Dive into Private Investment Due Diligence with a Guided Tour of the PPM

Brittany Hobson - Community Marketing Manager of Verivest hosts Chris Carsley of Kirkland Capital Group.

Verivest’s mission is to create and enable the conditions to increase the speed of trust in the private middle market real estate investment space. Their goal is to help enable investors to direct capital to those sponsors and managers who can objectively demonstrate they are trustworthy stewards of that capital and away from those who cannot.

“Everyone should read their PPM. It's important. It's the rules to the game. I always tell people, you really want to go in and try and play monopoly with a professional and not read the rules of how to play. If something goes wrong, that game is going to be rigged against you.”

—Chris Carsley

Nobody wants to read the private placement memorandum (PPM) for a potential investment fund. It's not hard to think of a dozen other things you would rather do (getting your teeth cleaned?) than to tackle an 80+ page legalese filled document.

So let’s show you the key sections to focus on first. Once you find any red flags, or even see that the fund does not fit what you are looking for, you move on. This can speed your due diligence process greatly. 

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Transcript

Brittany Hobson
Welcome everyone. Today we are going to be talking about diving deeper into the private investment due diligence with a guided tour of the private placement memorandum with Chris Carsley of Kirkland Capital Group. Firstly, I'm going to give you a brief about Verivest. You might've received the invite via Vera. So, if you already know, feel free to just follow along but we are a real estate investment platform designed to bring transparency and trust to the middle market investing place. Our mission is to create and enable the conditions to increase the speed of trust in the private middle market, real estate investment space, with the goal to help investors, to direct their capital to those sponsors and managers who can demonstrate they are trust, worthy stewards of capital.

Here is what the sponsor directory looks like. You can find a sponsor by MSA. You can search by minimum investment. You can search by strategy, by open opportunities and every sponsor has their background check for you to see, within the past 10 years. And you can also, check actually directly connect with the sponsor and email them through the site. So that's also a cool way to, just connect directly with. And then to be on our platform, there are obviously super, extensive requirements. No personal or business bankruptcy petition of seven years. No unfavorably resolved lawsuits, no regulatory sanctions, no film, felony criminal convictions in sign, the very best code of conduct.

There’re two levels. There's the gold level and there's a Verivest verified level. And I will go through the verified gold level here on the next slide. Here we have Kirkland Capital Group who is joining us today. They're verified gold members. They agreed to have all their active opportunities monitored on an ongoing basis to prove they are following the rules of the deals, operating agreement, and allocating money, the way that they said they would. Their primary strategy is private lending. Their primary property type is multifamily also with their investor capital managed number, and that they are a hundred percent monitored.

Also sponsors can engage us to verify their track record. So here you can see Kirkland Capital Group track record very transparent with the inception dates and they have the investment amounts. You don't have to do that research. That's another awesome feature of the platform that was super brief. But if you would like to find out more about Verivest, please reach out to me or connect on the Verivest community network. That's an awesome resource to talk to other people in the industry and find out when we have more educational events like this one. I don't want to take too much of your time because we have the expert on the line.

Who's ready to dive in with you. He has a diverse investment background spanning 25 years in covering traditional assets, hedge funds, venture, and fund to funds. He is the co-founder of Seattle alternative investment association. The co-head of Chartered Alternative Investment Association in Seattle, and then his expertise lies in portfolio construction and risk management and operations compliance and regulations. I will go ahead and give the floor to Chris

Chris Carsley
We're going to be talking about Private Placement Memorandum in the last segment we did with Verivest, we talked about the four key points. We're important to making you know, a successful investment. And we talked about documents, fees, operations, and then the transparency of a manager. And one of the things that we had some requests for was to go through and say, hey, can you do a deeper dive on some of these sections? And one of the things I started with is great. Everyone. When you get a private investment, you need to dive in, you need to understand the documents, they should be shown to you.

And you should have ample time to review and then ask questions from the manager. Let's dive in one of the most important documents that's going to give you that introduction is the private placement memorandum. Here's a simple definition, according to thank you to the people at Investopedia and offering memorandum is the legal document that states the objectives, the risks in terms of an investment involved with a private placement. I'm not going to read the rest of it. You guys can have time to read that. It's important because it literally is to the rules of the game. It's an explanation of what you're going to invest in. It has all the parameters and risks that you need to understand as an investor of how you will be treated.

One of the other documents that goes hand in hand with this is your operating agreement. Often not, you'll see in a private placement memorandum reference to an operating agreement, I will go back and forth between those two, but the meat of what you're going to be diving into is in that PPM, it's going to give you an explanation of like it says here your business operations, risks, and the management team, historical performance fees. It's going to run through a little bit of everything. Today's objective is I really just want to be able to go in and say, how do I get to a no more quickly. Most of these documents will range anywhere from 80 to a hundred pages. So how do I read dozens of these and get through them in a timely fashion?

One of them is just experienced of having read hundreds and hundreds of them. The other one is being able to identify what's important to you. And today I'm going to walk through a number of different points that I guide into that are important to me. That allows me to go through a very large document and get an idea of very quickly. If this is something that would match my portfolio. Is this something that I need? Is it going to be good for me? And does it match how I think about the world and get to a no quickly? One of the things that’s important, because I believe everyone should read their documents. Everyone should read their PPM. It's important. It's the rules to the game. I always tell people; you really want to go in and try and play monopoly with a professional and not read the rules of how to play. If something goes wrong, that game is going to be rigged against you. So don't do that. Read the document, come back with solid questions, and don't think anything like it's off the plate. You can ask questions about anything. There are no rules to the level of due diligence you can do. My previous due diligence, I spent eight hours after going through documents on an on-site verification.

I spend eight hours with a multi-strategy hedge fund because it was that complex. There was nothing that I couldn't ask. So don't be shy and don't ever fall into the trap of, I don't want to look like the idiot. I don't want to ask the dumb question. Sometimes that'll lead you down a rabbit hole that maybe will allow you to say, no I don't want to invest in that. I didn't like that answer. That's the key get to the no quickly. And one of the easiest ways to do that is pull up this document, read through. One of the things. These are the key elements that I like go through your business objectives, understand your fees, your fee structure, the types of fees, the fund expenses. You'll see, I'll talk about this a little bit later also, but this is one of those fees that it's usually a one short paragraph and it looks like a kitchen sink was thrown into that section. It's important to understand what is embedded in fund expenses and how the manager thinks about fund expenses.

