3 Tips for Note Fund Management

I was a recent guest on a Note Investing podcast. A lot of note investors want to hear the stories of the notes or get more information on the foreclosure process or other specific actions involved in the acquisition and liquidation of individual notes.

This interviewer, however, was interested in hearing about my experiences running a note investment fund, which has its own challenges beyond just the day to day management of the notes.

It was a higher level conversation about running our Note Investment business.

Here, I’ll focus on 3 reasons that managing a note investment fund is different than individual mortgage note investing:

1. 1. Raising Capital

After about a year of investing in non performing notes in a joint venture partnership, I noticed a big difference from investing in traditional residential real estate. You needed to have the capital upfront before you even bid on a loan.

In real estate, you find the deal first, put it into contract, and then find the money. When buying from hedgefunds (see this post that I wrote about that subject), you agree on price first, do your due diligence, and fund your deal immediately thereafter.

Wall Street note traders don’t have patience when it’s time to fund the deal. They expect payment 24-48 hours after signing the loan purchase agreements and they won’t wait for you to scramble to get the funds together.

Doing what the Big Funds Do

I told my partner, Sean, that we needed to what the big players did: Raise capital first, then go out to buy a pool of assets, which would help us lower the overall risk by spreading it amongst different assets. This process led us to the next step.

1. 2. Structuring the Note Investment Fund

Structuring a joint venture to buy one note is generally pretty easy and uncomplicated. Usually, you have a capital partner who puts up the money and a more experienced note investor who sources the deal, acquires, manages, and liquidates the asset. It’s usually a 50/50 deal.

For a note investment fund, things are a lot more complicated.

SEC Regulations

First, when you take on more than one passive investor, you need to be aware of SEC regulations and how they affect pooled investments, otherwise you run the risk of getting into legal trouble. This took us down a path where we needed to decide what we wanted to do and how we could do this while staying in compliance with the SEC’s regulations, state, and federal laws.

Specialized Attorney to Draft Offering

Once we had a good enough idea, we found an attorney that specialized in setting up Private Placement Offerings. This gave us the opportunity to examine how we were structuring the deal, how to do it, and what we needed to consider while doing so.

Other note investment funds typically offered only a preferred return. We wanted to be different. We wanted to offer a profit split in addition to the preferred return so that our investors could participate in the upside. We wanted them to be more like partners in a figurative sense.

506(b) or 506 (c)?

Our first Fund was issued under a Regulation D, 506(b) exemption, which meant that it was open to accredited and a certain amount of non accredited but sophisticated investors. After our first fund, we decided to do 506(c) funds, which are only open to accredited investors but allow us to do general solicitation for the fund. (Learn more about accredited investor status here.)

1. 3. Managing Capital

Managing pooled capital in a note investment fund is a lot more complicated than doing so for an individual note. You’re looking at the fund as a whole. You need to keep an eye on future costs and make sure you have enough so that you don’t run out of money.

Reserve Amount

We target 10% of our total capital raise as the amount we want to keep in reserve. This reserve is used for operating capital (costs of foreclosure, note servicing, insurance, property tax advances, management fees, etc) and minor rehab costs.

In our experience, 10% is about the right amount. If we keep more than that, we have too much idle capital as the preferred return is calculated on the total amount that our investors put in. Less than that and we run the risk of a liquidity crunch where we run out of money. We’ve never done a capital call to investors and don’t ever want to be in the position to do one.

When we have a liquidation, we do our best to estimate what we need for operating capital and upcoming rehabs and distribute the rest. If we get an REO, which requires a more substantial rehab, we’ll get a hard money loan on that property to provide the additional liquidity.

In the future, we’ll get warehouse and lines of credits from banks to help us maintain proper reserve levels.

Conclusion

Raising capital and determining the proper structure of your fund require a lot more time and effort than buying a single note here or there. Managing capital is a lot more difficult when you have to factor in all the variables from multiple notes.