This week’s blog is another excerpt from my upcoming book, “Capital Attraction: The Small Balance Real Estate Entrepreneur’s Essential Guide to Raising Capital”, which will be available on April 17th. This particular excerpt is on a topic on which I have written and discussed rather extensively, but that I find to still be very misunderstood by many people. My hope is to help SBRE entrepreneurs – syndicators, private lenders, note buyers, and other real estate asset based dealmakers – improve their chances of successfully realizing their dream of running their own pooled investment fund and to systematically attract capital to their enterprise.
Small Balance Real Estate Funds—Structure Matters
Perhaps the most widespread problem that impairs raising capital in a pooled investment fund is poor, mismatched, unattractive, or simply wrong fund capital structure. It is frankly an epidemic in small balance real estate funds and is even more prevalent with first-time managers. There are many reasons why it is so important to nail the structure to increase the chances of raising capital successfully—from aligning the interests of the investors with those of the manager, to properly allocating the revenue streams to the costs necessarily incurred to generate those revenue streams, to allowing the fund activities and results to be appropriately tracked and administered. Most of these elements are widely misunderstood and neglected, to the great detriment of both managers and investors. In this chapter, I focus on what I believe are the most important factors for you to consider when creating and running your pooled investment fund.
What is “STRUCTURE”?
The very concept of fund structure is foreign to most new managers because they usually have never had to even consider the concept when working in the one-deal-at-a-time or fractional/syndication model. In using the term “structure” I am referring to the myriad interrelated business, economic, administrative, and practical elements of the offering which will immediately and continuously come into play for you as you alter the way you capitalize your deals. Good structure helps attract investors, provides necessary and appropriate compensation to the manager for the work performed, can be more easily and accurately tracked and administered, and balances the realities you will face as a manager on multiple fronts with the needs and desires of your investors. Good structure is the foundation of a fund that stands a good chance of success rather than one that is doomed before it even launches.
Let me start with some questions you will want to ask yourself that will begin to address multiple elements of structure. These questions and many others are very important to ask, and it’s also important to understand the considerations and implications behind any answers or choices you might make when you are creating a pooled investment fund. The answers to these questions are at the core of the work I do when helping clients set up a fund that will give them the best chance of success in raising capital, and they are an excellent place for you to start.
- What is my investment strategy for the fund?
- That is, what kind of deals am I going to do inside of the fund and how broad or narrow should that investment strategy be?
- What impact does this decision have on my ability to raise capital, on my ability to value the assets for the purposes of share price calculation, on real estate market gyrations and cycles, and other factors?
- How much capital am I going to need to raise and over what time period?
- Should my fund be open ended or closed ended? Why?
- Who is my ideal investor target audience?
- Is the fund going to be structured as debt or equity (or both)?
- That is, am I going to borrow money from investors, or am I going to sell them shares of the fund entity?
- What impact does this decision have on when and how I have to pay investors back, on accepting self-directed IRA capital, on when and how I accept and deploy capital, and on myriad other factors?
- Am I going to use leverage for the fund or the assets in it?
- Will that be for each asset or for the fund as a whole?
- If so, how much? Should I place limitations on it?
- How does this impact my investors’ decisions to invest or not?
- What sort of lock-up period should I use, and how/when will I redeem investors?
- How will I calculate the price of a share of my fund (and who is going to do that)?
- What sort of fees are appropriate?
- Which fees should go to the manager and which should go to the fund? Why?
- What sort of returns to investors do I expect to produce? How do I know?
- How much money can I expect to make as a manager at various volume levels?
- Can and/or should I allow the fund to do business with affiliated companies (those over which I have complete or partial control)?
- If so, what parameters and limitations should I place around this type of business?
- What implications will this be likely to have on my ability to raise capital?
- How much of my own capital (if any) is necessary for me to invest in the fund alongside my other investors? That is, how much skin in the game is appropriate?
- What should my management team look like, and what roles/responsibilities will be necessary?
- How do all of these decisions (and many others) interplay with one another?
As you begin to see from this list of questions, there are many important decisions to be made that will affect the performance of the fund from the very beginning. Some decisions will have immediate consequences – as in the fund manager’s ability to raise capital out of the gates, for example – and some will only come into play over time as the fund gets off the ground and matures. Different decisions will have different implications at different points in time.
DEFINING THE INVESTMENT MANDATE
One major consideration when setting up the fund is determining the nature, scope, and breadth of the types of assets and investments to be pursued by the manager on behalf of the fund and its investors. It really comes down to how broad or narrow the mandate should actually be, and there are different schools of thought on this topic. On the one hand, savvy investors want to have some specific parameters around the types of deals the manager is able to do so that they have some clear scope of what business the fund is in. I have seen funds that literally were allowed to do any type of investment imaginable—real estate, oil and gas, coins, operating businesses, car loans, etc. This type of mandate is, in my judgment, way too broad.
On the other hand, being simply a one-trick pony can be very dangerous. Real estate markets cycle, and not every strategy works all of the time. Depending on whether the fund is open or closed ended and other factors, there can be real value to both the manager and the investors in allowing the fund some flexibility to pursue different strategies during different market cycles. This is easier said than done, as the manager should possess the requisite expertise to underwrite any deal types that are included in the strategy and should also have a relevant and robust enough platform to originate or acquire whatever asset types are included in the mandate. Finding the balance between keeping the mandate narrow enough so that you as the manager cannot do literally anything you want and keeping it broad enough so as to not become completely stuck in a changing market cycle, and doing it in a way that will appeal to investors, is more art than science. It pays to make the decision thoughtfully at the outset of the fund.