelated party.
So, that would certainly be something you would want to vote on as investors. Okay, so that brings us to pro tip number four. This involves the issue of power or control. Operating agreements typically contain a provision that enumerates the rights of investors to vote on these major decisions, such as whether investors must satisfy additional capital calls by the sponsor.
If, for example, a sponsor aborts the project’s development construction budget, you want to know whether or not you’re on the hook for more than the amount that you invest initially. And if so, whether or not you have a right to vote on whether you need to come out of pocket for additional cash if a project or a business needs it, or if the sponsor needs to look elsewhere to source those funds.
Okay, so while we’re on the topic of power, we’re going to talk about transfer rights as well. Transfer rights govern whether a partner is able to sell its ownership stake, whether to another partner or to a third-party purchaser, if for example, a partner needs liquidity prior to a deal going full cycle.
So, these rights range from a right of first offer or first refusal, they also include what’s referred to as a call option or a put option, could also include a tag along or drag along right. The bottom line here is that provisions that govern transferability of an ownership stake and the issuer will also set forth a purchase price for an early investor exit.
So, that being said, pro tip number five here, generally, or the general rule is that passive alternative investments are illiquid, right. So, you’re along for the ride until either the sponsor refinances real estate syndication, and the project’s existing indebtedness and buys you out, or if the sponsor sells the underlying project or business and everyone gets cashed out.
So, provisions that govern transfer rights are really the exception to that general rule. But if liquidity and the ability to exit an alternative investment is important to you for whatever reason, then that would be an area of the operating agreement to pay attention to. Okay, so we’ve covered…so far, we’ve covered key terms that govern money and power.
We’re going to switch gears now to the next class of [inaudible], I refer to as responsibility. So, money, power, responsibility. You know, in my opinion, probably the most overlooked provisions in an operating agreement involve the sponsor’s responsibility to provide periodic reports to investors. And as an investor, you know, really, since you’re not involved with the day-to-day management or operation of the company, you still want to know, you know, what the investment is doing and what the sponsors are doing, and whether or not their projections are on schedule, the project is on time.
So, if you’ve invested into a real estate project, for example, you want to know whether or not the sponsor is going to keep you apprised of construction progress, lease up, operations. But really, you know, investor information rights can range from a high standard, which could include annual audited financial statements and monthly summaries of the issuer’s activity to a lower standard, where the issuer is promising to provide annual K-1’s only.
So, you know, I would say, you know, the right balance is probably somewhere in between these higher and lower standards, typically involving annual internally prepared financials and a quarterly summary of issue activity. So, once you’ve completed your review of the operating agreement, and you’ve summarized those key terms into an investment abstract, you’re going to be better positioned to compare your understanding of the offering with the disclosures in the PPM, and you know, then compare those to what your understanding was coming out of just the pitch deck.
Now, here’s the important part, a credible sponsor will be responsive to any inconsistencies, but any response that falls short of your expectations as a prospective investor presents the opportunity to, you know, A, walk, B, assume the risk as an informed investor, or C, request a sign letter agreement that modifies the terms of the offering to better align with your expectations.
Okay, and, you know, again, the goal here is to put you in a position where you have the power to choose which of these paths to walk. Okay, so, you know, so that’s a very quick review and summary of, you know, how I approach due diligence when it comes to alternative investments.
And, you know, really the bottom line here is that, under federal and state securities laws, a sponsor is obligated to provide full and fair disclosure. And that obligation doesn’t end when you wire funds. The anti-fraud provisions of federal and state securities laws apply to sponsor conduct through dissolution and winding up of the issuer.
So, that being said, conducting this exercise upfront will better align your expectations with what’s actually enforceable. And like in any business deal, an ounce of prevention is worth a pound of remedy. So, Jimmy, I burned through that, which is actually great, because we’ve got a good chunk of time for Q&A as well.
Jimmy Atkinson: You did. Yeah, no, that was great, Andrew. We’ve got a few questions coming in, and I want to get to those questions in just a minute. Again, if you’re joining us late, you didn’t hear my announcement earlier, we do have a Q&A period that we’re going to start here in a moment. If you have any questions for Andrew on how he conducts due diligence for passive alternative investments, what are some best practices, anything that was unclear to you from his presentation, please use the Q&A tool in your Zoom toolbar, or you can use the chat function also, if that’s easier for you.
