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One of the most misunderstood aspects of 506 Regulation D real estate asset based funds is around the true liquidity characteristics of the investment. Not just the contractual obligations but the actual capability of the fund to meet those obligations. How does an investor determine the likelihood of his or her ability to redeem the securities (whether a debt or equity instrument)? I find that many fund managers in this space do not really understand the potential impact of the capital structure they have created on their ability to handle the return of capital to investors (based on potential outcomes of their asset model) and that most investors are unable to see past the surface to assess the real dynamics behind whatever structure and features are articulated in the PPM.
The crux of the issue is how well the asset model (and ultimately the performance of the assets over time) comports with the liquidity structure as designed in the fund’s architecture. There are many different asset models each with its own nuances that, depending on the individual fund, investors often do not fully appreciate. Too often, a fund is not architected with an understanding of this balance (asset model and liquidity/exit structure) in mind and therefore the manner in which the fund manager expects to be able to deliver liquidity to investors (whether that be meeting contractual maturity dates of notes, if it is a debt fund, or honoring redemption requests of equity interests) can be illusory.
This happens because the fund manager has a tendency when he or she creates the fund structure to believe that assets will always perform well. It also often happens to first (and sometimes second or third) time managers who have never been through the closing out of a fund. My experience is that it is rare that a proposed model is heavily stress tested in detailed financial modeling in advance based on various downside assumptions. The reality is that markets cycle and there are almost certainly going to be some periods in which at least some assets may NOT perform well. The capital structure can exacerbate bad, or support good, fund performance when this situation arises depending on the alignment of asset model and liquidity features baked into the fund’s structure in the first place.
When markets are favorable and assets are performing well, the liquidity of the fund may perform as projected in the PPM even if the structure was poor. All appears to be well. Investors are comforted by knowing (or thinking they know) how they will be able to get their capital back in what is fundamentally an illiquid investment. They don’t always appreciate the nature of a private placement with no public market for the securities whose assets are invested in a real estate based product.
When the market cycles downward, which it invariably will do, assets tend to take longer to perform (to collect payments, to payoff, to liquidate), or in some cases don’t perform well at all, and therefore less cash may be available to the fund manager at any given point in time to accommodate redemptions, to handle maturing notes, to refinance credit facilities, etc. Just because there is a maturity date of an investor note, for example, does not necessarily mean the fund will have the cash to perform on that maturity date. It will depend on the relative overall status of the fund – the asset performance, the cash flow, the number and amount of other notes due, the ability of the manager to raise new/additional capital at that point in time (which often has been reduced in down market cycles as investors tend to retrench), and a host of other factors. Some structures enhance this capacity, some inhibit it. Most people (including both managers and investors) cannot tell the difference on the surface. The fact is that it is very hard to do without a great deal of experience in the trenches of the space, which many times neither party has had. This is what makes it so tough to truly grasp.
No matter how competent, honest and experienced the manager, it is still hard to design a perfectly aligned fund. There are too many potential eventualities and life is uncertain by nature. However, there is no question that some structures are vastly superior to others depending on the goals and investment mandate of the fund. Structure is vitally important because even the best managers can and will make investment mistakes from time to time. The hotter the market becomes, the harder it is (for a variety of reasons) for managers to maintain underwriting discipline. Competition is fierce and borrowers/sellers gain the upper hand in negotiations. Brokers and other sales people earning commissions exert pressure to close deals that will generate those commissions. Asset level fees are there for the taking. And everything is going up, up, up! Many funds simply have not been built to withstand market cycles and it is when the line on the graph changes direction and heads south that this fact is exposed. It is the rare manager indeed who thinks long term, anticipates and models down markets, and builds this possibility into the fabric and structure of their fund up front.
The complexity and misunderstood aspects of 506 Regulation D real estate asset based funds underline the importance of thorough understanding and careful structuring by both fund managers and investors. A fund's liquidity characteristics can be influenced significantly by its capital structure, and the market cycles' inevitable fluctuations can either exacerbate or support the fund's performance. Fund managers must therefore not only anticipate and model down markets, but also stress test their proposed models based on various downside assumptions. Investors, on the other hand, need to look beyond the surface and assess the real dynamics behind the fund's structure and features.
Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions.
