Affiliated transactions can be thorny. They raise conflicts of interest and create additional governance challenges and risks. The relative fiduciary duties (or lack thereof) that the manager owes to each side of the transaction complicates the picture. Investors are understandably apprehensive about the conflicts in such deals because there is a higher likelihood that value is being shifted to the affiliated party inappropriately.
And yet, affiliated transactions of various kinds are common in alternative investment programs, both inherent in their structures and in the individual transactions program managers may undertake. This blog post will examine typical affiliate transactions and how to assess for mitigating factors to the risks presented by them.
Just a few examples
At FactRight, we often review programs that involve affiliated transactions. Typical transactions in DST programs, as an example, include:
- A sponsor with a privately managed portfolio of properties syndicates an asset or group of assets through a DST program, which generates gains and fees. The sponsor does not retain any ownership interests but keeps management of the assets.
- A sponsor/owner with a history and track record seeds a new program with assets and retains some ownership and management of the assets.
- A sponsor utilizes managed capital (or its own) as bridge financing to facilitate an acquisition for a DST program, charging the investors for use of that capital.
- A sponsor syndicates a DST program with an option of a section 721 roll up into an affiliated investment program. (In this case we are anticipating a prospective affiliated transaction!)
Financial Accounting Standards Board’s Accounting Standards Codification (ASC) 850, Related Party Disclosures, gives the disclosure requirements and provides additional examples of affiliated and related party transactions that can be present in the investment program context:
- Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates prevailing at the time of the transaction.
- Selling real estate at a price that differs significantly from its appraised value.
- Exchanging property for similar property in a nonmonetary transaction.
- Making loans with no scheduled terms for when or how the funds will be repaid.
The requirements for ASC 850 are intended to help the users of audited financial statements assess the financial consequences of affiliated transactions. However, in the direct participation program industry, audited financial statements are not often available. And obviously, financial statements are retrospective anyway. How do you get comfortable with the prospect of affiliated transactions in a private program, or assess them if and when they do occur?
Ways that risk can be minimized
We believe that the risks associated with an affiliated transaction cannot be fully mitigated, but there are ways to materially reduce the risk. Below are some of the most effective ways sponsors can do so:
- Fiduciary duties. Ascertaining through review of governance documents who the manager owes fiduciary duties to and who it doesn’t will set the stage of your assessment of affiliated transactions. Obviously, it is ideal if the manager owes the program and its investors full fiduciary duties, but unfortunately, more often than not, that is not the case, which makes the subsequent items on this list all the more critical.
- Sponsor policies. As part of its operational due diligence program, FactRight asks each sponsor for its affiliated transaction policy. On occasion, the sponsor under review has it documented in a formal policy that meaningfully restricts or even prohibits affiliated dealing. (When no formal policy is in place, a sponsor may simply state verbally that it will not undertake affiliated transactions.) While sponsors who have taken care to articulate a formal policy tend to be the sponsors that avoid affiliated transactions, remember that these policies are not binding, unless… (see the next bullet point)
- Transactional restrictions. When a sponsor memorializes restrictions on affiliated transactions in the PPM or the program’s governance document, they are inviting securities disclosure or contractual liability if they violate those restrictions. Thus, policies written into offering documentation usually carry significant weight. For instance, look for prohibitions on asset sales or purchases between the program and affiliates, or limits on the amount of interest the manager may charge on a loan to the program.
- As we’ve seen, for publicly reporting companies with audited financials, disclosure is key. That’s no less true in the private investment context. The PPM should be clear on the program’s ability to undertake affiliated transactions and the conflicts they pose. The PPM (or a supplement) should also disclose the details of any such transactions that have already occurred or are contemplated. But transparency extends beyond legal disclosure. A sponsor should harness its investor relations department to make clear communications with investors and make management available for questions.
- Governance safeguards. Implementation of procedural safeguards, such as forming a special committee of independent advisors or investors to review these transactions, or even subjecting the transaction to investor approval (as long as all of the material facts are fully disclosed) can help mitigate risk and reduce the threat of a challenge. A key due diligence item is confirming that the manager has followed its outlined approval process for any affiliated transactions it has previously undertaken.
- Appraisal or fairness opinion. Another important procedural safeguard that ordinarily accompanies a program’s ability to buy or sell assets with a sponsor affiliate is the documented requirement that the price be substantiated by a third-party valuation or fairness opinion. This process is not bulletproof, but if it is well-designed, it should increase the likelihood that the transaction is materially similar to terms that could have been obtained with a third party (a proxy for “fair and reasonable”). Look for the requirements that the valuer of the transaction be independent, performing a valuation based on accepted methods and reflecting current market conditions. (For instance, we’ve seen sponsors attempt to justify transaction prices with appraisals that are out of date.) Investors may even have the ability to object to the valuation and procure a second opinion.
- Prohibition on fees. A primary sponsor motivation to pursue an affiliated transition might be to generate additional fees from existing assets. A structure or policy that waives related acquisition or disposition fees eliminates a primary conflict and sponsor incentive to pursue such transactions.
Can there be benefits to affiliated transactions?
Even though affiliated transactions heighten risk, there can be compelling reasons for all stakeholders that a program participate in such transactions.
A newly launched program already seeded with assets can reduce some blind pool risk to prospective investors by providing actual investments for underwriting, and such assets may support the early distributions to investors. The disclosed investment strategy may involve a roll up for affiliated programs to create scale for an optimally profitable exit. From a sponsor perspective, the structure may be attractive because it may offer liquidity to investors that wish to exit, while giving the sponsor and rollover investors more time to realize the full potential of their investments. In some transactions, it can also be an attractive option to lock in returns and raise additional capital for investments that have thrived during the pandemic.
From a due diligence perspective, we want to make sure a sponsor has been transparent and built in as many safeguards as possible for both existing and prospective investors. That helps us to assess the bottom line: whether the transaction is truly accretive to investors.
Chief Financial Officer