Unlike listed securities which have standard disclosure and documentation requirements, private placements, as much as the law allows, write their own rules regarding fees, promotion, allocation of costs, control, and oversight. With Private Placement Memorandums (PPM) sometimes being over 100 pages, there is plenty of room for managers to insert concepts which may not be competitive, or even harmful to investors. Always read through the PPM of a potential investment and ask the manager to explain any terms of questionable nature.
Although this guide is not comprehensive, it will give guidance as to some of the items to watch out for when reviewing a private placement. This is not legal or tax advice. Always consult with your attorney, advisor, and accountant before making any investment decisions.
Managers are often paid an asset management fee on the commitments of the fund. Since a carry charge is not realized, often until years in the future, the manager uses asset management fees to cover their costs of operation. Asset management fees for funds with an investment period are often charged on either committed (more manager-friendly) or called capital (more investor-friendly). Once the fund transitions to the harvest period, investors should look for managers to only charge an asset management fee on invested capital and not committed or called capital.
Often, fees are the most investor-friendly when they are limited and kept as simple as possible while being clearly stated. Be aware of any fees where the fund is allowed to “fee stack,” which is charging overlapping fees for items such as acquisition, asset management, disposition, financing, or others at both the fund and investment level.
In addition to understanding the preferred rate of return, LP/GP splits for each hurdle, see if the manager is charging a GP catch-up or the more investor-friendly hard preferred rate of return.
It is imperative to understand the distribution schedule. One of the main reasons people invest in funds is for the diversification benefits. However, if the fund is structured with a Deal-by-Deal carry, otherwise known as American-style carry, each investment within the fund will pay a performance fee to the manager if the deal is profitable, regardless of how the other deals in the fund are performing. The investor-friendly carry structure is the Whole-Fund Carry, otherwise known as the European Style carry. With the whole-fund carry model, there is a netting of all asset performance, and the manager will only receive its share of the profits after all the contributed capital and possibly preferred return is returned to its investors.
Here is a list of terms which investors should be looking for when reviewing an offering.
Side Letters-Side letters can be an effective tool to entice larger investors into an offering. They should be limited to a reduction of carry with the manager or a lower asset management fee. Side letters should never benefit the side letter investor at the cost of other investors.
Operating and overhead costs-It is normal for the fund to cover its costs for investments in the fund, but the fund should not be paying for the fund manager’s business expenses directly, such as office space, staff, and manager company travel (exception for fund investment-related expenses). The fund pays the manager an asset management fee which the manager uses to run the management of the business, but the fund should allocate costs for any expense outside of direct fund expenses.
Reporting and valuation-Investors should receive quarterly or annual reports, K-1’s or 1099’s, audited financial statements (if applicable), and valuation. When possible, a manager should rely on independent third parties for verification of manager reports.
Related party transactions-generally speaking, acquisitions and dispositions should occur as arm’s length transactions. If third parties, such as financing or brokerage, are affiliates of the manager, these individuals or firms should be disclosed within the fund docs and questioned by the investor. Managers should have severe limitations on being allowed to acquire or dispose of an asset from or to an affiliate.
Co-invest-Often, managers will offer co-investment to fund investors and outsiders for investments within the fund. These co-investments occur for several reasons; one of the most common is the investment required for the acquisition is too large for the fund’s allocation limits. Managers may offer co-invest to their larger fund investors to give these larger investors additional exposure to an asset. Co-investing is not inherently bad for investors, but there should be limitations within the fund documents to ensure the fund is the highest priority of the manager, inclusive of fair allocation and reporting.
Leverage funds will often state the amount of leverage they intend to use at the property and fund levels. Investors should be aware of leverage ratios to ensure it is consistent with investor risk limits.
Recycling-As assets are sold, capital cycles back through the fund, which can be recycled into new investments or distributed to investors. Investors should be aware of how much, if any, capital is allowed to be recycled by the manager.
Private funds can offer diversified and outsized returns for investors. It is crucial for investors to spend time and utilize an attorney to understand the alignment of interests between the investor and manager to form a strong partnership.
Important Information
This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.
The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.
Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.
Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.
Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.