Let’s wrap up our five-post discussion of private placements by exploring some key considerations that often present risks in Reg D programs.
My primary goal in reviewing any investment program is to identify unique risks that may negatively impact returns to investors and the ability of the program to achieve its objectives. At FactRight, we balance the potential adverse impact posed by a risk with the likelihood of the risk event occurring in determining how we identify and prioritize risks for consideration of broker dealer and registered investment advisor clients. Private investment programs are generally subject to numerous customary risks, including the following:
- Illiquidity
- Lack of transparency
- Limited investor participation in company governance
- High reliance on key individuals to carry out the business plan
- Lack of asset or share valuation procedures and lack of leverage limits, which we addressed in Part 3 of this blog series
Beyond these customary risks, some of the most prominent red flags we often identify in private placements arise from affiliated transactions, investment allocation, and joint ventures. In this blog post we’ll review key due diligence questions that you should be asking with respect to each of these areas of concern, all of which relate to management conflicts of interest.
Whose best interest in an affiliated transaction?
Conflicts of interest for management emphatically arise in the context of affiliated transactions. Affiliated transactions may include affiliated acquisitions or sales, affiliated loans, and even services rendered by affiliates. Affiliated transactions required heightened concern because management may have an incentive to cause an investment program to enter into a transaction on terms that are less beneficial to the program than what would be available from unrelated parties. They often place management in a precarious position of having to simultaneously advocate for the best interests of adversarial parties (the investment program and management itself, or perhaps another affiliated program). And such conflict might not even just arise when the program enters into the transaction. For example, in the case of an affiliated loan, management may be forced, in an event of default, to determine whether to pursue remedies on behalf of, or against, an affiliate.
If is very important to consider the conditions under which an investment program can enter into an affiliated transaction. Key questions to focus on include the following:
- Any there any prohibitions of certain types of affiliated transactions in governance documents?
- Who is determining the price for any affiliated acquisition or sale? Is management required to obtain a third party valuation or fairness opinion to support the price and other terms?
- Is there a mechanism in place requiring any sort of independent approval?
- A public non-traded program will have an independent board, whose approval is required for affiliated transactions. However, this is most often not the case for private placements, where management generally has significantly more latitude in consummating affiliated acquisitions or sales.
- Will management charge its standard acquisition fee on an affiliated acquisition?
Finally, one due diligence practice that we think is particularly important with respect to affiliated transactions is confirming that management has adhered to any requirements or limitations on such transactions in the past. The answer may reflect on management’s level of integrity. For example, can you confirm that management actually obtained that third party appraisal to support an affiliated sale from a few years back, as required by the partnership agreement?
Opportunity for the best opportunities
Another potential area of concern for private placements (or any investment program) is how management is allocating investment opportunities between itself, the investment program you’re reviewing, and other competing affiliated investment programs. Reviewing an investment allocation policy is critical in determining if there are any procedures or policies that would allow management to keep from presenting the best opportunities it identifies to the investment program. Key questions that you should use as your guide when reviewing an investment allocation policy include:
- Is management investing in similar asset classes for its own account?
- Does management only raise and deploy funds for one investment program at a time?
- Do any of the affiliated investment programs have a right of first refusal to investment opportunities?
- Can management allocate interests in acquisitions to more than one program through a co-investment arrangement?
The devil’s in the details of joint ventures and co-investments
It is fairly typical that management will be permitted to allocate interests in investments to more than one investment program in a co-investment relationship. Additionally, some private programs have investment strategies that depend on joint ventures with third parties or affiliates. Co-investments and joint ventures often present unique risks. In evaluating joint ventures and co-investments, it’s key to consider the following questions:
- Are the entities investing on a pari passu basis? In other words, are they required to invest on identical terms and conditions?
- Will the investment program/its manager have control of the joint venture?
- Will the investment program have any right of first refusal to purchase the co-investor’s interest in the future?
Private placements going forward
Over the last few weeks this blogpost series on private placements has covered various topics:
- Reg D exemptions
- Evaluating the alignment of management’s and investors’ interest through distribution waterfalls
- Common features that differ between private and public direct participation programs, including leverage limits, valuation requirements, and investor limits
- Customary fee structures for private investment programs
- Key risk areas (addressed in this post)
Hopefully these posts have provided you a window into FactRight’s review process and can serve as guideposts for your due diligence of private placements as you continue to build your alternative investment platform. Please reach out to me at russell@factright.com if you would like to discuss any aspect of these programs in further detail.
