Questions to ask syndicators to prove they are not running a Ponzi scheme?

Question

I've been diving into research about being an LP (limited partner) on many types of syndications, multifamily being the most common. As everyone knows, anybody who started a syndication in the last 5 years made money, so it's hard to tell good operators from bad.

As J Scott has said in podcasts, if you're good enough at P&Ls and spreadsheets you can fool your investors. Many of the multifamily syndicators do so many deals, it would be easy to money from the latest deal to be going out the door to pay investors of the older deals, aka a Ponzi scheme.

How can I specifically protect myself from this danger? I know the operator is the most important part of the deal and you can google and full on background search them for shady dealings, but is there a particular line item that would be a red flag in their financials?

Thanks.

Taylor L. · Answer

Since you asked for a metric - the metric that LPs do not put enough weight on is DSCR. Too many folks just zoom right past the financials and look at return projections. DSCR is the key measure of whether you're able to pay the bank with incoming rents.

Now, if someone is absolutely dedicated to lying and is fabricating financials, it's going to be very difficult to sniff that out by looking at the numbers before it blows up. At least for those who aren't forensic accountants.

IMO there isn't one silver bullet red flag that is the end-all-be-all of "here's what to look for to catch a scam." DSCR is important, but it's not everything. It all matters in context, and it's not just fraud that you need to be on the lookout for. Well meaning newbies can do bad deals, too. Even experienced syndicators can do bad deals!

We do background checks on everyone we invest with, in addition to office visits and site visits. We also use CrowdCheck to review every deal. I don't invest with newbies or young guns still early in their careers. The young guns can mean well, but may make poor decisions and don't have the personal balance sheets to support their deals before resorting to capital calls.

Andrew Davis · Answer

@Taylor L. makes some great points, having a good understanding of underwriting and property financials will be very helpful.

I've raised a bunch of capital over the last few years, and I can tell you a lot of folks overcomplicate this. As an LP you need a high degree of confidence in two areas: integrity and competence.

Integrity: Will the sponsor do what they say they're going to do? Are they transparent and forthright in their communication.

Competence: Do they know what they're doing? Do they have the experience, team, and knowledge to steward your capital well.

To a degree these are value judgements on your part, but there are a few things that can really help answer these questions:

- Do they provide 3rd party audited financials? This will verify their track record and also their willingness to be transparent.

- How long have they been in business? The longer the better obviously, especially in a particular niche.

- How and when are they compensated? Their fee & promote structure will tell you a lot about them:

High fees and sponsor weighted promote structure means they get paid regardless of how the deal performs. I've seen acquisition, asset management, and disposition fees in the multi-millions - no performance required.

Low fees and investor weighted promote structure generally means they have a long term approach, and they want the investor to win before they do.

Todd Dexheimer · Answer

Audited financials or tax returns from past projects comparing them to what was reported and paid out to investors.

One of the biggest red flags that I see is sponsors raising extra money to then make payments to investors in the guise of being cash flow. If a sponsor raises more money that what they needed, then they should return it as a return of capital, not masking it as cash flow.

Russell Brazil · Answer

"Pardon me sir, but are you by any chance running a Ponzi scheme?"

Evan Polaski · Answer

@Matt W., Ian covers it pretty well.  There are signs to mitigate chances of a Ponzi scheme, but no guaranteed way to confirm it isn't a Ponzi scheme, or won't become one.  Case in point is Bernie Madoff.

I would say, your gut will tell you a fair amount.  As others noted, Audited financials is important.  The bigger the auditing firm, the better.

Syndicators that have multiple layers on their accounting staff (read generally larger companies) will provide some protection, as well.  Again, the more people that have to be in on fraud, the harder it is to pull off.

Going into lifestyle choices of GPs.  If they are driving around in 100k cars and chartering private jets everywhere, that is hard to give up, should things go south.  Will they make questionable financial decisions under that situation?

Just like there is never a guaranteed return in any investment (even T-Bills, technically, have some risk of default), there is no guarantee that a syndicator isn't going to succumb to fraud at your expense.

Jay Hinrichs · Answer

thats a good question.. I worked for a syndicator in the 80s doing land acquisition for them as a broker. End of the day they had about 200 LP 's and when one would have trouble they lent out of one of the good ones reserve accounts and this created a cascading effect that ultimately took the whole company down.. its a slippery slope when you rob peter to pay paul.

I suspect one could ask for audited financials for each project ?

Joe Vesey · Answer

Ask them about a deal that did not go as planned and how they handled it.

Christian Tibok · Answer

"The Hands-Off Investor" by Brian Burke has many suggestions!

Chris Seveney · Answer

@Matt W.

It’s so tough today because a sponsor could have done 10 deals the past 4 years and looked like superstars and now their deal is losing money left and right because of their inexperience in this type of market (let’s be honest a person in a coma would have made $ when we print $5 trillion).

Some things to ask for and understand :

Track record verification report

Audited financials

Key man policies

Do they have D&O insurance

Fee structure

Loan terms

Capital stack (where are you)

There are a lot more than this.

Also another thing some people do is hire a broker dealer who has vetted sponsors to invest through

Those B-D’S do get paid by the sponsor not you but also fall under finra and will get sued by the investor if they were to invest in a Ponzi

Ian Ippolito · Answer

The reality is that there's no way for an investor to protect themselves with 100% certainty that it's not a Ponzi scheme/accounting fraud. And this doesn't apply just to syndications but applies to all investments. Even publicly traded stocks (which are audited every year) can end up being a fraud (and there are many examples of this which happen every year).So unless an investor's going to keep their money under a mattress, all they can do is mitigate the risk. And every investor is different and so there are many ways to do this. Here's what I personally do:1) If there is an audit, that's not a 100% guarantee but it means they at least had to jump through a lot more hoops than a non-audited sponsor (and I feel reduces the chance of fraud by a lot).

2) Most Ponzi schemes prosper during bubbles and collapse during recessions. So (in my opinion), investing only in sponsors that have survived recessions with little to no money lost also reduces the chance.

3) Talk to other investors and see how the sponsor has performed for them in the past.4) I avoid what the SEC calls stereotypical signs of fraud: Sponsors who "guarantee" results when money is really at risk, funds with distributions that are eerily the same every quarter (in an asset class where they should vary) etc.5) I avoid any sponsor who I catch materially mispresenting anything (and doesn't quickly apologize and correct it). This is my "roach theory"...if I see one roach out in the open, then there are probably hundreds that I can't see. For example, Nightingale (which ended up being multi-million dollar fraud) hid the fact that had previous losses on their track record (and didn't correct it for months after investors complained about it...and instead raised more and more money). As soon as I saw that...they were an easy "no" (for me).etc.

Questions to ask syndicators to prove they are not running a Ponzi scheme?

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