You have evaluated the deal metrics of a prospective commercial real estate syndication and you like the deal. What’s next?
Ask the sponsor for the offering documents.
The “offering documents” are the instruments that create a legally enforceable contract among the sponsor, the investors, and the business entity (the issuer) that is issuing a passive ownership stake in exchange for your investment. So while you have been given assurances by the sponsor and are satisfied with the deal metrics as presented, a review of the offering documents is the *only* way to verify whether your expectations are legally enforceable. It may be helpful to summarize the key terms of the offering into an investment abstract (example).
The offer and sale of passive equity interests are governed by federal and state securities laws, meaning sponsors have a legal obligation to disclose to prospective investors the terms of the offering as well as any risks that are material to making an informed investment decision. Sponsors that provide information with misrepresentations, misleading statements, or material omissions are subject to civil liability and criminal prosecution, which underscores the importance of verifying that the sponsor is advised by securities counsel. When you ask the sponsor for the offering documents, you should receive the following materials:
- Private Placement Memorandum (PPM). Legal instrument used to disclose the terms of the offering and the risks that are material to making an informed investment decision.
- Business Plan. May come in the form of an executive summary, pitch deck, or financial projections. This is not a legal instrument and so it is not an enforceable contract, but you’ll want to ask for the most current financial projections because the underlying assumptions can change during the term of an offering.
- Subscription Agreement. Legal instrument used to close on your investment and also to allocate the risk of securities liability away from the sponsor and onto you as an informed decision maker. The subscription agreement will contain investor representations and warranties including that you are (a) an accredited investor; (b) purchasing for investment and not a view for resale; and (c) making an informed investment decision based on your independent evaluation of the PPM.
- Operating Agreement. Legal instrument that governs the relationship of the sponsor and the investors as business partners, as well as their respective duties and rights to the issuer and to each other.
Typically, the Business Plan, Subscription Agreement, and Operating Agreement are all included as attachments to the PPM, and so a set of offering documents can easily approach a daunting 100+ pages of legalese. Don’t be discouraged! The Operating Agreement is the most important of the offering documents because it is the only instrument that governs the three key terms of a commercial real estate syndication: Money, Power, and Responsibility.
Money. As a passive investor, you are primarily interested in verifying whether the Operating Agreement is consistent with your economic expectations. Economic rights are governed by provisions on cash distributions, tax allocations, and guaranteed payments.
- Cash Distributions. If you’re investing for cash flow, then you want to locate the provisions governing how net profits will be shared among business partners. Typically, the sponsor will reserve discretion on timing of cash distributions for when the project can afford it and only after payment of expenses and budgeting for contingencies. The surplus is then distributed pursuant to a distributions waterfall, which may provide for a preferred return of some annual percentage to investors, followed by a return of investor cash, and then some profit share between the sponsor and the investors as a class. More complex waterfalls will include one or more hurdle rates with adjusted profit splits. Pro Tip #1: If your expectation is to receive a preferred return, then make note of when the preferred return will begin to accrue. Sometimes it begins to accrue on the date that your cash is contributed, sometimes it doesn’t begin to accrue until project stabilization.
- Tax Allocations. If you’re investing for passive tax losses, then you want to locate the provisions governing allocation of profits and losses among the business partners. Typically, items of profit and loss are allocated proportionate to cash contributions but this isn’t always the case if, for example, the sponsor is taking a promote (a share of upside as incentive compensation for services performed). Pro Tip #2: If the sponsor is taking a promote, then verify that profits and losses are allocated in proportion to cash contributions and not percentage interests. Also ask the sponsor whether they plan to accelerate depreciation deductions via a cost segregation study.
- Sponsor Fees. A sponsor will perform certain services to the issuer that the issuer would otherwise need to pay to a third party but for those services being provided in-house. Examples include an annual asset management fee based on the amount of investor equity under management, a developer fee based on the amount of the development and construction budget, or a guaranty fee based on the amount of debt guaranteed to the project’s lender. Such fees are paid by the issuer to the sponsor prior to cash distributions to the investors, so it is crucial for investors to be fully aware of the sponsor’s authority to pay itself from amounts otherwise distributable to investors. Pro Tip #3: Verify that guaranteed payments are fully disclosed (no hidden fees), paid for actual services performed, and no less favorable than would be available at arms-length from a third-party service provider.
- Transfer Rights. Transfer rights govern whether a partner is able to sell its ownership stake, whether to another partner or to a third-party purchaser if, for example, a partner needs liquidity prior to the deal going full-cycle. These rights range from a right of first offer/first refusal to call options, put options, and tag-along/drag-along rights. Provisions that govern transferability of an ownership stake in the issuer will also set forth the purchase price for an early investor exit. Pro Tip #4: Generally, syndications are illiquid investments, meaning you are along for the ride until either (i) the sponsor refinances the project’s existing indebtedness and buys you out, or (ii) the sponsor sells the project and everyone gets cashed out. Provisions that govern transfer rights are the exception to that general rule.
Power. If the key economic rights outlined above are consistent with your expectations as a passive investor, then the next most important category of rights involve issues of control. In a commercial real estate syndication, the bargain is fairly straight-forward: the sponsor is primarily responsible for day-to-day decision-making as the general partner (GP) or manager and the investors are passive participants. Whereas passive investors are typically not interested in approval rights on operational decisions, it is not uncommon for the investors to have an approval right on certain major decisions that would have a material effect on any individual investor or on the investors as a class. Pro Tip #5: Operating Agreements typically contain a provision that enumerates the rights of investors to vote on major decisions, such as whether investors must satisfy additional capital calls by the sponsor if, for example, the sponsor busts the project’s development and construction budget.
Responsibility. Probably the most overlooked provisions in an Operating Agreement involve the sponsor’s responsibility to provide periodic reports that keep investors apprised of construction progress, lease-up, and operations. Investor information rights range from a high standard (annual audited financials and monthly summaries) to a lower standard (annual K-1s only). Pro Tip #6: The right balance is somewhere in between these high and lower standards, typically involving annual internally-prepared financials and a quarterly summary of issuer activity.
Once you’ve completed review of the Operating Agreement and summarized into an investment abstract, you are better positioned to compare your understanding of the offering with the disclosures in the PPM. A reputable sponsor will be responsive to any inconsistencies, but any response that falls short of your expectations as a prospective investor presents the opportunity to (a) walk, (b) assume the risk, or (c) request a side letter agreement that modifies the terms of the offering to align with your expectations.
Conclusion
A sponsor’s obligation to provide full and fair disclosure does not end when you wire funds; the anti-fraud provisions of federal and state securities laws apply to sponsor conduct through to dissolution and winding up of the issuer. Nevertheless, conducting this exercise up-front will better align your expectations with what’s enforceable, and like in any business deal, an ounce of prevention is worth a pound of remedy.
Andrew P. Doup, Esq. is a nationally ranked Top 25 attorney for tax-advantaged real estate syndications. He is counsel to private investors, developers, entrepreneurs, and fund managers on a range of real estate development projects to include commercial, hotel, office, student housing, multifamily, senior living, and mixed-use asset classes. He has extensive experience with federal and state securities regulation involving exemptions for the offer and sale of securities, including private real estate investment fund formation and real estate syndications, private placement memoranda, subscription agreements, and SEC and state “blue sky” filings. Contact Andrew P. Doup at (740) 504-3198 or andrew@syndicationcounsel.com.
The information in this blog post is for general educational purposes only and does not constitute legal advice.
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.