Because this is an area that can shift and move as a fund grows or expands, or maybe becomes more complex depending on the nature of the fund you're talking about, particularly a hedge fund that may have some style drift aloud. Those fund expenses might move also as they come in and encompass other additional strategies. That's one thing you've got to really understand and it's an overlooked expense, because everyone always talks about like, my fund charges 2 and 20, that's a management fee of 2% and then sent a fee of 20%. And no one ever seems to think about fund expenses, but there's a lot embedded in there. And so, we'll dive into some of that and. There's a slide here that I'll pull up, organizational costs, another thing that it takes money to build the fund. It's inevitable, you got legal fees, you've got time and effort. How are they doing those organizational costs? How are investors paying for that?

Because it's actually pretty common that the investor will pay for that organizational cost. Liquidity, everyone has different liquidity needs. Does this fund actually have liquidity needs that match something that works for you? Does it fully match the style of investment? I mean, those are a couple of key questions you need to understand. Partner contributions: You'll get a joke out of this one later on when we get to this slide, but it's another name for this that everyone commonly knows is skin in the game. Do these managers, are they putting money into this fund? One of the questions I had the historically was when you see very little money put into, a fund that there's someone's trying to sell you, you always ask, well, you don't seem to have much money in this fund. You know, how about we talk about where all your money's at, excuse me, maybe that's a better investment. You know, I say that tongue in cheek, but I did ask that a couple of manager wants, he didn't like that question. Leverage it's a component is used in a variety of different strategies. Very common in the hedge fund world.

Depending on the nature of the strategy. But leverage is something that's extremely useful. But it's also something that can turn around and bite you. As we saw in 2008, a lot of different strategies, you know, had their lines call, things were pulled back and that creates, you know, forced selling and can put a lot of stress on a fund. In times when maybe there's nothing really wrong with the underlying investments, but a third party that's providing leverage is now added stress to that system. And at the end of the day, the people who pay that price are you the investor? So, you need to understand what's the leverage use, what's allowable, and how much are they using and really get into the head of the manager. And then valuation's super important when you're dealing in a private investment. Not everything is going to be a public security. There are hedge funds and a variety of other structures that deals with public instruments that can be valued through public means on a daily basis but often may not exist.

So, you need to understand how are they valued? Who's valuing it, what's the double-checks and where are the valuation used? You'll find that valuation can be used in a lot of different ways, within a fund. This is one of the dealings that you'll see. You know, I do a lot of, write a lot of papers for people and I've had some requests for discussions around related party transactions. A lot of managers and a lot of documents that you'll see will come out and say, hey, it's a super big benefit to you as an investor because we are vertically integrated in our investment structure. And so, we have all of these related parties that help us succeed in providing positive returns or controlling risks or both. Just be careful that you really understand, and you've got to link some of this back to the fee structure. And we'll walk through this later on, where are you really saving any fees because they've got a bunch of related parties or are they just stepping in and taking multiple layers of fees from you and how do you double check those related party transactions to ensure that you know, they're being, I guess utilized correctly by the managers, let's dive right in.

And one of the things you'll see here, I actually used a real PPM, obviously took names and everything else out of it so that we can actually look at some real language, and understand how this PPM was structured, for better or worse. There are some things in this that I don't necessarily agree with. They definitely raised red flags for me. But just note nothing in this means fraud. And that's important to understand as you're going through this, just because someone has something that might be a little wonky, it doesn't mean they're bad people or something could be wrong. This is a walk through and a tutorial to understand a PPM so that you can understand what fits you and also where things might happen. So, there's a lot of things that have happened historically that have led to fraud. One of them being related party transactions, one of the reasons I threw it in there was you historically, you've always found people when something goes wrong, there's some level of hidden fees and structures in related party transactions.

So, first is the business. And it usually be the first part of a PPM. You want to walk through and understand, you know, just that business description and that PPM match what you've been told. I assumed by the time you're looking at a PPM, you've probably had an intro phone call with the manager. Does it match your notes? Sometimes you'll read through a PPM, and you think this is weird, but I've had this happen where you talk to somebody, and you will read their PPM and it wasn't exactly what you discussed. And so, you were wondering if they sent you the wrong document or did something change since the document was created versus the time when you talked to them? This is the very first step to understand if it doesn't match this early, that's an early warning sign. And you probably need to think about it well, here's a set of questions already, what am I really getting into? And why did the manager talk about something that doesn't match with what the document is?

Do you believe this is a solid investment? Is that something that really matches with what you need once you read that description? Can this business objective take advantage of some inefficiency? Is it feasible when you read through this? Does it make sense as it easily understood? I have a very simple rule. If I read through a business objective of how they're going to invest, and I can't understand what they're doing, something really super complex. If it's not your forte and you can't get your hands around it, just walk away. It's I know that's a pretty simple rule, but it'll keep you out of trouble. So, you're not trying to understand what maybe went wrong because you didn't understand what was being done. Are they over promising in their statements? That's another thing. Or in fact, are they promising anything? I wrote that in there. You just have to be very careful when people use certain words of guaranteed or promising, nothing in the investment world that I've been aware of over time can really be guaranteed or promised. In times of stress, even things that have guarantees, usually can fail, and not have the monetary means to support them. So, it's something to be weird, you know, example here, if they're doing development projects and the people, by the way, the PPM that I am using is a real estate fund.

So, we'll keep it on track to what Verivest and Kirkland Capital does in there in the real estate space. If they're doing development projects but the fund has a short window to liquidity. You look well, that's, that's a problem. That's an immediate red flag of if they're offering liquidity and they're doing development projects, there's already a mismatch in duration. They've already got an asset and liability mismatch. And if they are doing that they are offering, then that would be a good question to bring up how are they actually making that happen? How do they structurally make that possible to create liquidity in a fund that should have a longer duration and tie up of capital especially in real estate development projects.

