Did you know that when you buy into either a stock, a bond, or a mutual fund, the issuing company or fund makes a prospectus available for your review before investing?
How many investors know what’s in a prospectus and how many read one before investing? The answer to either question is probably “not many.”
The average retail investor bases their buying decision off the recommendation of someone else – be it a friend, a colleague, or the financial media – and not off of the prospectus.
A prospectus is a company’s offering document. It is meant to provide an investor with information about a company, it’s offering, the investment objective, strategy, use of funds, financials, management, etc., in order to make an informed decision about whether or not to invest.
The SEC doesn’t require the delivery of a prospectus to every potential investor of public securities – only that it’s made available. That’s why most retail investors never read a company’s prospectus, with many not even aware of what a prospectus is.
Private offerings are different. Unlike public offerings where the SEC doesn’t care if you read a company’s prospectus or not, every prospective investor is required to receive a copy of the company’s offering document. This is most commonly known as a Private Placement Memorandum (PPM, private offering document, or confidential offering memorandum).
In a private offering, a company is not required to go through the lengthy and expensive process of registering an offering. This means that its offering document is all the more vital for protecting investors.
The PPM is meant to act as a gateway as well as provide investors with a valuable due diligence resource. Unlike with public offerings, private investors don’t typically rely on the advice of registered brokers or advisers when making investment decisions. They have to conduct their own due diligence and rely on their own evaluation and instincts.
For those who have never received a PPM or evaluated one, the following are some tips for making the most of a PPM as an evaluation and due diligence tool:
- First of all, a PPM is long (often 75 pages or more) and full of legalese that will put even the most avid investor to sleep. Written by lawyers, PPM’s are written from templates and customized to each company’s unique situation. No attorney’s going to write a PPM from the ground up. They have too much golf to play.
- With that in mind, you should expect a PPM to contain a lot of canned legal language, particularly with “Buyer Beware” type disclosures and disclaimers meant to scare investors off and protect a company and its principals if things go south.
- It’s not the canned language that should scare investors off; it’s the specifics about the company, the offering, business strategy, use of funds, financials and management profile and track record that investors should pay particular attention. Vague information about any of these vital factors should scare an investor away. If you see anything along these lines, run!
“Our principals have no experience with multifamily, but they’ve had success flipping a couple of homes, so what could go wrong? We will consider multifamily properties at all price levels and profiles with no geographical limitations. Financial statements would be purely speculative at this point, so why bother?”
The above example may be a little extreme, but there are amateurs out there raising capital, and you should know what to look for to avoid losing money with these clowns.
So, what should prospective private investors be looking for in a PPM? Here are the vital sections of the PPM and what an investor should be looking for in these sections to make informed decisions:
1. Title Page and Introduction
The introduction typically a summary of the most vital terms of the investment including the company making the offering, type of security being offered, how much the company is seeking, the price of the offering, how the company intends to use the funds, investor compensation, investor qualification requirements, the minimum subscription amount, identification of the principals and management.
Pay attention to vagaries or unrealistic figures or expectations.
Is the company overestimating or underestimating the amount required to carry out its business plan? Is the use of funds specific, or are they unfocused?
2. Business Description
The Business Description section should provide a thorough summary of the company’s business and investment strategy, its plan for executing its strategy, all financing sources, its infrastructure, processes, investment criteria, market research, industry, and market analysis, geographical focus, post-acquisition plans, and exit strategy.
The issuer company will also use this section to discuss competitors, competitive advantages, and sources of income.
Prospective investors need to go through this section with a fine-tooth comb. Does the company’s proposed strategy support its investment and financial objectives? Does it have the infrastructure, processes, and personnel to carry out its plan and achieve the projected financial results?
Does the fund have a clear, defined strategy in a proven real estate asset class? Does management clearly communicate this strategy? Investors should avoid vague, unfocused, and speculative strategies.
Funds taking a scatter-shot approach with no defined asset class or geographic area or delving into asset classes management has no familiarity or experience with should be avoided.
A clear, concise description of the company’s business goals and strategy along with realistic, thorough discussions of operations, including results all point to a company with experience and the expertise to accomplish its goals.
A clear and proven strategy will contain specific details, such as clear-cut:
- Asset class
- Geographic focus
- Industry understanding
- Company and market data
- Development or renovation plan
- Financial projections
- Exit strategy
3. Management and Management Compensation
This section contains a description of the principals and management of the fund, including biographies providing educational and professional background and experience.
Does management have a track record of success in the asset class in which the fund proposes to invest? Does management have the requisite experience and knowledge in the asset class and locales in which they are proposing to invest? In other words, is this particular investment in the manager’s “wheelhouse” or is this new territory? Be wary of managers undertaking a real estate class they’ve never invested in before. Due diligence is, and transparency is key. Do the managers make themselves available to answer questions?
On the matter of compensation, does management compensation seem reasonable? Excessive management fees can zap growth and profitability. Well-run private investment funds eliminate unnecessary fees or excessive fees.
Beware of funds where management compensation is derived predominantly from fees instead of from the financial success of the fund.
Credible private funds typically pay managers profit distributions only after the investor makes money. Some even compensate managers based on performance.
4. Projected Use of Funds and Financial Statements
The Projected Use of Funds section outlines in a spreadsheet or table format the company’s projected sources and uses of funds. In terms of sources, is the company relying on other funding sources like debt for its acquisitions? Are the projected sources and uses detailed and outlined, or are they vague?
Included with most PPMs are pro forma financial statements showing the fund’s projected income for at least 3-5 years and sometimes longer.
The failure by a fund to provide financial statements or coherent ones should be a red flag.
When evaluating these pro forma statements, make sure the revenue projections are realistic and not over inflated and that the expense projections are not overly conservative. If there’s a leap in projected net income from one year to another, are these projections based on sound economic principles, or are they based on speculative factors? Beware of over promising by the manager.
5. Summary of the Offering
The Summary of the Offering or the Summary of Principal Terms provides a snapshot, in a table format, of the most important terms of the offering. This includes the organization of the company (entity type, date, and state of filing), investor qualification, minimum subscription, investor fees, management compensation, profit splits, and business and acquisition plans.
If you’re in a hurry, this is the first section you should review to get a general snapshot of the company and the offering. Red flags should be immediately apparent in this section.
This section has the most amount of canned language that you’ll see in every PPM, but you should be looking for risks specific to this investment. Does management understand any specific underlying risks, and do they discuss them?
A PPM that only lists universal risks should be avoided.
One risk in particular that investors should pay attention to are the conflicts of interests involving management. Do they have a financial interest in the company that conflicts with investors? Are they making any affiliate loans or affiliate transactions? Do the principals have other funds that will demand their attention and time. Do the strategies of these other funds conflict with those of this fund?
You can be forgiven for ignoring a 75-page + document full of attorney hot air, but if you know how to wade through the muck, the PPM has vital information. This information is very useful for helping you make an informed decision about a potential investment and save you from potentially losing money.
Knowing the key factors to look for and recognizing the red flags could potentially save you from a bad investment.
When evaluating a private investment opportunity, don’t ignore the PPM.
Invest for Success,