But Andrew, just to kind of quickly recap those six points that you were trying to make, things to keep an eye on, the six considerations that you really want to have front of mind when you’re reviewing offering documents, you know, number one, you talked about the preferred return, making sure you understand not only what it is, but when it begins.
Number two was the promote, understand how those profits actually get distributed. Are they based on cash contributions or percentage interests? And then, what kind of cost segregation goes into that, are they bothering with a cost segregation? And if not, maybe you should ask why. Number three dealt with guaranteed payments and hidden fees, making sure you understand all that.
Those were the three money issues, right?
Andrew Doup: Yeah.
Jimmy Atkinson: And then you got into power issues of number four being major decisions, including potential for additional capital calls, if things don’t go according to plan. Number five was just understanding that alternative investments are illiquid. And then number six was based on responsibility. We had money and we had power, and then number six, responsibility.
Responsibility doesn’t end when your wire hits, but the sponsor needs to communicate with you what is happening with the investment through the course of annual financial statements, quarterly summaries. That was the example you gave in terms of what you’d like to see, sometimes the burden is a little bit higher, sometimes a little bit lower, but you think that’s a good balance.
Did I do a fair job of summarizing those key points there?
Jimmy Atkinson: Yeah, yeah, you got it.
Andrew Doup: Good.
Jimmy Atkinson: So, we’ve got a few questions here. The question coming in asks, “Andrew, can you elaborate on the notion of the preferred return accruing at different points? It seems really important but I don’t fully understand this.”
Andrew Doup: Mm-hmm, yeah, absolutely. So, the question here is, you know, if you’re being offered a preferred return on the amount of cash that you’re putting in, and this is pretty common if you’re a passive investor, right, since you’re not involved with day-to-day management of the venture, you’re going to be somewhat insulated from risk by having a return that is preferred to the folks that are.
And so, the question is, you know, on what date does that pref begin to accrue? If I give you, Jimmy, $100 today, obviously, if you’re undertaking a new construction project, you’re not going to be able to pay back or begin paying down that preferred return of say 10% until the underlying investment, the asset itself begins generating revenue.
So, what happens to that pref, to that promise to pay a certain percentage above the amount that I put in during the interim period? When does it begin to accrue? Does that 10% in this example, does that begin to accrue on the date that I invest my $100 with you?
Or does it not begin to accrue until a later date, such as when the construction has been completed, or the project’s been leased up, or even later when the project’s been stabilized? So, reviewing the offering documents, the operating agreement specifically will give you the answer to when that preferred return will begin to accrue.
Jimmy Atkinson: Yeah, and that oftentimes will just depend on the type of investment that you’re getting yourself into. If it’s an investment into a stabilized, already cash-flowing asset, you should see the preferred return come through immediately, right? But if it’s new construction, or significant value add or heavy rehabilitation, you know, you should understand that it might be several years before you see cash flow, before you see any type of preferred return.
Am I understanding that correctly?
Andrew Doup: Yeah, yep, that’s right. Yeah, it’s going to vary. It’s going to vary by asset class, also vary by the business plan. And to your point, Jimmy, it can vary, you know, in the stage of, you know, if it’s a real estate project, in this example, the stage that you’re coming into that project’s development and operation.
Jimmy Atkinson: That’s a good point too, the stage at which you come in. I’m very familiar with opportunity zone deals, Andrew, so just to kind of talk about opportunity zone deals for a minute, those are always opportunistic type deals where it usually takes several years before the asset actually starts cash flowing, because, by definition, they have to be either new construction, or heavy rehabilitation.
But if you come in a little bit later, if you come in in year two or year three, you’ll get that cash flow much more quickly, although typically, you have to buy in at a much higher share price than somebody who came in, in year one. So, just some different considerations there. Moving on to the next question here. Brandon asks, “Andrew, do you offer services that involve reviews of the legal documents, PPM/operating agreement, associated with LP investments, essentially looking for assistance to ensure the pitch deck resembles the wording in the 100+ pages of legal docs?”
So, that’s another key thing, right? Sometimes the pitch deck and the actual legal docs, there might be a little bit of mismatch, do you offer that type of review service?
Andrew Doup: Yeah, absolutely. And, you know, really, I think it would be important for a lot of investors, if you’re considering placing your capital with somebody, and you know, you have a pitch deck, which you know, is going to be a lot easier to communicate, you know, what your expectations should be. But if you’re also given a set of offering documents, you know, again, it can be intimidating to, you know, attempt to, I call it stirring concrete with your eyelashes and working through those documents.