So that's right after that, a number of things to think about with regards to business objectives, does it match what you need? Does it make sense, and do as magic and, understand the nature of the investment so that you can. Make sure everything that they're going to be talking about in another stuff we're going to be walking through makes sense. These, this is what you get paid to be a part of it. I mean, you should, I mean, if anything, you're going to read in a PPM, this is something you really need to understand. What are you paying to be involved? I have literally had professional investors tell me, and I say professional they're high net worth through call themselves professionals. They've said that, you know, they don't pay incentive fees, or they don't pay certain structures or there's no fund expenses or anything else. And I read through their PPM’S for free and I pointed out to them the layers and layers of things that are occurring. So, this is real language from.

The PPM that I read through and I'm presenting today. This is nothing added here. This is literally I copied and paste straight from their PPM. They have a management fee of 3%. They have development fees of 6%, disposition fees of 6%. They have general contractor’s fees of 12%, there's origination fees. If they actually act as the lender. And then I throw in the class A units here, it doesn't really come across as a fee in the language, but that's actually the fee that will be viewed as the incentive fee. That's the class of units that they own that will participate in some level of upside. Sometimes it'd be 20, 30, 40%, whatever. It'll be different by fund that you look at, but this is something you. It's a development project. I understand. And this goes back to that related party transaction. you'll find that throughout this presentation, there's no one section that doesn't overlap another section.

And that's where things, you just have to go through these and ask questions and become familiar with them. Because when you look at fees, it kind of goes into wait a second. Why are they talking about general contractor fees? Why are they talking about origination fees from lending? Throughout this PPM, they actually say that they will act as the lender. They will act as the general contractor. They are the developer. So, from beginning to end, this manager you're working with, it's taken a lot of ease. There's a lot of layers of fees and you really need to ask the question of. Hey, give me an example. What am I really paying in full freight here? If I invest a hundred thousand dollars, what can I really expect in the end in a standard project that mine tire fee based. That's a very valid question and they should be able to provide that to you. And then you can get an idea, but you can see there's a lot of layers here and some of these are situational, but I can guarantee you this vertical integration that they talk about in the document, they make it say, oh, we don't have to be the general contractor, but why would they pass that off to someone else?
It's their project. They're going to take every layer that can possibly get. So, let's just be realistic. You're going to be paying all these fees to this particular manager and it's worth the time to say, great. Let's dive in. Give me an example of what this actually means to me as a base level of fees.

So, I mean, that's, you know, and there again, also, if anyone's got any questions, Brittany, please interrupt me and we'll answer questions. Cause I'm kind of looking at monitoring some smaller screens here. Sorry, I don't have chat. And this is a next section. I mean, obviously fees are pretty important. I couldn't fit it all on one slide. So, this is that class D share. This is that further dive into incentive fees. And so, they supplied this little, tiny chart where they could come in and say, hey, depending on the amount that you invest will depend a little we'll determine. I mean, the profits would be okay. So, if I write a hundred thousand dollars check, you know, I'll, 53% of the return goes to the manager. So above and beyond now I laughed. They only stayed here in this little chart, the management fee of 3%, they don't bother dimension out in sort of this well, here's all the other fees that would, that you would basically be paying, throughout the life of these projects. But as a class B investor, I have an incentive fee of 53%.

Okay. And I have a sarcastic kind of comment here. You can take it for what it's worth. I've done this a long time and I've known some pop level hedge funds. The standard in the industry is 2 and 20. There are some guys out there in the hedge fund land that they literally charge like 50% incentive, but they've been doing it for 10, 15, 20 years. They've proven that even at a 50% incentive fee, they can beat the market and stay alive. And these guys can do it with billions of dollars. Okay. Just to give you a reference, this PPM is from a relatively new manager, so that's pretty aggressive to say I'm going to charge the same kind of incentive fees that a global Titan in the hedge fund world would, would be. Okay. I mean every investor to their own, like I said, there's nothing fraudulent about any of this. There's nothing illegal, but this is where you need to really dive in. Understand that that's something that would work for you. Is that something that, you know, does that makes sense to me, to me, this was one of the things that kind of jumped out at me is like, that's a pretty bold statement.

You're putting yourself in a very, very small circle of unbelievable managers that believe they can charge, that level of incentive fee. Just make sure it fits your pallet, fund expenses, some of the hidden stuff. This is actual language fund expenses shall include, but not necessarily be limited to the following fund organizational. You’re putting yourself in a very, very small circle of unbelievable managers that believe they can charge, that level of incentive fee. Just make sure it fits your pallet, fund expenses, some of the hidden stuff. This is actual language fund expenses shall include, but not necessarily be limited to the following fund organizational. Let's mark that, remember that statement tax preparation, CPA fees, legal fees, and any other expenses associated with the operation of the fund and the management of its assets. It has a nice broad term. You know, the fund is responsible for fees related to marketing its properties for sale, including broker and agent fees.

The fund is responsible for reasonable fees related to marketing this offer to potential investors. Okay. This is what I'd like to point out. That one, that line there about marketing fees and pre-2008, it was pretty common to see marketing fees covered by the fund. And this, these are marketing fees and related to the efforts about the expenditures to go raise more money for the fund, and they would push that onto the investors post 2008, at least in the institutional world. There was a lot of push-backs on this about, Hey guys. We're not really sure if that's a feed that should be borne by the investors there, again, there's no written rule on this. This is something you just have to develop your own personal taste for. And it's something to worthy to go in and ask the question of like, well, what is marketing expenses generally been?

Get that detail, understand what it really means and what your share of that will be. And if that's something there again, it's palpable. I will tell you that institutions have not been terribly happy, especially by big wall street funds that had very large expenses for their marketing. The manager shall be reimbursed for all reasonable out-of-pocket expenses occurred on behalf of the fund was, shall be considered fund expenses. Great. The manager has on behalf of the fund borrowed money to cover some initial fund expenses. It may and its sole discretion issue units in exchange for forgiveness of debt. Okay. That's a little different of term. That's not very common term in a lot of PPMS, but uh, in relation to being a developer in the real estate space, you might see language to that term there again, you need to understand that how much might that occur?

