The syndicators and most real estate agents are familiar with the term ‘Private Placement Memorandum’ commonly abbreviated as PPM. In case you are a greenhorn in the investment arena the content of this article would provide sufficient background information on this very important aspect of real estate investment.
Simply put, PPMs i.e Private Placement Memorandums are legal documents which are given to all prospective investors partaking in a real estate investment, despite their investment categories (as individuals or Limited liability companies). The program is designed to provide potential investors with the full disclosure of the investment program as required by the requirements of the federal security laws. More often than not, a lot of investors confuse a Private Placement Memorandum with business plans. It must be noted that the Private Placement Memorandum (PPM) is not a business plan, rather, it is a document which outlines the total investment plan, taking into note all the information required by investors, including the commissions and fees which would be earned by the sponsor of the real estate investment as well as a complete description of the property itself.
Basically, all PPMs have four key parts which all passive investors must be aware of:
- The Introduction
This section details a short summary of the offer at hand. It describes the property including the period the investment is expected to last. It also provides details about the minimum investment acceptable as well as a statement of any risk(s) involved in the process. Other items detailed in this section include: Suitability standards statement, disclosure of fees and commission payable to the sponsor of the investment.
- The Disclosures
Being a legal document, the PPM is required by law to provide information which would help potential investors to make adequate judgement of the capabilities of the sponsor of an investment. The document must include a full disclosure of the key items which are associated with the deals of the sponsor. Also, a dedicated portion of the PPM would provide key information about the property’s description alongside estimated cost of projects. The document should also include a description of how proceeds would be utilized as well as provide information on gross sales revenues. The document could also include a preforma as well as any projected returns. Each of the entities is usually separated from the other exhibits by making different entries for each of the exhibits in the PPM.
Also, in the PPM, a section relating to the risks associated with particular investment oppurtunities must be included. The risks recorded in the PPM should include market problems, tenant issues, tax or legal issues. Unique risks may be involved in some cases e.g areas where the property in question is located and other specific tenant concerns raised.
- Legal Agreement Basically, the third section of PPMs is regarded as the operating agreement which details t how limited liability companies, limited partnerships and other special purpose vehicles would be managed. The above are governing rules of the sponsors and investors which would include key information like management plans, accounting rules, the group members’ rights, ability to assign or transfer ownership, termination plans and other potential issues in the investment process.
- Subscription Agreement This is the aspect in which agreement is given to the terms and conditions of the PPM. At this point, the investor or sponsor is expected to sign the agreement which borders on how much share you are willing to purchase at the offering price. All investors are required to submit funds at this point of the agreement in order to seal the offer at hand.
Things to Consider Before you Sign the PPM
Several issues must be considered before you eventually sign the PPM. Such issues include:
This is an important aspect of the investment niche that most investors realize later in the deal. More often than not, a lot of passive investors only make enquiries about their ability to sell their shares. It must be noted that passive investors do not own the property they have invested in. Rather, they only own shares in the limited liability company or other establishment sponsoring the investment plan. Thus, the ability of the passive investor to sell shares is subject to the decisions of the sponsor of the investment plan.
The reality of the matter is that, the earlier you get to know the terms and conditions attached to the investment you engage in as a passive investor, the better the outcomes of such investment would be for you. You get to know how much control you have over the shares you own in the investment plan (since you do not own the property you invest on in the passive investment plan). Usually, a lot of sponsors are not willing to let you sell your shares. If on the other hand, selling of shares is permitted, a lot of limitations and specifications are laid down (since the sponsor gets very concerned about the nature of the new partner you would introduce into the establishment by the sale of the share).
In some cases, sponsors put information about the sale of shares in the PPM. Other sponsors review the request by potential investors on a case-by-case basis. It is important that you make clarifications before you eventually sign the PPM.
Some legal limitations stipulate the minimum period that passive investors must hold their shares before being eligible to sell the shares. Therefore, not all the shares you buy can be sold right of the bat! There are terms and conditions.
- Equity and Fee Split
Basically, there are two main ways in which the sponsors of syndication deals earn money. They earn from:
– Income and
– Fees from equity splits.
It is a fact that the sponsors of invest plans bring lots of expertise and knowledge to the investment table. They work hard to find properties which would worth the consideration of passive investors. When the deal is completed, a lot remains to be done. Such things to be done include:
– The search for proper financing and
– Management of the purchased property until it is eventually sold
Usually, the equity on the property is split between the investors and the sponsors (i.e the general partner). These people are called ‘Limited partners’. The Limited partners often receive the higher amount of equity. Also, the sponsor receives equity split when the proceeds from the sale of the property is available.
There are two major equity splits in the investment industry. They are:
– The 30% to 70%
– The 20% to 80%
The normal equity splits are usually those of the 30% to 70% type. Usually, the sponsor also receives 50% of the proceeds from the sale. In some cases, the sponsors prefer the waterfall equity split in which they get higher percentages of the equity when they are able to provide predetermined returns to investors. A typical example is illustrated as follows: About 30% equity if the investment yields 15% IRR to investors and about 40% if the investment yields 16% IRR. This scheme usually functions as an incentive which allows the sponsor to maximize the returns for investors.
Usually, transaction fees range from 1% to 2% of the total value of the transaction at hand. The value is designed in such a way that it compensates the sponsor involved in the transaction for the hard work they put into the investment. Basically, the investment lasts a period of 3 to 6 months or it might be longer in some cases. In addition, some sponsors do have operating and overhead costs which are related to the process of searching and acquiring the property. This might include: hotels, travel, employee salaries as well as other overhead costs which might ensue during the course of the investment.
Another important component which must be put into consideration is the asset management fee. This fee usually represents 1% to 2% of the effective income which is usually paid to the sponsor to compensate for the effort expended in searching for the property and overseeing the management company endued with the responsibility of managing the asset.
It remains a fact that the amount of work to be done on multifamily property is constantly more than what a single sponsor can handle at any point in time. Thus, the sponsor hires and oversees the affairs of a property management company. All investors appreciate this cogent function and strive to understand such terms as the rent structures, vacancy rate and search for excellent tenants. Also, resources are put in place for rent collection, repairs as well as minimization of tenant turnover. All these resources are put in place to ensure that empty units do not occur at any point in time. Thus, several arrangements between investors and management is put in place.
- Indemnification The last but not the least item to pay attention to on the PPM is the sponsor’s indemnification. It must be ascertained that the investment’s sponsor does not qualify for indemnification in all causes. If this is not the case, the investors would be liable for eventualities of the investment. In essence, be sure that the indemnification clause is not included before you sign the PPM.
It is not easy to review a PPM! However, it is very important that one takes the necessary diligence and patience to go through each and every item on the PPM before signing it. Once you sign, you are bound by its provisions! Understand perfectly, clarify with the sponsor, cross-check confusing provisions with your attorney or tax advisor to make the best decisions for your investment.