So, oftentimes, it’s much more efficient to hire an advisor to review those offering documents for you, so that you can discuss not just with your counsel, but you know, also with your tax planner and your wealth advisor, whether or not that specific investment opportunity would advance your own planning goals.
Jimmy Atkinson: Yeah. So, I would say if you’re an investor and you want to review docs, Andrew can help you with that. But if you’re an operator or a sponsor, Andrew can likely also help out with making sure that your pitch deck and your operating docs do line up one-to-one.
I wasn’t sure which point of view Brandon was coming at there, but I’m sure Andrew can help you out no matter who you are. We’ve actually got several questions now that have come in into the Q&A, so thanks to everybody for all those questions, we’re going to try to get through as many of these as we can. We’ve got another…we’ll probably go for another 20 or 25 minutes here with some Q&A before we cut you all loose.
And I’ll be sure to let everybody know how they can take that quiz for CE credit if you are a CFP holder. Our next question is, “Would a side letter apply just to me or does it amend the terms to all investors?” So, an investor coming in, getting a side letter, what’s your thought there, Andrew?
Andrew Doup: Yeah, yeah, so let’s talk about side letters. A side letter is an instrument that is used to create an exception to the general terms of the offering. And typically, these are used by the sponsor to induce participation by an investor who’s willing to write a larger check, maybe in exchange for that higher level investment, the investor wants additional rights that aren’t being offered to the other investors.
And so, a side letter agreement is the instruments that is used to pay for that agreement. And as an investor, it would apply only to the person requesting it, whether you’re an individual writing a larger check or you’re a group of prospective investors whose participation is contingent on achieving this certain concession, whatever it is, maybe it’s…you know, it can be economic, it could be a greater share of a profit split, maybe it’s not, maybe it’s just additional information rights that you would want, that isn’t being offered to other investors.
Or, you know, maybe like we mentioned during the presentation, it’s a transfer right. It is a right for you to accept the investment and achieve liquidity when you want it. Those exceptions to the terms of the offering, you would contract for in a side letter agreement, and they would apply, you know, again, either to you as an individual requesting it, or to a group of investors who are rallying around that common cause.
Jimmy Atkinson: Good answer there. So, I guess the answer could be either or, in that case, but typically could apply to just the one single investor or group of investors. Next question is, let’s see, “Is it common for investors to have the ability or right to physically visit the properties in the portfolio? This would be more applicable to real estate investments, but I guess maybe would apply to operating businesses as well.”
Andrew Doup: Yeah, so the answer is, generally you have as an investor, as a member of an LLC or a partner in a limited partnership, you have a legal right to inspect the books and records of the partnership or the LLC at the principal place where those records are kept. So, if they’re not kept at the site that is the subject of or the beneficiary of your investment, then no, you wouldn’t have that right as a matter of law.
So, if that’s something that’s important to you, to have that right, I would encourage you to speak with the sponsor about it. Sponsors that I work with would all be thrilled to know that their investors have any interest in an on-site visit.
Jimmy Atkinson: Yeah, I was going to say, I guess the right doesn’t legally exist, but anecdotally, most of time when I talk to sponsors they want to bring investors or potential investors to their sites to show them off and to get them more excited about. So, I guess in that case, do reach out to the sponsor and ask, and you’ll most likely get a yes. Let’s see next question here.
“When private investors start looking at these types of investments, what kind of timeline or timing have you seen from idea to actual investment of funds? How long from idea to investment, knowing it’s objective, but do you have an average?”
Andrew Doup: No, I can’t give you an average, because, you know, each offering is different. And they can be different in terms of timing of the underlying asset that is being invested into. So, you know, for example, say you’re working with…say the sponsor is an entrepreneur who doesn’t have a real estate project, but they have a business plan, and it’s going to disrupt, you know, a certain industry, but they need cash to capitalize it, you know, to bootstrap its initial operating budget.
We might refer depending on how early you are, or how early that sponsor is, and the development of that business, we might refer to that as a seed round of equity. And, you know, typically progression goes from a seed round of equity in the case of a startup or maybe even in the case of real estate a pre-development round of equity to a later round, which you know, which is where the sponsor is raising that round in order to finance whatever phase of development that business or that real estate project is in.
So, the answer to your question is, it can really vary, just depending on where the sponsor is in their development timeline.