What's the dilution, you know, how much money are they giving away? And what's the real base there. Again, cost to you as an investor. And you heard me say this earlier fund expenses are a place where people can throw everything, including the kitchen. It'll, like I said, it'll usually be a long paragraph with a bunch of commas separating terms out. Just made sure you're comfortable with all those terms. And one of the things that in this PPM that we'll see in a later slide is that first line item, the fund organizational costs at no other point within this document is that ever mentioned, this is the only part. And the only section of the PPM that talks about what those are. They're not itemized out. I'll save that for the later slide, but we'll come back to that. So, obtain a listing fee go into past deals, get the detailed information. What did this really cost? I mean, they should be able to itemize this out, or have an idea if it's an emerging manager, it's their very first fund.

Maybe they won't have a lot of line-item detail from past deals, but maybe there'll be able to give you any good fund manager. They're running a business. They should have this in some kind of proforma and understand what these costs would be so that they understand they're going to run a successful manager. They're again, ask, get this information, get that line-item detail, understand those costs and how that would affect you because. Fund expenses can be a secret space to where a lot of fees come your way. And you know, also on your investor statements, see if you can get some of those line items out, you know, separated out. So that, from your standpoint, if they're audited grades, you might be able to see that if they're unedited, you're there again, and you're going to have to ask for that detail so that you can understand, and you can track effectively, you know, fund expenses spike there again, you should ask the question.

Why did it spike? Because don't just track your returns. Cause one of the things is, you know, a fund can actually take on more risks and increase their returns or deploy more leverage to increase their returns and maybe their fund expenses doubled. But it was muted, and it got sort of buried in an increase in return.

You know, and that's something that if you didn't look at some of the line-item detail, you wouldn't be able to see that occurrence. I know that's a lot to ask for a small investor, but that's the kind of information you should be aware of and then try to get that information so that nothing surprises you and you don't wake up one day and go wait a second. When did fun expenses get to be, you know, you know, 1%, 2% of the fund? And I will tell you, there are some fund expenses, there's a structure and, and fund expenses, and be very careful about this when this PPM did not have this, but there's something called a pass through where they will pass through every expense as a fund expense. And it gets pretty scary. I've seen some PPMS to where fund expenses can be upwards of 90% fee. I know that sounds large, but I've seen it. Let's dive into the next, when you're talking about organizational thoughts. Okay.

Brittany Hobson
And Chris, I got a question for you. How do you know until you are already in the deal? I don't know of that.

Chris Carsley
So how would you get this information before you're in the deal?
Like I said, in two ways, one, it's already a functioning fund and they've been around or they've run a previous fund, asked for that detail, ask for that information, that you would like to have them walk through an example of how that played out and understanding some of that level of detail. If someone's not cute, you know, going back to those four ways to, you know, make sure your investment works out. One of them was transparency. If you find somebody who's like, just doesn't want to put the time in or provide transparency. Okay. You should approach with caution, you know, but to answer your question of how would I get this?

Well, you got to ask, and I understand that's, what I'm trying to do in this presentation is really kind of giving you some of the questions, of what to go after and what to ask. And you would get that you would ask that line and if it's line item detail, if it's a, it's a manager that had a previous fund, if it's a new fund, then you've got to go the other way. And then hopefully you're dealing with somebody who's running their fund, like a business, and they've actually looked at it and thought about it from a performance standpoint of what would be that expense and how do I make sure I cover the expenses of my business, and get the numbers, you know, on a forward-looking basis, because maybe they're relatively new. And don't get, don't get me wrong. I mean, there's advantages to dealing with new managers. It's just a different way to assess that risk of like, okay, they haven't gotten there yet. But I still can ask that question because they should have at least thought of.

Brittany Hobson
I have one other question too. How do you know if a fee is reasonable?

Chris Carsley
That's a good question. A fee is reasonable. Start with a general benchmark, in the world of alternate investments, you can always start with, you know, most alternate investments tend to be kind of a two and 20 you'll find it sort of a gravitas. Like the 220 mark is kind of like a black hole, sucking everything towards it. And you'll find outliers in that where certain people, because of the nature of what they do, is not as complex.
They'll charge them less management fee and incentive fee. You've got to go in and make an assessment of the complexity of the investment. How complex is it? How much work does it take? What kind of team do they need to manage? And if you're going to get the best team? Like, am I at my time when I was working for a hedge fund, you got to pay the right people to work 18-hour days and do it every day and then on weekends? And there's a cost to that. And sometimes that'll be passed on to the investor, a fair amount of those costs.
It's a combination of understanding the nature of the, of what the fund does and the level of complexity and also level of the targeted return. If you're looking at something that's, well, we'll use Kirkland Capital Group, as an example, we're targeting a 9% return. Most of the debt that we write is a gross return of 11 to 12%.

If I was going to come out and charge, you know, a 5% management fee, it's just, we're working with the absurd here. Okay. That, that clearly not warranted. I basically. Almost half of the entire gross return and a management team. That's probably not warranted. I mean, I'm trying to give you some scenarios to look at it, because there's no written rules of what's acceptable. You have to come up with a benchmark of what's acceptable to you as an, as an investor, but let's also, you know, bill look at just one fund, they'll look at like 10, 15 different funds. Don't spend a lot of time, just go grab 10 funds that are all very similar and look at their fee structures and kind of build a line in the sound for yourself.
It's like, well, where's, everyone's sort of gravitating to, with regards to a certain strategy. You'll find that there won't be a lot of deviation. And if someone does deviate well, if you're a super curious person, you can call them up and say, well, why are your fees so much lower? Or why are your fees so much higher?
If you're just curious or, or you're looking at that particular fund, you can dive in and say, well, wait a second. Everyone else is charging 1%. You're charging three, on a management fee. Walk me through how you came up with 3%. I get asked all the time. How did I come up with one and a half percent? Why am I not charging two? I mean, it just, it's a, it's a totally valid question and they should have an answer pretty much ready to go. I mean, you know, I know there are some people out there that just while I charge two and 20, because that's what everybody else charges. Okay. It's not a wrong answer.

It's not an answer that clearly put a lot of thought into how to build their business and understanding. Do they understand their fee structure in relation to the investment in the cost of their business? They were just grabbing, you know, the center line. And maybe that's okay for you. Maybe. Maybe it's not. hope that answers your question.

