Matt shares the one thing that poses the greatest threat to investors and engenders the most fear in them.
There are a lot of great things about Small Balance Real Estate (SBRE) funds. A well-conceived and well-run fund can produce attractive risk adjusted returns completely non-correlated to the broader equity markets. They can produce regular income or capital gains or depreciation benefits or strong capital preservation or all of the above.
There are also important risks that need to be understood if one can expect to invest wisely and do well in this space. While I could articulate in much detail some of these risks, I am going to focus in this blog on the one that poses the greatest threat to investors and engenders the most fear in them.
The single scariest thing about a private 506 Regulation D discretionary pooled investment fund is that the manager might misappropriate or even outright steal the investors’ money. We have all heard way too many stories, both big and small, of this happening with some private investment fund or another. Because of the lack of discretionary decision making by investors, which in a fund resides instead solely with the manager, and, more importantly, the lack of oversight and ability to monitor what is actually going on once the investment has been made, it can be relatively easy for an unscrupulous manager to claim everything is going swimmingly when in fact they have crossed the line into criminal behavior.
I believe that, almost always, a manager committing fraud does not start out that way. Rather, it may begin happening when a significant enough number of the investments being made by the manager fail to produce the anticipated or hoped for results and instead lose value. The seminal moment occurs when the manager fails to immediately acknowledge that outcome and instead tries to hide it, hoping to make it up on later investments. If that doesn’t materialize, the manager finds himself in a predicament. Because he has now crossed the proverbial line, however slightly, it then becomes easier for him to move farther and farther away from that line as time goes on. Turning back may prove more difficult for him than going deeper, since he has already entered into forbidden territory, and deeper he descends. Often, it seems the manager is able to cloak the real situation for a significant period of time, thus exacerbating the size and scope of the problem.
People ask me all the time about this risk and how can they know whether or not it is happening. The answer is that it is difficult for investors, particularly non-institutional investors, to truly know whether or not it is in fact happening. Most individual high net worth (HNW) investors and frankly even registered investment advisors (RIAs) just do not possess the expertise, tools, and/or bandwidth to make the effort necessary to significantly mitigate the risks of such an event occurring. So how can an individual HNW investor (and their RIAs) gain access to the attractive returns and positive aspects of this space and at the same time reduce their chances of becoming a victim of a Ponzi scheme?
There are several simple (and some more sophisticated) factors that reduce the chances of such an outcome. Mostly they involve making sure that the fund manager is not operating completely in a vacuum without any third party involvement and oversight. It is far easier to manufacture and/or report false or misleading information when no one (or only people who do not know what they should be looking for) is watching. The following list is not exhaustive and none of the following recommendations are foolproof, and one or more may not be workable for a particular fund for good reasons, but they can go a long way, especially in combination, towards mitigating the possibility of outright fraud and misrepresentation by a manager.
Third Party Administration
The things that make an SBRE entrepreneur really good at generating strong returns in the real estate field do not have anything to do with properly accounting for pooled investment funds. Doing pooled fund accounting accurately when there are both investments and investors coming and going at different points in time is a completely different skill set than identifying, underwriting, negotiating, closing and managing real estate assets. I have met a select few who are outstanding operators at every aspect of their business who perform their own fund administration exceedingly well. However, I have met a far higher percentage trying to do it themselves who do not understand pooled fund accounting, share price valuation, calculation and allocation of income to different investors coming in at various points in time, and other critical elements of proper fund administration. Quite often they simply do it wrong. Usually this only manifests in unwitting inconsistencies and inaccuracies rather than criminal behavior, but doing their own administration and reporting allows for moving from the former to the latter much more easily.
The role of a third party fund administrator is not to prevent fraud per se, and even the most competent fund administrator may not be able to detect intentionally fraudulent contact. But having a professional third party handling this function, who does it for a living, and who has their eyes on the money, the accounts, the income and expenses, and the investor allocations not only helps ensure it is being done properly in the first place, but may also be a significant deterrent to criminal behavior. In addition, it is quite inexpensive compared to doing it internally and thus is a relatively easy function for a manager to outsource. This is probably the simplest step a fund manager can take to help mitigate the possibility of sliding down a slippery slope into fraud.
