How to vet a private placement opportunity & general partner?

Question

Hello. I'm relatively new to BP. While I am currently invested in a few multi family properties, I'm considering my first private placement deal where I'm one of several investors. It's a large deal for roughly 250 units that appears to offer attractive returns as well as a five year exit strategy. I'm considering it to diversity my holdings and to be involved in something that would be well beyond my reach otherwise. On paper everything seems to make sense about the deal. The questions for me are more about trusting the people involved, trusting the projections and getting a grasp on whether everything is as it's being presented. How does an investor on this type of deal verify whether others have actually made their capital contributions? How do you verify if the financials are accurate? I've read up on the General Partner's respective bios (two people) and have spoken with one of them who has an active R/E podcast and has been on BP previously. He certainly understands the business but the track record isn't terribly lengthy simply because the company is relatively young as are the principals. Among other items, I've requested and received a copy of the PPM (Private Placement Memorandum), partnership agreement, the unexecuted loan approval with the lender and have had Q&A's with one of the GP's via email.  While the GP is investing in the deal as well, it's just above the minimum amount of $50k. If anyone can offer insight on the best ways to evaluate this type of deal AND how to determine if the general partner is solid, please advise. Do I need to consult an attorney to review the PPM and partnership agreement? I look forward to feedback from those who have participated in this type of deal or have some knowledge. Thank you.

Jim Groves · Answer

Barry, you've asked a lot of good questions so I'll try to cover them all with the disclaimer that this is how I would do my own due diligence if I was comfortable enough to even spend the time pursuing.  So here goes:

- Verification of funding: This one is fairly easy as the property acquisition would close through a title company, and the title company would need to make sure there is sufficient equity to satisfy the lender requirements.  My concern wouldn't be whether or not the money is there, but where the money is coming from, particularly the GP's $50K.  I've seen situations where the GP throws cash in that they got from some other source, and the money that they represent is theres isn't really.  There is no great way to verify this other than ask for legit account statements showing that they have the ability to write that check.

-Verification of financials: I'm assuming this is an existing property, and as such there should be a rent roll and some reasonable operating statement (even if unaudited). The biggest ongoing operating expense is the property tax.  That can be verified online in most counties.  Utilities can also be verified by contacting the utility company.  Right there you've identified 30-40% of the operating expense.  Insurance can be determined by calling a couple brokers.  You get the picture.  In multi, expenses are the most difficult to underwrite.  Rent is as simple as touring the comps.  I found that most leasing agents for apartments are young and like to talk a lot.  You'll get a lot of good info by touring around with them.  The property proforma is exactly that--a proforma.  It's anybody's guess.  Just question whether the assumptions they make for expense reduction or rental increases sound reasonable.

-PPM/Partnership Agreement: It's probably worth it to have a lawyer look over the partnership agreement just to make sure you know what you're signing up for.  Things like capital calls can be contentious, and know how decisions will be made, dispute resolution, etc.  That reminds me--you should have a decent idea of who the other LP's are as you'll be in bed with them and they may need to write checks.  Make sure they can.

As far as the suitability of the GP/Sponsor, I don't have great ways to determine as how do you really know if the person you deal with is a good person? Google at a minimum. Be wary of embellished predictions.  It's not easy, and I tend to always see the best in people so I should be more skeptical.

Good luck

Jered Sturm · Answer

@Barry Dameshek You are asking great questions. Your instincts are all correct and have had great responses thus far from others. Rather than just repeat those general items that have already been mentioned I can bring a different perspective to the conversation that may make you feel more comfortable vetting this potential sponsor because I am a sponsor in multifamily syndications, a younger one, and also newer to the strategy so very similar to the sponsor you mention. Because of that, I can take this from the other side of the relationship. My opinion is If an investor is considering placing his/her capital there is no correct way to go about their due diligence it because it all comes down to what makes you as an investor comfortable. For example, I have one investor who does financial auditing for a living. His focus, of course, was for us to send him financial information so he could poke through it. Another Investor said you can tell a lot about a man by meeting his wife so I said: "great let's have the wives and us all go out for dinner". My point is asking for whatever makes YOU comfortable is appropriate.

A successful syndication boils down to one thing and that is trust. Will the GP's do what is needed to make sure the investment is successful? From sourcing leads to executing on operations it all comes down to trusting them to get the job done they say they will? Also when s#%t hits the fan will they be the first person there with gloves a broom willing to do whatever is needed to clean up the mess and get back on track because if anyone tells you it will go just as planned their lying I often tell potential investors I am a younger guy and plan to be doing this another 30-40 years. If we do business on a deal this year great if we don't do business for another 5 years because we have to build up that trust that works for us too.