Brittany Hobson
Yes. Thank you, Chris.

Chris Carsley
You know, a lot of this is, it's an art. This is not a science, so you know, well, who do I lawyers create these dockets. It was a science lawyer. Wouldn't be creating these dockets. I'm sure I just made some lawyers upset. That's okay. It won't be the first time. So organizational costs, well, this is where this guy document kind of got kind of interesting is they say you're going to pay for this. They stated in the earlier slide, but there's no mention of what it is, how it's treated.
This is you have to ask this question. One of the things that I have seen time and time again is managers who really, maybe it's their first fund. I mean, it could be a variety of reasons why they just don't know everything they're going to be doing. They go to the third parties and pay full freight and ended up paying, you know, I'll take this number with a grain of salt because there are some strategies that are super complex and they do require multiple levels and they'll cost like 150,000 to create all the documents and structures, but for pretty generic.

Investment fund in the private space, 150,000 in today's world is a lot to be paying to build it in my opinion. And you know, so much of the fact, I think I make reference here, the federal regulators for even coming down on this, like I was just talking to the Washington state department of financial institutions and, you know, in the last month, and they're trying to peg for their own benchmarks. Well, when they're reviewing new managers that are coming out and looking for registration, what's really an initial acceptable amount. I think their amounts may maybe a little low depending on the nature of the fund, you can't pay everybody to the same benchmark, but they were kind of looking at it's like, listen, if you're passing on organizational costs more than 50,000, it's a red flag to them.

They'll ask you a question about it. Because they're trying to verify how much money did you spend to build your fund and how much are you putting on the backs of your investors? Think about these organizational costs is the manager's way of basically passing the cost of building the fund on to you as the investor. If I went out and spent 150,000, that could be a large amount of money that you have to carry. It's actually really important and it was really funny. And this BPM that we read through; they say you're paying it is they don't give you any detail. So that's an immediately for me, that's a scary item.
That's I'm definitely asking that question. I'm going after. You know, I'm going to see what did it cost to build it out? I, you know, show me your financials. I mean, cause any money can go. Oh, I only paid 25K. Okay, great. Could you line them out exactly how much that's going to affect my return? Cause that's going to create a little bit of a hole and if it's a fund that's been around for a while, we'll have all the organizational costs been paid because I'm getting it in year two or three. Or how does that, am I doing a catch-up for the other early investors? If you're the early investor, how much of that freight are you carrying? You know, these are all questions you need to ask with regards to, you know, the timing of your investment, the age of the fund and the size of the organizational costs.
So it can be, it can be a little scary.

Brittany Hobson
We're having lots of questions come in, which is good.

Chris Carsley
That’s fine by the way. Questions are far more entertaining than me looking at screen.

Brittany Hobson
This is very helpful. I'm sure. Do you see any value in using a ratio of fees to IRR, to compare opportunities?

Chris Carsley
I've never really done that and it's more about the IRR than the fees. IRR is a forward-looking return that can be, manipulated, and to some degree, especially within real estate, if you're looking forward and someone's got a target of IRR over the next five to seven years, There's a lot of fraud in that number. And a lot of people will manipulate and maneuver models to try and target an IRR. So, it's not that you’re looking at it at a bad ratio or something of a comparison. You just have to be careful about your denominator there and how that was calculated and maybe even apply a discount to an IRR that's provided by a manager, to give a more conservative view. I've never used that metric personally. It's more of, I like to look at a standpoint of the, the fees really mesh up more with what I understand in the broad market, I'm a little biased because I look at literally dozens of funds and read through their PPM’S. It's easier for me to come up with like, okay, hey, these guys are a little off mark, or this is right on the mark.

Especially in syndication, because you can't have just like this fund here in this development fund in syndication, you can have multiple layers of fees. And you know, are they mitigating fees? Are they charging a financing fee? I mean, some people I know, they're like, hey, I'm not going to charge on financing. I'm not going to charge on disposition. What are they giving up? And are all the other fees in line, is the acquisition fee in line? Is the management fee in line. You know, and that's just a matter of sometimes doing it. Nothing against that ratio, but just be careful about the denominator, the IRR calculation, because It may not be exact as you like, because it is a return cap that's forward looking and it can be manipulated by very smart people.

Brittany Hobson
Thank you, Chris.

Chris Carsley
Any other questions?

Brittany Hobson
Yeah.

Chris Carsley
Okay, no problem. That was a good question. There's lots of ratios to look at, it's just a matter of, you know, how you want to benchmark stuff. I just say, I always approach IRR calculations with a lot of grain of salt, make sure you're working with a group that really understands and is maybe already conservative.
Their IRR is conservative, run your own models and say, great. They said it was going to be an 18 IRR. I come up with it should be 20. Okay, great. We'll go in and ask that question at that point of like, well, how'd you come up with 18? I'm actually getting a higher IRR than you and then kind of read out how they were conservative.
What conservative nature did they take in their model that maybe you didn't that's one of the things that, you know, that I do is like, I'll run my own models and then say, well, wait a second. How did, how did I get a number that's better than theirs? Let me understand what did they haircut? I don't know if you guys have an event coming up on IRR.

Somebody has an event coming up on IRR it's a topic that's been around for a while. There are tons of white papers out there. Super smart people have gone after IRR for many years. It's not a bad number. It's just, you have to understand how it's calculated. So, liquidity. Alright, this is an important one to understand because it's very personal to you. Does an investment match your liquidity needs? Is this a portion of your money that, hey, I can be out there for five to seven years and that's fine or is this something to where I'd rather have shorter term, and this applies to any type of alternative investments, because one of the things that you're taking advantage of in an alternative investment to capture an outside return often is what they call an liquidity premium.

You're paid a certain return over a traditional say benchmark because you're accepting liquidity allowing the manager to go do something that may take a little bit longer to materialize and that's when you've got to make sure that matches up with you. So, this document here, you know, any number of desiring to redeem their units in the fund may do so after two-year lock-up period and subsequent to the provider, the manager will notice of intent. Reducing the units and writing the receipt of this notice will then trigger a start-up a 12-month notice period. Okay. So, in simple English, this is a three-year lock. I mean, I don't know why they just didn't say that. But okay, great. That's what it is. And they go through and other parts of the document and sort of talk about a various number of events that are around this three-year lock and the fees and everything else that are applicable to it.