Jimmy Atkinson: Yeah. Yeah, there’s no real average there. No two private placement offerings investing in underlying alternative investments are alike really. You know, sometimes you’ll have maybe a single asset project that they’ve identified the asset, and they have already acquired it, and typically, in that case, it could be pretty quickly from ideation to actual capital deployment.
Other times you’re investing in a multi-asset, blind pool fund of different assets that might be spread all over the country, they might have a pipeline, but it might take years before the actual capital raise gets deployed at the 100% level. Just I don’t know, just some additional thoughts for me there. So, kind of a tough question to answer, not really a one-size fits all answer there.
Let’s see. Next question coming in, “What kind of background or due diligence would you recommend the potential investors do on the people/firm they’re looking to invest with outside of what you mentioned today?”
So, I guess, when it comes to the actual people behind the operating firms or sponsor firms, what do you like to look at, Andrew?
Andrew Doup: You know, so if you’re conducting what’s called a Reg-D offering, then there is a requirement that, you know, anyone involved in sponsoring that offering is not subjected to what’s called bad actor disqualification. And what that means is that they have a clean securities record, they don’t have any history of, you know, conducting shady business or mishandling investor money.
So, at least for all of my sponsor clients who are undertaking Reg-D offering, we run a bad actor disqualification check. Because, you know, if they come up in a record search, then they’re going to be disqualified at the outset from being able to rely on Regulation D exemption to even conduct an exempt securities offering.
And so, I know that’s not very helpful from an investor’s perspective, but where it may be helpful is if your sponsor is relying on Regulation D, then they are also making representation to you and to all their investors that they are not subject to this bad actor disqualification, except as otherwise disclosed in the offering documents.
Jimmy Atkinson: Gotcha. That question dovetails nicely to a question we just got in from Khalil. This person asks, “Other than a simple Google search, what are some of the best ways to do a background research and checks on fund sponsors and operators, looking for violations, fraud allegations, etc.?” And he asked, do you know of any specific websites to check?
Andrew Doup: You know, as a law firm, we use a third-party service provider, and there are a number of them that are out there that conduct those checks for you. And then, you know, outside of that, you know, I think what’s also super important is asking for references from your sponsor. You know, if this isn’t their first equity raise, then they shouldn’t hesitate to provide references to you to speak with other investors that have previously participated with them.
And if it is their first equity raise, then that’s certainly something that you would want to take into consideration as part of your risk reward analysis.
Jimmy Atkinson: Yeah, if it is their first equity raised, then at least have some sort of track record with their own money or with friends and family money, that would be an important question. And then one other thought comes to mind, and this is not always the case. In fact, it might rarely be the case, but if anyone on the team is a FINRA registered broker dealer, you can typically find them on BrokerCheck.
You can do a Google search for BrokerCheck, and they’ll have a pretty thorough history of any potential violations that they’ve run afoul with FINRA. I don’t know if there’s anything else like that that you might use, Andrew. But maybe we’ve exhausted our thoughts on that question.
Andrew Doup: I mean, you know, what I’ll add is it, you know, in the results that we get back on our, you know, bad actor disqualification check, you know, we’re looking at court filings, we’re looking at police reports, all of that stuff, and, you know, again, most sponsors are aware of this bad actor disqualification requirement before undertaking a Reg-D offering.
And if they’re not, you know, then it doesn’t take them long to become aware of it, because it’s a clear bright line rule. But there have been some instances, you know, in my experience where that background check has really been critical to determining whether or not a prospective client can even rely on the Reg-D exemption.
And the SCC has it as a rule for a reason. If you don’t have a clean securities record, then, you know, that can pose some problems for prospective investors.
Jimmy Atkinson: Good thoughts there, Andrew. Thank you. And hopefully, we answered those two questions that came in. Next question is, “Andrew, can you elaborate on some common ‘red flags’ that an accredited investor should watch out for when evaluating various private placement offerings?” So, I think that was kind of the bulk of your presentation today, those six tips or six pitfalls to avoid, but I don’t know if you wanted to highlight any additional red flags to look out for.
Andrew Doup: Yeah, you know, and I wouldn’t necessarily say that, you know, my presentation cover the red flag. I mean, those aren’t red flags, per se. They’re just, you know, pitfalls to be aware of. But, you know, red flags, you know, in my mind, would, one, be this, you know, whether or not the issuer has a clean securities record.
