Computed ROI on fund and impact of Reserve for Loan Losses

[Chuck Van Court]

I am an investor in the BroadMark fund, which provides investor return from 1st lien position hard money loans. I am generally happy with the fund thus far, but they seem to be using an overly favorable method to compute actual investor returns. I am hoping that folks in this forum can speak to if their approach is customary and/or reasonable.

Here are the particulars:

1. The fund pays returns on 1st lien position loans they provide to developers.

2. The month an outstanding loan goes into default; they place 10% of the outstanding balance of the defaulted loan into a Reserve for Loan Defaults (RLD). If the defaulted loan gets worked out, the RLD applicable to the previously defaulted loan is removed.

3. BroadMar's investor return is computed monthly on the outstanding principal invested by investors less their share of RLD. This clearly increases the return by using a reduced principal for the computation. I am generally OK with this.

4. Other than reducing the principal used in the ROI calc, the RLD NEVER has a negative impact on the computed investor ROI, regardless how large the applicable RLD to the month the ROI is computed.

5. BroadMark said that the RLD is only a paper loss and should not be included in the ROI calculation. However, RLD applicable to any investor that has not been worked out at the time they withdraw their money is reduced from the investor's compounded investment return.

By computing actual investor returns using the outstanding investor principal less applicable RLD and never reducing the actual interest paid to investors by the applicable RLD losses, they seem to be providing a computed return that is overly favorable and not reflective of what investors actually will earn in any realistic scenario. The only way RLD will not negatively come into play for the actual investor ROI achieved is if the investor leaves their money in the fund until no defaulted loans exist or if no loans default for the time they have investment in the fund, which are not a realistic assumptions for deriving actual investor ROI.

In addition to their current computed investor ROI, I suggested that BroadMark also provide an adjusted ROI that takes into account the applicable RLD beyond just reducing the outstanding principal. They were not receptive and provided me with the obvious and somewhat hostile option for me to take my investment elsewhere. Again, thus far, I am satisfied with my return (after my own adjustments for RLD) and have no intentions of moving my investment elsewhere at this time.

However, is BroadMark's approach in computing investor ROI reasonable, SEC approved and commonly used by other like funds?

Thanks for any thoughts you can share!

[Dion DePaoli]

Hey @Chuck Van Court!

Let's walk through an example for clarity.

Let's say 5 investors each pool their $100k investments together into the fund. So in initial periods we have $500k in Net Asset Value or NAV. The NAV is going to be the gross asset value minus the funds total expenses.

So when the fund makes a loan to Billy Borrower for $300k at 10% interest only (easy math) the NAV at origination is still $500k. $200k cash and $300k in UPB. No return is produced.

When the next period rolls around we have the interest only payment which comes in at $2,500. So now we have a gross value of $502,500. $200k cash. $300k UPB. $2,500 income. Let's assume minimal expenses to the fund so the NAV right now is $300k in UPB, $202,500 in cash or $502,500. If the fund compounds the $2,500 income just grew the fund 0.5% for the period or 6.0% annually adjusted.

Now let's assume the fund makes another loan for $100k at 10%. Month 3 rolls around and the $300k loan makes another payment and loan 2 is made. Then Month 4 rolls around and both loans have made payments. The $300k loan has made 3 payments each at $2,500 or $7,500. The $100k loan makes one payment at $833.34. Period 4's income is $3,333.34. So we have $400k in UPB. We $108,333.34 in cash. ($7,500 payments loan 1 and $833.34 loan 2 plus the original $100k cash balance) The fund's NAV is then $508,333.34. Period 4's income of $3,333.34 is rate of return of 0.67% per period or 8.0% annualized return.

For clarity at this point in period 4 we have 5 investors each putting in $100k. The fund's NAV has increased by $8,333.33. Each investor's capital balance is now $101,666.67. Each investor has a gain of $1,166.67. Over 4 months of the fund the investors have had a 5% rate of return.

Now in period 5 let's say loan 1 misses payment and that triggers the RLD. Loan 2 makes its payment of $833.34. So we have $400k in UPB. We have $9,1667.67 over all 5 months in income. However, our cash is reduced to $50,000 which is the $100k cash balance less the 10% of loan RLD. So total cash on hand then is $59,166.67. We now have a NAV of $459,166.67. The fund still had income of $833.34 but it lost value when it set aside the $50k.

If any one of the investors were to request redemption they would have a pro-rata share of the $459,166.67. Since we had 5 investors each putting up $100k they are 20% of the fund each. So the investor who redeems would only get $91,833.33 back.

So the investor's return for this period should reflect the loss in asset value. The fund's net income was $49,166.67. The actual income of the $833.34 minus the $50k reserve.

The investor's capital account, just like the fund NAV rises and falls every month. So in month 6 the beginning capital balance of each investor remaining is $91,833.33. That is, the RLD affected the overall capital balance, of which the investor are the parts of the sum, and each investor's capital account is reduced. Income received in month 6 would be reported against the $459,166.67 NAV. Not the capital balance of all investors. This would give the perception that month 6 return is higher than month 5 even though the actual cash received is identical.  That is how it works.

In the event loan 1 is reinstated and the RDL is removed then that cash would return back into the NAV calculation.  The capital goes from asset to liability back to asset.  So it affects the fund.  In reality it probably comes back a little less than the set aside.  

To combat against this in some sense a fund might place a "high water mark" on the investor's account. This mark on the balance is where the investor's capital account must return to prior to the manager taking any further distributions. So in our example, if the 5 investors had a high water mark of $100k, their original investment, then the manager of the fund must go make that $40,833.33 loss up before they get any distribution of profits above their management fee.

Broadmar's statement the RDL is "only a paper loss" can't be true if it affects the capital account of the investors. That is simply what he is saying to you as an investor but it is not being accounted as such by the fund administrator or through fund audit.  It is a loss of capital while it is a liability.  

Now, it is not common for an investment fund to create a default reserve account.  Banks have to do this per regulation.  Which if we remember back a couple years ago the banks were all up at arms about the reserve levels being changed which forced the banks to have to re-capitalize.  That is how reserve accounts work.  They are not - nothing.  They are liabilities.  

The true measurement of the investment is going to be the original capital balance you put in minus the ending capital balance at year end.  Not just the income on a per period basis.  In period 12 you could have a rate of return of 20% but not have any real gain if that 20% gain only returns you back to par with the original capital balance.  

Private funds are exactly that, private funds.  So at some level there is no oversight into how they are accounting and reporting.  In accounting we have GAAP and FASB which have rules around how most of this is treated.  I suppose the issue would be having one number reported all year long and then getting a completely different number on your income statement for taxes.  In general, most private funds that are serious obtain a 3rd party administrator and have 3rd party accounting and auditing.  The reporting should come from them with management overlays to peace of mind to the investors.