So just again, understand what you're getting into. If you were deemed before this three-year lock, okay. This was an interesting one. the manager has the right to buy your position. First refusal actually, I mean, this is the actual language of the PPM. If I need this, let's say I have an emergency. I need to liquidate my position. I actually have to sell it to the manager first at a 15% discount. And they may charge an additional 5% redemption fee. Well, okay. That's not good for you, but we don't really get the point. If I'm getting out of a fund, I don't care about the other investors and let's just be honest.
This is all about us. We're diving into this PPM, and the effect being the investor would receive 80%. It's talking about a 20% haircut, 15% of value that would go to the managers, and they have this as a first refusal. It's like, if you have any need to get out early, you're looking at a pretty bad situation. They have a couple of comments in this PPM about best efforts and, and a couple of other things, but there, again, proof is in the pudding. Ask the question, have you had anybody Redeemer early? What was the situation of where you were able to redeem someone that didn't have to pay any of these fees? Cause let's just be honest. They're always going to take this from you because if they believe in the project, why wouldn't they buy it from you at a 15% haircut? I mean, it would be as given trade, I'd do that all day long. That's like trading one-on-one I can make 15 cents on your dollar.

I'm taking it every time. You're kind of stuck with this and that's the rest of the clauses. The PPM goes on to talk about other possibilities that would be available. You're not going to see any of those, you know, you can pretty much guarantee that, you're going to get hit. So, understand what it says here, the second line of the fund doesn't actually document language. If the fund doesn't want to buy it, an existing investor can buy it's only a 5% discount on a 2% fee. Well, if they don't take that opportunity, that would scare me. That means, you know, you should probably take the 20% discount. Cause if they don't want to buy it at a, at a 15% discount, that means something's wrong with the asset. So maybe it's a good thing. You get out and get your money. But there, again, this liquidity links in to does it match and are there terms for you able to get out in extreme situations, I'm not talking about the market gasping, and you need your money.

I'm buying, you know, a true emergency where, you know, go get a doctor's notice and hey, I need my money because X, Y, Z, you know, and have they dealt with that situation and been able to provide liquidity without charging a lot of fees. That's, uh, something that's important because let's just be clear. It's a long-term relationship between a manager and their investors, if it's not, it should be. Make sure that the document and the manager has that alignment with you. You keep yourself out of trouble and, you know, you're dealing with somebody who's going to have some of your best interests at all times, not only from a return standpoint, but from life events. Let's move on here further in the liquidity side. Let's see distributions of profit, understand the waterfall. And if people aren't aware of what a waterfall is with regards to an incentive fee, there is a category of who gets paid first, returns of incentive fees of profits. And it's just called a waterfall. Do you guys want to talk about waterfalls? There are different kinds of waterfalls. We can have a whole another conversation about that. But who gets paid when? The manager has the right and its still discretion to withhold the distribution of cash would not be in the managers.

Would be in the best interest of the fund. Okay. That's fine. It's pretty common language in one form or another. And a lot of PPMS, just being really careful. These vague definitions, these are the things you need to ask questions about. This is what you need to dive into. These are the things like, hey, what does that really mean? And when did it occur? When is this ever occurred that you didn't pay something out and also ask the question of why didn't you put this in the document? Give me examples of where this would happen. If you don't know, ask the question because when it happens and all of a sudden, you're on your heels wondering why you were expecting a distribution and not getting one, it'll be better for you and better for the manager overall.

Because they build a proper expectation of events that could occur. And if it's an event that they're coming forward and saying, we're not paying it out and it doesn't match any of the examples they gave to you when you were first doing your due date. Be on your toes, be ready. There could be greater problems at the fund. Just understand that, ask those questions. And also, if there's any point throughout this, that there's like a specific question I'm trying to be fairly thorough and give you some real questions and things that go after. That's kind of the point of this. But if, if there's something that you like, you didn't feel like, hey, I don't have a tool in my toolbox to walk away with regards to this. Let me know.

Partner contributions. Okay. All hands in. Interesting enough. This PPM had absolutely no section whatsoever ever said the partners were going to put any money in it. That's actually pretty rare. In today's world, most people generally expect Some level of skin in the game that the partners will have some amount defined. You'll see certain things, a very common language is, the managers will always try to be 2% of the fund. Some people will put a dollar amount to it. There'll be like, well, I'll be 2% or at least 500,000 some nature to that level. I mean, I've seen some people where, you know, they're very fortunate individuals, so I've seen one PPM say I'm going to have a minimum of 5 million on my phone and they have the capability to do that. That's a great indicator. He believes in his funds and he's putting 5 million into the fund. But one of the questions you can come back and understand is, what kind of percentage of that is of your liquid net worth?

Give me an idea of what that is. How committed are they to their fund? Is this a really great investment that they're excited about? And they're putting a lot of their dollars towards and if you're not seeing that, then that goes back to what I was saying earlier when I was walking through all the key elements is like if your money's not in this fund, where is it? And maybe I should talk to you about that investment because that's obviously a better investment because that's where you put your money. You know, it will be tough on these guys. They created this big document and they're telling you to write a large amount of money. No, put them to their test.
So, this was definitely a red flag for me. It doesn't mean they're not putting money in just oddly enough. They didn't take the time to put it in their document. So here again, this is that question of walk me through, how much money do you put in? And here's one of the things is you can ask for, if audited you'll get this information.

If not, ask for information around banking statements and transfers and sub docs. You know, one of the things that Verivest does, which I thought was great was when they went through, Kirkland Capital Group, PPM. Lance called me up and said, hey, you say, you're going to put X amount in semi all the sub docs approve that. And I was like, wow, what a great question. If Lance can ask it, you should be able to also show me those sub docs, show me the legal documents. They have a fund administrator. Is the fund administrator name verified and say, hey, these guys put this money in. The next step is also, there's a few funds I've seen in the real estate space.

