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Private Placements Explained: Part 4 (Fees and Expenses)

by Russell Putnam

Happy New Year! Last month, we launched a series of blog posts on private securities offerings, which you can read here (Regulation D), here (distribution waterfalls), and here (differences between public and private direct participation programs). Let’s continue our discussion of private placements by exploring typical fees and expenses for private programs.

When reviewing an investment program, you must consider the fees:

  1. Are fees and expenses reasonable (i.e., enable the investors to take on an appropriate risk/return profile) and in line with similar offerings?
  2. Does the investment program’s fee structure create any perverse incentives for management?

In evaluating these questions, it’s key to assess individual fee components, including the front-end load, acquisition fees, and ongoing operating expenses, as well as the fees and expenses as a whole.

How is the front-end loaded?

Did you know that the NASAA and FINRA 10% limits on underwriting compensation and 15% limits on front-end load does not apply to private placements? Although not required, we still look for private programs to adhere to these public limits as a matter of best practice. Generally, for private programs, we see front-end offering commissions and expenses totaling around 12% of gross offering proceeds. This typically includes fees and expenses falling within the ranges as shown in the table below.

Up-Front Expense

Percent of Gross Offering Proceeds

Selling commissions

6% - 7%

 Due diligence and/or marketing allowances

1%

Managing broker dealer and/or wholesaler fees

2% - 3%

Organization and offering expenses

1% - 3%

The terms of up-front fees and expenses are usually straightforward. However, it is important to review disclosures regarding organization and offering expenses with a keen eye, in order to ensure the following:

  • Expense reimbursements are capped
  • Expense estimates are not listed as a flat dollar amount or based on the maximum (and not actual) offering raise

If either is not the case, be aware that these expense amounts can be relatively substantial if the program is unable to raise a significant amount of capital. For example, let’s say the PPM estimates organization and offering expenses to be $500,000. First and foremost, without a cap, management can cause the company to exceed this amount without any limitation, which obviously could be problematic and dilutive to shareholders, who are paying O&O expenses. Further, if the company is able to raise $50 million, $500,000 of that amount is 1% of the raise, which is reasonable. But what if the company is only able to raise $10 million, and 5% of capital contributions are going towards organization and offering expense reimbursements? As the great Lee Corso would say, “not so fast, my friends!”

Remember, the front-end load represents the amount the investment assets must increase in value for the investors to receive all principal back at exit of the program, although let’s turn to other costs that will similarly need to be made up over the life of the program.

Other front-end costs

Acquisition fees for private placements generally range from 1% to 2% of the asset purchase price. Additionally, acquisition related expenses are typically around 1% of the purchase price, but are typically not capped. Acquisition expenses usually include expenses related to assets that management researches but does not cause the program to purchase—dead deal costs—as well as assets where the investment program actually completes the acquisition.

Some private programs also have financing fees. These fees typically range from 0.5% to 0.75% of any loan amount. When reviewing a financing fee, a key consideration is whether the fee is only applicable to the amount of money actually borrowed by the investment program, or to the total amount of funds available for borrowing under a line of credit. Of course, the former may be much more fee-friendly.

Nuances of operating fees

Assessing the reasonableness of ongoing operating fees is one of the more difficult tasks in reviewing private placements, because operating fees can vary so significantly based on each program’s investment strategy. However, an annual asset management fee of approximately 1% to 2% of gross assets is fairly typical for private investment programs. However, consider that gross assets as a basis for the fee, instead of a function of equity raised (which is also a common basis for a management fee), may increase the likelihood that management would lever up assets in order to increase the amount of compensation it receives.

Certain types of Reg D real estate programs also charge a property management fee, which can vary by property type. Private real estate programs typically have more of a value-add oriented strategy and require more intensive management or lease up efforts compared to public programs. As such private programs, often charge a higher property management fee than what may be customary in the public, non-traded space.

Finally, 5% of hard costs is a relatively standard development fee for private placements that are focused on development or construction.

The balancing act

In order to determine whether fees and expenses for private placements are in-line with similar programs and whether the fee structure creates any perverse incentives for management, it is critical to keep in mind that evaluation of fees is a balancing act. We need to assess fees as a whole, as well as their individual components, including the front-end load, acquisition fees, and ongoing operating and disposition fees.

To wrap up our blog series on private placements, next time we’ll take a look at key considerations related to affiliated transactions, co-investments, and other situations in which conflicts of interests arise.

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Filed Under: Due Diligence, Regulation D