At our company, we view capital a little differently rather than just thinking of it as money coming from someone's bank account we always view it as the time that person had to trade to earn that money. Sure some of our investors have lots of money in the bank but at some point in their life they busted their butt and traded a portion of their life to earn that money so rather than view our investors capital as money to fund the deal we view it as small portions of that person's life they are entrusting us with. I bring this up because if someone raising money has this outlook(which I believe they al should) being asked things like "can you send me your bank statements before and after closing to prove you did in fact invest" or " I want to meet your wife" Or whatever in the world you need to build trust that is what they should be willing to do if they hold the capital they are borrowing to the standard they should.

Best of luck of on your vetting!

David Thompson · Answer

Hi Barry,

I talk w/investors almost daily and raise capital for syndicate sponsors.  This is a common question. I'll add a few comments here.  What does the sponsor have to lose if they are not honest, reputable and interested in their investors being successful ?  A lot !!! Like, go find another career.  Risk being sued, etc.  I like to partner w/folks who have a lot to lose if they aren't honest and interested in putting their investor's interests first.  The more public the GP and the more visible things they are involved in where they rely on their reputation and their clients (whether that be thru coaching, podcasts, being visible on REI social networks, etc) is one thing I look for.

I'm involved in restaurants and a brewery in AZ.  My partner has 5 kids, got his degree in hotel/restaurant management and spent 15yrs in the business before I met him. That said, when I met him, he only had one store that he was running on his own.  So if I said, hey, this guy has only a track record based on one store, I might have run for the hills.  But I took a step back and said, what does this guy have to lose.  Everything !!  He met his wife in the business, has 5 kids, one is working in the business now, has a degree in the area, and worked for 15 years in the business before he started his company.  So, you have to look past the one store that was only up for a few years and say, this guy is "all in"...like Texas hold em....he's got to give every ounce cause he doesn't have a backup plan.  That's who I want to invest in.  As far as some practical things we can tie this to:

1) Check out their public information - Google their names and review.  Any concerns?  Do they have a website?  Polished / professional and aligned w/what you are reviewing ?

2) Ask for 2-3 investor references, folks who've been in a few deals, what's their experience? Communications - frequent, crisp, projects tracking well ?  Most value is created in the first 2-3 year on deals so it doesn't take too long for early investors to start seeing solid returns thru distributions and cash out refinances.  Do they do what they say they would do?  Any changes, do they explain rationale to investors clearly.

3) You want conservative assumption / underwriting / projections.  Market growing rents 6%, project 3% as an example. Ask for sensitivity analysis report - good syndicators should share w/you what happens if occupancy goes to "x" in a downturn, what's my return look like?  If interest rates go here, what does my financing and cap assumptions looks like?  Exit should have higher cap rate than entry as a good assumption.  Stress test and still holding up is the idea here.

4) Clear business plan.  It's not rocket science.  The simpler the better. I especially like deals where the previous operator has put a plan in place and the new owner is simply going to continue it.

5) Ask for a copy of the deed at close and ensure the partnership name (each project usually gets its own naming convention) is on the deed to ensure it was purchased.

6) You don't need to know any of the LPs.  Not sure why that is mentioned.  We have 50-75 investors in our deals, most are all over the place.

7) The PPM - I would get familiar w/it but honestly the attorneys who write these things think of black swan events and GP protections from suits so more confusion than helpful for the average investor. You don't really want to have voting power o/w you may risk being construed as a manager and not limited.  You can have an attorney review it but they can't give investment advice, it will be more to just understand what latitude the GP has, and it's usually pretty wide to cover black swan events.

8) Fees, are they in line w/experience and are returns projected after fees.  Checkout industry standards. Acquisition and asset mgt fees most common (range from 1-3%). Although I'm a big Vanguard proponent for stocks, REI has a lot of weight on the operator and they can make a huge difference in your success, hence I'm not wanting that to be a big deal, just keep it simple.  The simpler the better.  Returns in the 10% CoC and 20% IRR (although getting more challenging is not uncommon in value add deals - 5 yr holds are common).

9) Yes, nice to see the GP invest but honestly, the GP is risking a ton in these deals..call it sweat equity, putting their own net worth at risk even if non-recourse, situations could occur drawing back bad boy clauses that risk the GP's personal finances.  GPs do a ton of deals, good to see some money going in each deal but the GP should be thinking of diversification like anyone else in achieving and protecting long term wealth.

Bottomline, in syndication reputation is everything IMO.  So, if the person is public and they are active on BP, ask the members if they have done anything w/"X" and how its going?  You say the person does podcasts, on BP, just ask ?

