On my last post, I guess I made the mistake of using the sponsor and deal name. It got significantly way more views then I expected, which could only be the result of people trying to research the deal. When I typed the sponsor and deal into Google, my post was the 2nd thing that appeared. Oops. So now I’m using acronymns.
This deal was a real estate debt fund. Typical due diligence on a debt fund includes finding out the real estate type mix the debt is being loaned, the states the debt is in, how many loans are non performing or in default, LTV, 1st/2nd/3rd position debt, etc. In discussing this deal with investors I know, it did not garner much interest, since the risk profile seems higher. For instance, there was a decent amount loans against land/development, there were some 2nd/3rd position liens, and there were some NPLs. Now I agree, the loan portfolio didn’t look optimal.
What I felt what they were all missing was the fund structure. Fund structure encompasses many things. One example is fees/promotes, which are simpler concepts to understand. For instance, if a deal is investing in a property you know, believe in, etc., but the sponsor is taking too much fees or too much promote, the “structure” is bad even though the property may be great.
In this fund, the hugely beneficial structure has to do with how the entities are set up, which is an inherently harder concept to understand. This fund, which I’ll call “HDF”, is a subsidiary to a parent fund which I’ll call “HC”. HDF holds about $30M in assets (the loans). As an investor, I’m coming in as limited partner into HDF, which is given the preferred rate of 9.6% annualized. HDF is relatively new, and currently has <$1M of investments.
Boom!
Investors I spoke with did not grasp the significance of this. This is preferred rate, meaning the first income is paid to HDF investors until they reach 9.6%, and the rest going to HC. Taking a ratio of $1M of investors to $30M of AUM, over 95% the loans needs to be non performing for the HDF investors to not be able to get paid 9.6% preferred. So it’s not the 9.6% that’s the highlight, but the incredibly low risk entailed to get 9.6%.
Most investors could not see past the loan portfolio. However, compared to another debt fund with a better loan portfolio, even if the risk was 3x higher, the ratio of $1M to $30M AUM brings that risk to 10% of the comparable fund. This is just mathematics.
Now what I didn’t like was that this fund is started by one guy, and although he has a number of employees, he’s the “main guy”. He has key man insurance, but it’s enough just to cover wind down of the fund, not to keep it going. So there’s the “what if he gets hit by the bus” risk.
However, as an objective investor, the mathematics here would suggest this is by far the safest risk/reward ratio to obtain 9.6% return. Of course, if for instance, more investors were to pile in, the risk starts to increase. So this is one that it benefits me that other investors aren’t realizing the significance of the fund structure.