They have some kind of accelerated mechanism that allows them to recapture their money, be weary for that. I mean, it's not common, but I've seen it to where you'll see people like, hey, I'm going to put in, you know, $500,000 then all sudden there's some kind of mechanism of where they get paid out sooner than other people up to the point of their contributed map. Excuse me. You're getting earlier percentage distributions so that you can cover your 500,000 in sooner than other people. Just be careful. Just like I said this is an art, not a science. You will, you dive in, and you start reading these documents. You will see a little bit of everything.
It's a little crazy. But be wary of that. It's one of the things in real estate that I've seen and hedge funds, they're under such regulatory constraint and they have such institutional backing. They don't really get away with a lot these days. VC is next in the firing squad.

They're having the government go after them about tax structures on incentive fees, as venture, as PE private equity investment, big dollar investment, late-stage buyout stuff. It's trickling down into your later stage, mid stage venture, wherever money flows, regulation follows. Oddly enough, there's not as much regulation in the real estate space, which unfortunately puts more effort on you as the investor to really make sure things really match up because there's no one really watching or setting guidelines as much as they are in the other private and alternate investment worlds. So, leverage. I always I love this little chart. It always shows that you're making lots of money. The only problem is when the amble falls on the other side and then the two little guys go flying. The statement and the PPM, the fund will utilize leverage in various forms, including seller financing, acquisition loans, bridge financing, that's all pretty common stuff, especially in the real estate world.

If you're looking at another document, say a hedge fund document that would really be wonky. That's not very common. Nothing too out of the ordinary here, it's just an understanding of what leverage really means. It is a powerful tool. It can be utilized to capture returns for investors, but one of the things I like to dive in, and one of the questions I like to ask is get into the head of the manager and ask, is leverage a strategic play, or is it a tactical play?
Strategic means it is a material piece to the long-term performance of the fund. And they would not be able to give you the returns you expect as an investor, given the risk you're taking without leverage. That's one of the things you're going after when someone says it's a strategical piece, if it's tactical, it means it's something that they plan on using for a variety of different reasons on a shorter end, and that if they didn't deploy any leverage, it might not hurt their investment goals with regards to what they promised you in the documents and for the fund.
That's one of the things I like to go after. I like to understand where they are going to use leverage in the hedge fund world, in my previous life, leverage was definitely strategic. I mean, it was very important because we were deploying billions of dollars and picking up pennies and nickels.

You needed the leverage aspect and the capability of the power of using other people's money to create the return objectives that you know, was required by our investors. But not every investment works that way. There's enough, there's enough meat on the bone per say if they're in an inefficient space that may leverage is not strategic. I'll leave it at that. But dive in, get into their head. Evaluations, all right, this is a huge issue. This is this stem to became center stage in 2008. Because everyone was worried about readings and valuations and what things were actually worth. There's entire organizations and the government created to understand better understand valuations.

Now in this document, you know, the stated value should be determined by the manager at their sole discretion and shall reflect the manager's best estimate of the ivory value of all of its investments on the effective date. The manager may use one or more methodologies determined in the sole discretion and they can change their methodology. I'm not going to bother reading the rest of that. Here again, not necessarily something wrong but something to be concerned about and keep your eye on as an investor. If you decide to invest in this fund, you're basically trusting the valuation capabilities of the manager. There's lots of conflicts of interest that come out of that.

There, again, it doesn't mean they're bad people that are doing anything wrong. It just opens the door for things to go wrong. And I always believe that everyone who's going to start a fund doesn't start day one is like, I'm going to rip investors off. Something goes wrong and they'll use every door they can to try and fix the problem or escape out the back. And valuations are one of those doors that you'll commonly see where valuations are left, stagnant, or they're just outright lying about it. They're inflating it for one reason or another.

In hedge funds and a variety of other spaces, this would just not be allowed. It just, it's just flat out. You would never raise an institutional dollar in your life if, you were running say a long, short fund and you had some tier three type assets, tier three means it's not publicly priced. And you weren't using a third-party valuation source as further verification to your evaluation. It doesn't mean you're not running your own valuations and understanding and doing your own work, but you're having that checked by a third party that is going to be compliant with a variety that rules and regulations that are going to come in and make sure the valuation is correct to the best of their ability.

And not just yours. So, I hope everyone understands that. If you're reliant on the manager to do their own valuations and that's the mark, you're going to be taking. There again, not necessarily bad thing just could be a problem going forward. You got to get in there, you got to ask for the valuation methodology.
Actually, in this PPM, they did walk through an example of how valuation was done. Now. I thought it was very interesting in a section right after they give the example was hey, we just recently changed our evaluation methodology. And then they give a second example. So there again, I was like, why are you showing an old methodology and then turning around and saying, there's a new one. more reading for you. I guess but that's one of those things, walk through. If you don't understand the example, that's in the document, there again, don't be shy, have them walk you through it and explain why they make certain assumptions and how they structure things. Because this valuation is extremely important.

It is used in multiple aspects of where you need to get out in an emergency. You're going to take your 20% haircut off what, off of their value so heaven forbid they choose their methodology. And then mark the portfolio down a little bit at the time in your emergency. You're going to find yourself that even steeper, haircut and you wouldn't necessarily be able to prove it. It's also utilized when new people come in because this PPM stated, hey, you, we can actually bring you in a certain number of times at set intervals. And they're setting those valuations of when people come in and have them, how much share they get of the fund at the time of that valuation.
Now depending on that, they could actually, you know, inadvertently mark that higher. I'm not saying they do that. I'm just saying it opens the door for some flexibility that may not be in the best interest of investors. So there again, you have to find a way to mono-culture that really get in and that, that out related party transactions.

This is a good one you can actually do some white papers throughout the alternative investment world. This is where so many bad things have happened. You know, there's nothing technically wrong. There, again, it just opens those doors of where people can, you know, capture excess fees for themselves. Hide expenses. I mean, there's just so many things that can be done now in the premise of this PPM, they're coming across and saying, hey, we have the ability, we have the knowledge, we have all these pieces and you're going to benefit by having this vertical integration. I sound like a good thing. But when you walk through the fee section, I don't see any real discounts in fees or structures. Because if I was promising you, I have all this stuff, that allow you to go end to end and I have full vertical integration. I'd want to be able to cut those costs to the benefit of my investors throughout that step.

