Notes funds for individual investors. What are the best players?

[Demjan Van Der Kach]

Hello everybody, I am strongly considering part of my SDIRA to be in Notes funds. I am looking for high quality players in the industry with great historical record. Let's talk about good and "not so good" funds! I would appreciate any leads/opinions. I am new to the Notes and my impression is - the notes funds are very difficult to understand in terms of historical risks, their transparency. there is no much of the SEC regulation/reporting requirements like, say, in mutual funds. Are there any financial analysis stats out there, rankings et cetera? Are these funds legit, here to stay??? Or is this Notes fund market is short- lived hype created by recent mortgage crisis and huge inventory?

[Bob Malecki]

Hi @Sandy Uhlmann, funds can vary in term and how the investors are paid. Some like PPR's pays a flat return, usually what is called a "preferred return" which means that the investors get paid that stated return before the fund manager gets paid, but the manager then gets all of the remaining profit. Realize that the preferred return is NOT guaranteed. If the fund earns only 4% after expenses then the investor gets that 4% and the manager gets nothing. If the fund earns 20%, then the investors get their pref and the manager gets the rest. 

Also many funds are designed to pay the manager an annual management fee ranging from .5 to 2% of the value of the assets under management. This can erode the net profit and the manager would still get a paycheck from the management fee even if the fund's return was not favorable or even negative. This is why hedge fund managers make a great living even if their fund does not perform well. Go figure. 

Other funds are designed to pay a lower preferred return (anywhere from 6-10% on average) but also provides a split on the profits earned after expenses and the pref payments to the investors.

In that design the investors get the first X% via their preferred return, plus a portion of the additional profits. So if the fund performs beyond the min. preferred return requirements, the members in the fund essentially get a "bump" when the profit splits are paid. As you can imagine, reworking distressed debt purchased at a substantial discount can to into double digit returns when a successful outcome is completed. This is where the annualized return to the investor is more dependent upon the performance of the fund and expertise of the managers running it. 

Our fund invests in first position, borrower occupied distressed debt, and it's a closed-ended 5 year fund with a wind-down in 2021. I can't provide any specifics on returns since as a Reg D 506(b) we cannot advertise. Under this exemption, though, we are allowed to have up to 35 non-accredited, sophisticated investors. We did this so that we can accommodate the smaller self directed investor who is looking to park some money at what we think will be a good return from our performance as fund mangers in this investment space. 

We selected a 5 year term so that in years 1-2 we are in acquisition and modification mode, then assuming successful outcomes, years 3 thru 5 are cashflow income on the loan payments. During this term we expect that the notes also appreciate in value as the markets in which the homes are located appreciate (since we are purchasing the paper at a discount to BPO and the UPB is typically higher than that current BPO value, the notes "equity" grows in sync with market appreciation). The goal in year five is to liquidate the performing assets at a much higher value than we acquired them providing very good profit split for our members and us a managers while having that cash flow income along the journey.  We are basically buying and renovating paper rather than homes. 

Other funds are "open ended" or "evergreen" where there is no set exit term and investors can come in and out during the active term of the fund. This is more flexible but also adds more complexity since the value of the shares will fluctuate over time and that needs to be monitored and calculated every time an investor joins or leaves the fund. 

Most of the funds you reference are, I believe equity only funds, which mean that investors are trading cash for an equity position along side the other investor/members in the fund. Some funds use a hybrid approach, offering both equity and a debt component. So an investor can either trade cash for equity and that preferred return + profit split, or essentially act as a lender to the fund for a fixed interest rate over a specific term. Again the hybrid model adds more complexity and requires more overhead for accounting and tax reporting. 

We designed ours as equity only, with a 5 year term primarily to keep things simple while we build our platform, finalize relationships and increase our knowledge base. Both myslelf and my partners, Ben & Kevin feel that this will provide us a good foundation to start subsequent funds based on a solid track record and the efficiencies we developed while operating Fund I. 

As you can see there are a lot of ways to design a fund to capitalize one's note investing goals. Sorry for the long-winded response, and I hope this fairly verbose response answers your question! 

Bob Malecki