Third Party Custodians
A much more difficult step for a fund manager to take but an even more powerful way for HNW investors to gain additional oversight and confidence is to custody the fund’s assets (cash, negotiable instruments, and other assets) with a third party custodian. This is a step that most institutional investors will absolutely require but many HNW investors are unaware of. It can be a very challenging move for an SBRE fund manager to make operationally, as it can be accompanied by significant inconveniences and time delays in getting things done (wires initiated and received, documents sent, deals closed, etc.). It may also be entirely impractical for some managers depending on the asset strategy. For example, a fund that focuses on a large volume of small assets with high asset velocity may not be able to utilize a third party custodian even if the manager wants to, as both the operational impact and the financial impact from the fees may be intolerable. For other funds, however, it may be much easier than the manager thinks to use such as service. From an investor standpoint, it is a significant protection against fraudulent activities.
Audited Financial Statements
Another step that virtually every fund of any meaningful size should take, in my opinion, is to have its financial statements audited by an independent third party CPA firm. The main value of this step for investors is the CPA’s focus during the audit on assets that may be impaired in some way, the primary thing for which they are looking. It is another measure to help ensure that proper acknowledgement of any actual impairment is being recognized by the manager. A CPA audit of the financials is not a perfect science. The process can be somewhat messy when it comes to determining actual impairment as valuation of individual assets can be quite subjective, but it calls significant attention to the issue. Although no panacea, taken in conjunction with other steps as outlined in this article, an audit is another useful safeguard for investors.
A clean background check is by itself not a guarantee of good future behavior as there will be some managers who have a perfectly clean record prior to crossing the line into fraudulent reporting. But sometimes a simple background check can reveal a great deal that may be indicative of such tendencies. Even a simple Google search of the principals or other key personnel may shed quick light on behaviors. I am continually amazed at how frequently this basic, quick and inexpensive step is overlooked by investors.
Taking the time and effort to go visit the office of your fund manager is a basic, easy and smart step, especially if you are local. You can tell a lot about the fund manager by visiting that office, including how elaborate or spartan their space is, how they interact with and treat their people (and how they treat you), whether or not they have information readily available while you are there, and many other nuances that are not readily apparent over the phone. Less than scrupulous operators may spend profligately on over-the-top office space, use a dummy address, or otherwise reveal clues that things are not well. It is no coincidence that these factors were frequently present in many of the funds that were eventually revealed to be Ponzi Schemes.
Investor Advisory Boards
I am seeing an increasing number of SBRE fund managers take steps to form and utilize a Board of Advisors (BOA). Such a BOA can serve multiple useful purposes. The manager can get an important sounding board of quality people to provide advice, guidance, and feedback as well as connections and referrals for key needs, including other investors. A BOA will often consist of some of the fund manager’s largest and savviest investors, as well as other well-considered individuals who can bring specific resources, skills and/or connections to the manager. Having a BOA with several larger investors on it is another way for the other investors in the fund to know that people who invested alongside them have additional access to the manager and insight into developments in the fund.
I cringe every time I hear or see another fund manager steal money, commit fraud and/or execute what turns out to be a Ponzi Scheme. I cringe because I know that it will once again give a black eye to all of the ethical, capable and worthy fund managers in this business who are honest and disciplined stewards of investor money. I cringe because I hate to see investors get their hard-earned money stolen. And I cringe because almost always there were obvious warning signs that were ignored and few, if any, of the suggestions I mention above were happening. I am not saying that a manager has to do ALL of the things mentioned above in order for them to be trustworthy. And I am not saying that a manager who does none of them is automatically not. What I am saying is that the great majority of Ponzi Schemes were executed by managers or operators who did few or none of them. Many of these steps are so simple, so easy, so inexpensive and so potentially effective in both keeping managers honest and engendering investor confidence that it is hard to understand why serious managers would refuse to incorporate them into their operations at an appropriate point in their evolution.