Barry Dameshek · Answer

Andrew, these are all salient points. I agree completely that buying anything these last few years would have to make even an average GP money (although in many parts of CA that's become more difficult unless a substantial equity contribution is made).

I intend to check on what their response is to the higher cost / lower rent increase / market decline scenarios.

Thank you for the feedback.

Michael Le · Answer

Basically once enough replacement reserves and working capital is in place to make sure they can run the property, anything left over after expenses and debt service should be paid out as distribution. You should have full transparency such that you should be able to see down to the bank statements if you request it. You are a partial owner after all.

As for projections, you should be doing your own underwriting and determining if the sponsors projections are in-line with what you expect. I've invested in both types before based on my own underwriting. I've invested in deals where the numbers look too good and my underwriting does not match it but my underwriting still shows the numbers are good enough for me. And I've invested in deals where the numbers are leaving much on the table and I think the sponsor is too conservative.

Barry Dameshek · Answer

Michael, thank you for the reply. With respect to the returns the next question that comes to mind is what metrics or levers are typically in place to ensure investors will benefit if the cash flow exceeds projections? In other words, at what point does a typical GP to determine there is "excess" cash flow that should be distributed accordingly?

When I work with borrowers seeking financing, their projections are usually conservative. I know every investor group is different just as every transaction is, but do GP's tend to take the same approach with projections -- under promise and over deliver? The risk of being too conservative could make many investors shy away if they feel the projected ROI is too low, so this could prompt some GP's to take the reverse approach to entice as many investors as possible.

Michael Le · Answer

I'll take a stab at it.

1. You have to decide whether or not those returns are good enough for you. The market is certainly tough and it's harder to get as good returns as in the past. You also have to look at how they are determining their projections and whether or not you agree with it. For example, if it is not a high cash flowing property and the majority of your returns will be from the sale then it is even more important what the sale price will be at that time. So what have they put down as the reversion cap rate, the cap rate at time of sale? Is that realistic?

2. The distributions are surely based on free net cash flow. If there is none then you will get none, regardless of any preferred return percentage. The preferred returns you see quoted are no guarantees of return, just that you will get first swing at whatever returns are available. But yes, if the returns are higher then generally you will get some of that benefit. It will all depend on how the PPM is laid out. With some waterfall setups, the higher the return the bigger a piece of the pie the sponsor will get.

3. Could be yes, could be no. That's very property and market dependent.

4. Yes, if you run out of money then a capital call could be made. If you don't have liquidity or refuse then the money will be raised from somewhere and your share of the deal will be diluted accordingly. This should all be clear in the PPM.

5. Most leases are 12 months long so usually most renovations are done within 12-18 months. Your lender will not normally let the renovations go longer than 24 months anyway, so it's a reasonable time frame. If a tenant renews their lease and does not allow you to renovate but is willing to accept the rent raise to market value, that's bonus.

Hope that helps.

Chris Strokes · Answer

@Barry Dameshek I think you are asking the correct questions.  The deal your are referencing looks familiar.  I'll send you a DM.

Barry Dameshek · Answer

I wanted to take a moment to respond to all of you above who took the time to answer my questions in great detail several months back. This is actually the first time in 10 months I've been back on the site, prompted by another opportunity with the same investor group I was asking back then. I didn't proceed with that deal because I just felt my research wasn't through enough, but I'm seriously considering a new opportunity with them now. In my limited due diligence I haven't come across anything negative. I'll continue to ask questions and we'll see what the response is but all indications seem to be that the reputation is clean and their intentions are positive.

I do have some new questions on the new deal:

1- The new project is a multi-family deal, 300+ units, $40MM+ in the southwest. It is a value-ad deal in which all units will be renovated along with the common area, bbq area, name rebranding, etc. Is a projected 8.7% ROI and 18% IRR (post sale in 5 yrs.) a reasonably attractive return?

2- In the event of a higher vacancy rate than projected, what should an investor's realistic expectation be with respect to the GP's adjustment to the monthly distributions? What about the reverse -- if rents turn out to be HIGHER due to a strong market? Would investors presumably benefit?

3- They are projecting renovation costs of $7500/unit. Is that reasonable?

4- If renovation cost / cap-ex turns out to be higher for some unforeseen reason, can the GP require investors to kick in additional capital? Can that occur at any time? What happens if an investor refuses or just doesn't have the liquidity available at that moment?

5- Renovations for all units are expected to take place over 24 months. If that's a reasonable timeframe, what happens to the tenants who are still on lease or have renewed? I should note that in the conference call the GP indicated leases are coming due for all tenants over the next 12-24 months.

Thank you in advance for your input.

How to vet a private placement opportunity & general partner?

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