And so, I think that previous conversation would definitely be a, you know… I would categorize as a red flag. But outside of that, you know, you want to make sure that when you’re evaluating your sponsor, and this is part of due diligence, but outside of the offering documents, you want to ensure that they’re available to answer questions that investors have, and that they have referrals or folks that you can speak with, that have invested with them in the past and are willing to…and that they’re willing to provide you their information.
And that relates back to prior performance, what does their track record look like? Do they have a team around them or is this one person? If it’s just one person, that’s not necessarily a red flag, but you know, what happens if something happens to that key person that renders them unable to perform their day-to-day duties?
Is there a backup plan in place? Do they have a team around them? Do they have someone who assume those responsibilities? So, those are some of the more common considerations that investor clients have.
Jimmy Atkinson: Okay, good thoughts there. Here’s a question for you. This this might come across as somewhat controversial, we’ll see what you have to say about this, Andrew. This person says, “I’ve got a question about the allocation of profits and losses. Wouldn’t it actually be good to be allocated a lower portion of the profits and losses? Initially, you would get a lower portion of losses passed through, say in years one through five, but then a lower portion of profit once the investment starts cash-flowing. What are your thoughts on that one?”
Andrew Doup: I mean, my immediate response is it depends. I mean, every investor has different investment objectives. So, if you’re sensitive to tax yield in alternative investment, and you have high taxable income, then you’re probably going to want to take as much losses, paper losses, tax losses as you can, as soon as you can get them.
Now, if you’re, you know, a tax-exempt entity, obviously, that that doesn’t matter to you, so, less relevant. I’m not sure if that answered the question, Jimmy. What do you think?
Jimmy Atkinson: I think it answered the question. I guess it’s another case of well, it kind of depends. It depends on what you’re looking for as an investor. That was kind of what I was thinking in my head too, Andrew, was, well, yeah, you’re going to have… You know, if you’re letting your tax liability kind of determine your goals, then yeah, I guess you would want lower cash flow paid out to you. So yeah, it depends.
I think you answered it just fine, Andrew. Let’s move along to the next one here. This is a follow-up on the pref accrual issue. “Isn’t it correct that a pref can start accruing at an earlier date even if it won’t be paid until a later date, i.e, it could start accruing immediately and accrue during construction but not be paid out for several years?”
So, can you touch on some of those finer points there?
Andrew Doup: Yep, yep, 100%. And that’s what we mean by accrual. You want to know as an investor when that prep begins to accrue, you know, again, whether it’s on the date that you write your check, or if it’s at a later time, such as when the project has completed construction. Even if it’s not paid, you know, until stabilization, just being sensitive of those different timelines, you know, I think is really what’s most important.
Jimmy Atkinson: Yeah. So, if you have or if the sponsor has an 8% pref, let’s say, let’s say the carry doesn’t kick in, the 80/20 split typically doesn’t kick in until the sponsor hits an 8% pref. Let me see if I can do this math in my head properly, I don’t have this backwards. I guess as the investor, you want that pref starting to accrue as soon as possible if it’s not cash-flowing yet, because that would kind of sandbag the actual accrued return once it does start cash-flowing.
I mean, do I have that right or?
Andrew Doup: Yeah, yeah, that’s right.
Jimmy Atkinson: Okay. Because then if the… By the way, I’ve always found…you know, I run OpportunityDb, deal a lot with opportunity zone, qualified opportunity fund investments, and I always get questions about fees, you know, “What are the fees of this one versus that one versus that one?” And I just have to say, you really need to look into the offering documents and really talk to the sponsors, because it is so difficult to compare fees across different opportunity zone funds, and that’s just from my world.
I’m sure it’s similar just broadly with Alts, broadly with private placement offerings. It can really be an apples or oranges comparison, I mean, even a 8% pref and an 80/20 split, you look at that across three different private placement offerings, and it might mean three different things just based on the timing of when the pref starts accruing.
So, that’s yet another way you can get tripped up. And I had never even thought about that before, Andrew, so I’m really glad you pointed that out, I learned something new today from your presentation. We got a few more questions here, and then we’re going to wind things down. I’m going to share on my screen right now while we get to these last few questions. So, I’m going to take over screen sharing from you, Andrew, here for a second.
Let’s see. I’m going to share on my screen. If you do have a CFP designation, first of all, thank you for attending today, and you do need to take a CFP CE Credit quiz, you can find that quiz on altsdb.com/advisors. If you’re not watching this on your phone, you can use your phone to also scan that QR code, it’ll take you to the same place.
