As part of the diligence and syndication onboarding process, one of the most overwhelming documents to read is the private placement memorandum (PPM). In a prior snippet we detailed they key sections of the PPM. However, a question frequently raised by fellow passive investors is – what are top 3-4 areas I should pay the most attention to. In today’s quick snippet we’ll dive into this topic. After all, each PPM can be as long as 200 pages and we recognize it is not bed time reading but rather full of legalese and financial terminology.
1. Key Risks.
This is usually in the beginning of the PPM and this section will highlight all the possible risks that might materialize with the investment. As with any investment, real estate syndications carry their own risk. Thus, it is important to not only be aware of what these risks are, but also understand how the sponsor is mitigating those upfront. One cannot eliminate risk 100% but can plan for contingencies to minimize such risk or the impacts thereof. For example, there is always a risk that the property may be destroyed or severely damaged by a hurricane. Having proper insurance with adequate named storm coverage as well as loss of rent helps mitigate the risk of having to bring the damaged units back into operation.
2. Capital Calls.
When an investment is short on liquidity, the sponsors may elect to do a capital call (especially if the deal is still salvageable and has a chance of meeting the original returns or avoiding losses, with the additional cash infusion). However, not all capital call provisions are equal. The most typical one is optional participation in the capital call with potential for dilution for the limited partners (LPs) who choose not to partake in the deal. However, we have seen deal with mandatory capital calls or others with optional capital calls but with penalties assessed (in addition to ownership dilution) should LPs choose not to partake.
It is best if LPs and their attorneys review this upfront. However, if you are not in a position to hire an attorney to help with the PPM review, then you can at least ask the sponsor to clarify this provision for you upfront.
3. Distributions and Preferred Return Structure.
Most distributions are sent quarterly, though some may be monthly. Especially in the beginning, the cash flow after debt service may not be sufficient to cover the full preferred return. The PPM will usually clarify if such preferred return deficits will be cumulative (most common) or cumulative and compounding (less common but better for LPs) or lost altogether (we avoid such deals altogether). It will also clarify if distributions are a return of capital (we avoid such deals usually) or return on capital (most common).
4. Voting Powers And Management Changes.
Passive investors are usually truly passive, i.e. they do not participate in the day to day operations and decision making. However, there may be special situations where it might be necessary for the management team (or certain members) to be voted out or for the LPs to take over. The operating agreement within the PPM will spell out if or how such changes can be effectuated.
All of these sections pertain to extreme and adverse events. However, good planning always entails thinking about such adverse extremes upfront because in times of crisis the original documents will govern how such events or decisions will be handled.
And if reading through these four sections only is still too overwhelming, you can at least be familiar with the four key PPM questions to discuss with your sponsors. They will be able to walk you through those sections and address the key points raised above. We hope today’s snippet provided an easy to digest overview of the four key sections of the PPM so you can be a more empowered and better educated passive investor.
Vessi Kapoulian
Peeling back the layers of passive real estate investing, so you protect the downside and invest with clarity and confidence.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.
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