The private placement memorandum is one of the most essential forms of due diligence passive investors perform when considering a real estate syndication, yet it can often get overlooked. How can that be the case, as it is such a critical phase of the investment decision when analyzing private placement offerings? It could be sheer fatigue. By this time, prospective investors have explored the track record and had discussions with the deal sponsor. They have decided the returns compare favorably with other real estate investments and will cash flow well. They have pored over financial statements and the investment summary. They have studied the submarket and have approved of the underlying fundamentals. After collecting all this information and spending several hours, they have concluded that this is a good investment opportunity. Instead of receiving a gold star, the investor is now handed a 100+ page legal document that could numb your mind unless you are an attorney. The PPM could be considered the fine print that you don't read when you buy a stock, and real estate investors compare it to the prescription your doctor hands you, which could potentially cause side effects. What is this fine print? Just what side effects (risks) are we talking about?
In this article, we'll explore what a PPM is, why it's necessary, and what you can expect to find within this essential document.
What is a private placement memorandum?
In contrast to the investment summary containing all the pretty pictures of tiles, backsplashes, shimmering pools, and frolicking dog parks, the PPM is a dry, detailed disclosure document. It covers every topic potential investors need to know before placing their hard-earned private capital into a deal. It contains the offering details and a complete description of the property. It points out the fees, including the asset management fees. What exactly are the acquisition fee and the property management fee? What are the commissions? How is this deal structured between the general partner and limited partner, and what are the risk factors of this investment opportunity? The PPM includes all the information that you will need to make an informed decision.
Why is there a private placement memorandum?
Businesses selling securities use a PPM for a private real estate offering. Such enterprises include syndications, a REIT (real estate investment trust), a RE investment fund, or crowdfunding. The latter may not require a PPM since it sells securities using Rule 506C of Regulation D under the Securities Act. A Reg D/506C isn't required by the Securities and Exchange Commission (SEC) to provide a PPM or disclosures to private investors. Real estate investors performing the best practices need all the details to make an informed decision, so while this may be legal, it is not sound investing protocol.
Providing a PPM to the investor is necessary for anyone selling securities, such as a real estate syndicator, as it will assist them in gaining investor trust. The PPM will also help avoid any misunderstandings that could come back to bite them (nobody wants to get sued).
Contents of the Private Placement Memorandum
PPM's commonly follow the same flow and structure, so what I lay out here should help you prepare for what you will find.
Introduction
The introduction summarizes the team and a description of the private placement with which investors will place their money.
Investment summary
The investment summary is similar to the marketing prospectus (the investment summary or operating memorandum), less all the pretty pictures and fancy graphs. It will highlight details of the business plan and the property itself. This is the equivalent of the Investment Summaries' executive summary.
Risk Factors
These are the "prescription side effects" that I mentioned earlier. Both the securities attorney and the general partners want to remind real estate investors of the investment risks. Although syndications seek recession-resistant asset classes, reward comes with risks, and it is possible to lose money. Those risks might include natural disasters, economic downturns, incompetent operations, managerial issues, increased competition, tenant and tax challenges.
Description of the Company and the Management
This section contains the company's background information, citing its extensive experience and expertise in property management. It will go into team biographies, special skills, and performance history.
Use of Proceeds
Whenever I hand over a sizable income tax check at the end of the year, I wonder, for what will this money be used. Here the disclosure document must be completely transparent and list what investor funds are for. Those uses include capital expenditures (renovation budget), downpayment for the loan, and fees associated with the offering.
Offering Terms
Also found in the subscription agreement, offering terms cover membership interests purchased, projected returns, hold period for the particular investment, and goes into great detail on the deal's structure. The terms will also include the equity split and delivery of distributions.
Investor Suitability
An offering may only be available to Accredited Investors depending on how it is regulated by The Security Exchange Commission (SEC). However, there are exceptions. If it is a 506B offering, slots will be available to "Sophisticated Investors," who have sufficient funds and knowledge to participate. Conversely, if it is a 506C offering, then it will be restricted to only Accredited Investors. If it is the latter, you will be required to verify your status using a third party (including your tax professional). A 506B offering allows accredited investors to self-accredit (basically, give your word).
Fees
As alluded to earlier, there are fees associated with private placements. Sponsor fees can include acquisition fees, asset management fees, and disposition fees. Additionally, there are loan fees as well as closing costs.
Description of Securities
The description of securities describes rights and restrictions of securities such as voting rights, transferability, and liquidity of shares. It will also detail accounting and how the company can change its capitalization, which can include capital calls, creation of additional loans from investors, different classifications of shares, distribution of funds, and termination.
Subscription Procedures
At some point, you will need to know just how you can invest in this offering. Once you agree to the terms of the PPM, you will be required to specify the number of shares you wish to purchase and instructions on how to invest (funding instructions).
Timing and Location of Funds
Where did my $50,000 or $100,000 go? Having such large sums of money vanish from your account can be unnerving, so it is paramount that there is the disclosure of just where funds are held, for how long, and what could happen if the offering isn't fully funded.
Conflicts of Interests
Conflicts of interest can exist within a partnership and therefore must also be disclosed. For instance, the hired third-party property management company may own a building down the street and could be considered competition for tenants you are trying to attract. Another example could be that one of the general partners is also a broker and will be earning a commission on the closing of the property.
Taxes
The tax section describes tax documents, most notably the K1, which get sent each year.
Other Documents
There should be an exhibits section that will include the operating agreement—the agreement goes into great detail on how the team will run the deal. We can't forget that you have to sign on the dotted line. This happens with the subscription agreement, which legally binds the issuer and investor. The SA is also where the investor acknowledges that they have read the PPM.
Finally, Take the Time to Carefully Review the PPM
Having said this, we are often put into unfair situations. Think of how you are handed a stack of escrow documents an inch think, while your realtor sits next to your making statements like "This just means," and "sign here, initial there." Not a big deal; it is only hundreds of thousands, or in some cases millions of dollars. For whatever reason, it seems to be human nature to skim lengthy, albeit important, documents.
While you don't have a realtor breathing down your back when reviewing the PPM, you may feel fatigued as you have just completed your own due diligence, reading, listening to, and watching information that has helped you come to this point. How do you combat this fatigue? Give yourself ample time. If you have been looking to place some capital, start the due diligence process early, so you can get a jump on the competition because these offerings are limited and do fill quickly. Once you have concluded that this could be a great investment opportunity, now you can place your soft commitment, give yourself a little break, and then dive into the details of the PPM with a fresh and rested mind.
I will end by getting back to the prescription analogy. Nobody likes to read, "may cause rash," but we take the medication regardless because we believe it will help our situation. It is no different when investing. Entering into a private placement may help your financial situation, but you will see some scary language like "you may lose all your money!" Do not be too frightened. Remember, nobody wants to be liable, so they scream it out there in bold print. But isn't that better than the fine print you never read when buying a stock (or, for that matter, your own house)?
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