That's the advantage of the vertical integration because I'm basically using all people I know in control and transparency into. And so that hopefully it cost me less to perform that act and I can cast, and I can pass that savings onto the investors. I didn't really see that in this PPM. But it's something you can dive in and really understand, but just be wary, because every PPM will basically say a related party. Transaction is, is a positive thing. It's going to help you because you know, it's the seamless relationship between groups, but seamless relationships also allowed accountants to hide a lot of stuff. I got caught once, on a related party transaction between two hedge funds. and it was almost impossible to see what was going on behind in accounting relations.

And it turned out that the lead accountant for the two groups was embezzling money. It's very hard to catch some of these people. If you have very smart people trying to trick you, they're spending a hundred percent of their day trying to trick you and you're spending 10% of your time to catch up.
Let's just be honest. It's going to be tough. But that's a reality. So luckily, recent conflicts of interest, this is a huge section and every PPM, some of it will be very generic. If you leave enough of these, you'll begin to understand what are the common statements? There will be risks and conflicts that are very good at use and critics of the type of fund you're looking at.

Those are the ones you really want to hang in on. You want to understand this development fund, what is it that's going to be important to me with the relations, the projects that are going to be involved in that are ending up in my returns. You know, there's always conflicts of interest. You're never going to escape them. But it doesn't mean there's a negative. It just means as a manager, I want to give you the, my best return, but sometimes to get there, I mean, if I got to charge fees okay. That in its nature as a conflict, it doesn't mean it's a bad conflict, but, you know, make sure that the manager and there again is tracking and justifying the fees as we discussed earlier.

This one, the one that bothered me in this PPM here again is, you know, the manager's interest may be in conflict with the members' interests. Of course, there is no requirement that the fund creator utilize a or a committee or unaffiliated members or other advisers to review and approve transactions that may constitute a conflict of interest or a determination of the manager of the value of the fund assets.

Okay. This goes back to the valuation situation. I'm. Very bothered when I'm like relying on the manager, I come from a world where you always have third parties, and you have general mandates of how things are treated by large third parties. So, there's rules and guidelines evaluation, and you have people looking over your shoulder with that, and to rely on a party that may have other interests other than your, your sole interest is the highest returns, as an investor, it's something to be worried about.

This one in particular, I'm used to having those committees. I'm used to having those people, looking over my shoulder, sort of verifying and monitoring everything. I'm okay with it. Some people don't like that idea. But that's the world I come from. I'm very used to having people looking over my shoulders, become, it's kind of required for me. It's the, what I call sort of the best practices. That's one that kind of jumped out at me is you know, great. They can also do transactions. that don't really need to be approved by an outside source, but it may not be a core source of or a listed sources of what they're going to do so you can get what they called style drift.

These guys can go out and do other things and other transactions that may or may not be best for the investors. But there's no one watching. And the only people watching the hen-house maybe as the Fox. So just watch out for that. I always believe in third party service providers are very important to have embedded into what you would call an institutional class fund. The other one was dependency on key personnel. The company is dependent on the fund manager and the key persons, the departure or incapacity of one or more of these individuals could have material adverse. There's nothing wrong with this statement. It's a key man sort of statement of like, hey, we've got two or three important people.

They get hit by a bus. That'd be a material issue. The one thing that kind of jumped out at me is they didn't say that what the plan was in the document of well wincing. And if that does happen, what happens, especially in this fund where you could be mid development project, buildings are halfway built or, you know, oh my God, we just plowed dirt. How, what happens? How do we define that? Who one wines this, how does this all work? That was a little troubling because the PPM didn't actually define what that process was going to be. Make sure that's defined in the BPM or maybe it's embedded in the operating agreement. And if it's not, and you don't find it clear and understood, ask the questions. I've actually had a couple of investors ask me that question.

If my partner Brock and I, you know, get run over, what happens, in our world, that's a little bit simpler because we're doing debt that's, you know, three-to-12-month terms. Great, if Brock and I are not here, our CFO steps in and moves the debt to, maturity and then returns to the capital on a pro-rate basis. I mean much easier to deal with, but in a development fund you could, could be in trouble. You might be, holding onto a lot of assets and not really sure who's going to liquidate them. I love this slide because all of this at the end of the day, all this review is trying to get the manager.

And you aligned is this manager in your quick review of these nine points and you're talking maybe meeting 20 to 25 pages of an 80-page document. That's the goal back to the center of objective of what I was trying to achieve here is how do I get you reading 20 pages, maybe not 80 home in on what's important and get you to that note quickly so that you can assess well, is this manager aligned with what I expect, given what I need for my portfolio and what I expect to in relation to their investment?

Lastly, Please if you've got questions after this, don't hesitate. I love talking to them about this stuff. I go through and spend my entire career, send me an email, reach out on our website. There is a paper that I co-wrote with one of my good friends, John Kanara who works for a very large, investment management shop. Due diligence is a huge, huge topic right now, as the alternative investment world is be expanded and opened up for a lot of people who don't have teams of 20 people to read through these things. They don't have maybe, you know, 15 years of knowledge or have drafted these before. It's, it's very complex world.

And we're trying to write some papers, very like this, a webinar that I'm doing here in those papers. We're trying to give you questions and things to think about so that you can avoid red flags, identify them, ask the questions about them and really just be able to move away from things that make you uneasy and define uneasy. And then that helps you to find what should make you feel uneasy. I know there's a lot of people out there that just, they just don't know. And so that's what we're trying to do. I appreciate your time. Thank you very much. And I'll take any other questions you might have. And if not at this time, feel free to reach out to me by email.

Brittany Hobson
You have a comment here. Thank you for the great information. Thank you. It was very informative. Thank you, Chris, for joining us. I also learned, more than I have ever known about the PPM and I appreciate your expertise. So, thank you again for joining us, Chris. And, if we don't have any questions, you guys feel free to reach out to Chris. He, as you can tell, he loves to inform people on due diligence, and he would be happy to chat with you. So, take care everyone and have a good evening.

Chris Carsley
Thank you very much.