Broker-dealers and RIAs need to have a robust due diligence process to satisfy regulatory requirements and make informed investment decisions with respect to private placements. And let’s face it, thorough due diligence of private placements does not always take a straightforward route. Investment strategies are wide ranging, transparency is typically limited, and offering structures often vary significantly, even for “similar” deals.
With private placements, its sometimes easy to lose sight of the big picture in the morass of PPM disclosures and convoluted operating agreement provisions. Whenever I find myself having trouble seeing the forest through the trees, I try to come back to one of the most important questions we can ask regarding a private placement structure: How are management’s interests aligned with those of investors?
In this post, we’ll focus on four primary considerations that broker-dealers and RIAs should focus on when evaluating alignment of interests.
Skin in the game
First, we need to identify whether management has any skin in the game in terms of capital contributions to the program. We also want to confirm whether management’s contribution (if any) is being made in cash, property, or through the waiver of future fees. We typically look more favorably on programs where management is making a material contribution that sits alongside non-affiliated investors, entitling management to distributions and tax benefits on the same terms as those investors.
In our previous blogpost we argued that due diligence does not end at the signing of the selling agreement. And this rule applies for monitoring management’s level of investment as well. For example, over the last year we’ve come across a few programs where management had not satisfied its required or anticipated level of investment. It’s one thing to identify management’s anticipated investment amount; proper due diligence requires we confirm that management actually followed through.
Second, in evaluating alignment of interests, we need to look at the distribution waterfall. We need to assess whether investors are being compensated adequately for the risk they are taking by investing in that particular structure, strategy, and market. For example, a 6% preferred return may be appropriate for a real estate program targeting stabilized assets, but probably doesn’t adequately compensate an investor in a program with a higher risk profile, such as a development or opportunistic fund.
Intuitively, we focus on whether investors are appropriately being compensated through the waterfall, but it’s also important to ask whether management is adequately incentivized to preserve investor capital and produce investor returns. I recently reviewed a program that included multiple affiliated funds investing in a single joint venture. Management decided not to take a carried interest in one of the funds in order to make that particular program an attractive investment option for new investors. Admirable in theory. However, in this instance management failed to provide itself any meaningful financial incentive at the fund level. This could potentially lead to management making decisions at the joint venture level that might not represent the best interests of our program at hand.
For a deeper dive into distribution waterfalls, check out our previous posts addressing return calculations, catchup provisions, and carried interests and how joint venture waterfalls impact investor returns.
Another area of focus when considering alignment of interests is the quantitative and qualitative analysis of management fees. And this is one area where wealth managers can really leverage the research of a third party diligence firm. FactRight has reviewed hundreds of private placements over the last few years and can benchmark individual fee amounts and clarify whether the aggregate fee structure is reasonable. For example, FactRight has compiled a DST fee database consisting of every DST program we’ve reviewed over the past few years. This allows us to assess precisely how a program’s fee structure compares to industry standards, which is a necessary step for wealth managers in evaluating reasonable alternatives in order to meet duties to clients.
Beyond benchmarking, we also need to perform qualitative assessment of fees to determine whether the fee structure creates any conflicts of interest or unreasonable incentives for management. For example:
- If the management fee is calculated as a function of NAV, what procedures are in place to ensure appropriate valuations? Third party NAV calculations are almost never required with private placements. Regular third party appraisals are sometimes required. More often than not, there is no independent appraisal requirement.
- If the fund is using a capital call structure, is the management fee calculated on capital commitments or actual capital drawn down? Should management be receiving a fee on capital that hasn’t been drawn down yet? It seems like a stretch, but we see it in programs sometimes.
- Is management being reimbursed for management overhead, including employee salaries and benefits? This is atypical of most private placements we review, but could allow management to receive significant amounts of compensation, without limits, at rates determined solely by management.
Finally, when evaluating alignment of interests, we have to focus on conflicts of interest, specifically affiliated transactions. Product sponsors often rationalize affiliated transactions because they represent the sponsor’s best interest (and potentially multiple programs) as a whole, even though the transaction might not necessarily represent the best interest of a particular program or its investors. Here are some questions we consistently ask through our process to evaluate whether investors best interests are being protected with affiliated transactions:
- Do affiliated acquisitions or sales require investor approval? Rarely with private investment programs.
- Is a third party appraisal required for affiliated acquisitions or sales?
- Are affiliated acquisitions being completed at the affiliate’s cost or current market rates? This question is particularly key for oil and gas programs, where management sells acreage from its inventory to the program.
- Are there any restrictions on affiliated borrowing? Interest rate? Term? Will the sponsor retain any markup between its cost of capital and the rate it lends to its programs?
- Can the program lend money to the sponsor or make inter-fund loans? This is a frowned upon practice, but it does happen. Affiliated lending may raise conflicts of interest as to whether management would pursue remedies on behalf of the program in the event of default. Additionally, affiliated lending is typically not contemplated as part of a program’s articulated investment strategy in the PPM.
While these questions can get us started down the right path, reasonable due diligence entails an ongoing assessment of whether management and the fund are actually complying with the stated restrictions on affiliated transactions once the program begins operations.
Implementing alignment of interest analysis into your due diligence process
The next time you’re reviewing a private placement, take a step back to consider how are management’s interests aligned with those of investors. This post has provided a number of tips to help work through that question. But if the water remains murky, we urge you to take advantage of FactRight’s due diligence capabilities, as our team of analysts has the industry knowledge and product expertise to take due diligence on private placements from complexity to clarity.
Broker-dealer home offices and RIAs can access all of FactRight’s due diligence reports on the FactRight Report Center. Wealth managers can also check out FactRight’s website for more information on FactRight’s custom risk management services and product coverage. We’re also happy if you reach out to us directly to discuss any questions you have.
Co-President & Principal