So, if you want to type in the URL or scan that QR code, totally up to you. But getting back to, let’s see, those last few questions here. Let’s see, we answered that one. We got… Looks like we got two more questions, and then I think we’ll cut everybody loose, unless we get some more that come in. We’ve got a little bit more time left.
But next question for you, Andrew, is, “Is the preferred return calculated on a compounded basis, and is this number legally required to be computed in any particular way?”
Andrew Doup: That’s a great question, because that’s…it is a nuanced deal term. And for the benefit of the broader audience, you know, the question here is, I’m being offered a preferred return, but is that at a simple rate or is it at a compounding rate?
And the answer is, it depends on what the operating agreement says. So, you know, another…that may be pitfall number seven, Jimmy. You know, when you’re preparing your investment abstract, you want to make note if that preferred return is compounding or non-compounding.
Jimmy Atkinson: Yeah. And yet another way that comparing different private placement offerings can be an apples to oranges exercise, that’s interesting, too. That’s a great question. Thanks for that question. Last question from our audience here, “Is there a standard when it comes to the pref…?” Well, actually hang on a second, this might be a similar question.
He’s asking a similar question, compounding or non-compounding. “I’ve seen a fund with a 12% non-cumulative pref, which, when I did the math, was roughly equivalent to an 8% cumulative pref.” So, we may have already answered that question, I didn’t see that before. But that’s another instance of yeah, they can compound differently, so make sure… Pitfall number seven, hidden pitfall number seven, I guess.
Andrew Doup: That’s right. That’s right.
Jimmy Atkinson: We have to change the name of this presentation.
Andrew Doup: I’m going to add another question to the quiz now, Jimmy.
Jimmy Atkinson: Excellent. I’ve got a question for you, Andrew. What’s… Maybe you can give some examples of some of the craziest offering documents you’ve seen, what are some of the examples of some of the craziest or red flag type things that you found buried in some PPMs that you’ve uncovered over your time?
Andrew Doup: You know, nothing immediately comes to mind, Jimmy. I mean, you know, what’s great about alternative investments generally, right, is that, you know, sponsors that are undertaking these business ventures, you know, usually have really cool ideas, but they don’t have the capital to, you know, to finance their ideas.
And so, that’s generally speaking if you’re talking to a sponsor about an alternative investment, and they’ve gone through the trouble of hiring securities counsel and putting offering documents together, then, you know, you’re going to be in a decent spot, right? If there are any crazy things that I’ve seen, it’s in sponsors who try to DIY their offering documents.
And, you know, again, it is…it can really… The issue with that is, you know, you can really create some onerous securities liability risk for the sponsors. So, you know, I know that’s not as juicy of a story, Jimmy, as you’re probably hoping, but that’s probably, you know, the biggest red flag and tragedy that I see, is sponsors who are, you know, maybe even unwittingly exposing themselves to securities liability risk.
Jimmy Atkinson: Yeah. So, maybe a good rule of thumb there. But by the way, that was a great answer, because you know, it brought up one good rule of thumb when you’re as an investor doing due diligence on any potential deal, if you see someone who has tried to DIY their own offering documents and hasn’t employed or retained the services of a legal professional with some experience in constructing private placement offerings, you might consider running, not walking away from that deal, because there’s probably a lot that could go wrong with that deal and some legal liabilities there as well.
Well, that’ll wrap it up for today. Again, if you want to learn more about today’s presentation, if you want to take the CFP quiz for CE credit, if you want to download some of our free resources, and we also have an upcoming webinar coming up in a couple of weeks that will look at best practices for Delaware statutory trusts, you can learn more about all of that at altsdb.com/advisors, or you can scan that QR code there on your screen.
Andrew, before I cut everybody loose, thank you so much for joining us today. Thank you to all of our attendees as well. Before we go, can you tell our attendees how they can get in touch with you, how they can learn more about you and Kegler Brown. And if you have a slide with your contact information on it, feel free to share that now as well.
Andrew Doup: Yeah, absolutely. You can find me online, Andrew Doup. And my firm has a website as well, and you can find me there or on LinkedIn.
Jimmy Atkinson: Fantastic. Well, thank you to everybody for attending today. If you have any follow-up questions for us that we didn’t get to, you can always email us, [email protected] I’ll cut everybody loose there. Andrew, again, thanks so much today, it’s been a pleasure. Thank you.
Andrew Doup: All right. Thanks a lot, Jimmy. Happy to be here.
Jimmy Atkinson: Take care, everyone.