Part Two: How To Set Your Syndication Up For Success – Regulations And Hot Tips
In part one of our discussion on Multifamily syndication, we looked at why you would consider a Syndicate and what securities you need. Click here to read that piece if you have not already.
In part two, we are going to look into the security regulations in greater detail, plus some tips for setting up a successful syndication. Let’s get started.
What Are The Security Regulations?
In the last article, we talked about how any Managed Syndication deal has to be registered with the Securities and Exchange Commission (SEC). There are a number of ways this can be done depending on the kind of deal you are creating.
So, what are the different security regulations and which is the right option for your deal?
This regulation was created within the Jobs Act, which was passed in 2012, and allows private companies (or investors) to raise up to $50 million from the public. Reg A+ allows investors to apply to the SEC for a permit, but it is not full registration. You are not going to get on the New York Stock Exchange with this kind of registration!
But with the permit, you do have the ability to advertise and to sell to both accredited investors and non-accredited investors. Basically, it means you can sell to anyone that meets your suitability standards and it allows you to raise $50 million in a year.
In the real estate world, it would have to be a blind pool as an investment fund. From the time of application, it could take the SEC around 5 months to issue the permit. Therefore most funds raise the money first and then look for an asset to purchase.
Regulation D (Reg D), Rule 506
Most commonly in a Multifamily Syndication, the private placement money is raised via Reg D and it’s Rules 506(b) or 506(c). Reg D allows small companies (or investors) to raise capital for a deal, without having to register all the individual contributions as securities. Rule 506 ensures that any Deal Sponsor provides information free from false and misleading statements.
From the beginning, a Deal Sponsor is required to choose whether they will register under rule 506(b) or rule 506(c). The difference between the two rules is the ability to advertise. 506(c) allows advertising, while 506(b) doesn’t.
When it comes to property deals, the type of exemption needed under federal securities laws is typically stated in the disclaimers section which is usually within the first 2-3 pages of the private placement memorandum (PPM). They will tell you how this offering is brought about under federal securities laws and will state the exemption.
Reg D 506(b)
Regulation D Rule 506 Is the most common SEC Exemption to Syndicate with. 506(b) allows investors to raise as much money as necessary. Remember, we talked about Reg A that was limited to $50 million a year? Well, in rule 506(b), there is no dollar limit. You can raise an unlimited amount of money and there’s no timeframe related to that. It also means you can have an unlimited number of accredited investors.
With 506(b) Investors can self-certify if they are accredited. They can just simply check a box and say, yes they are. 506(b) allows you to have up to 35 Sophisticated investors that do not meet the definition of being accredited, but they must have experience. They need to have advisors who can help them make a sophisticated investment decision to see if the investment presented to them is within their risk tolerance.
The reason you can have self-certification for accredited investors and have sophisticated investors in a 506(b) is because you can’t advertise.
As part of 506(b), Deal Sponsors need to record and prove Pre-existing relationships with their investors. That means that they need to display they know enough about the investors and can prove they had a relationship with the investor prior to providing any offerings that “promote” an investment.
Reg D 506(c)
We mentioned above that the main difference between 506(b) and 506(c) is that with 506(c), you can advertise. Other factors in 506 (c) vs are as follow:
- Raise as much capital as you want.
- Have an unlimited number of accredited investors.
- No sophisticated investors.
- You can advertise and take people you don’t know.
- No self-certification by ticking the box.
- The Deal sponsor has to verify that the investors are accredited according to the processes outlined by the SEC. For example, the investors may be required to provide their tax returns or a letter from the investor’s CPA or stock broker.
Setting Up A Syndication
Now that we understand the different security regulations, let’s look at some practical aspects of setting up a syndication.
Firstly, you need to understand the kind of deal you are going to make so that you can apply for the right securities and bring on the correct number and type of investors.
A lot of it will hinge on the information within the Real Estate Placement Memorandum (PPM). These are the things you should look out for in a PPM:
- Asset description
- How much money is to be raised
- How is the money going to be spent
- The asset suitability as an investment
- Distribution schedule
- Fees paid to the sponsor
- Outline of risk factors. Including any potential for natural disaster risks like Hurricanes, Earthquakes and hail storm
- Conflicts of interest, ie Either conflicts of interest between the manager and the members, possibly other offerings that the manager has and this offering etc. A good PPM should have full discussion of those conflicts.
- Liquidity section for enforcing event like illness, death or divorce etc.
- Dispute resolution process
Tips For Setting Up A Syndication
Here we will not cover all the nuts and bolts of how to go about setting up a syndication. But, we will cover off a few things you need to consider.
Ducks In A Row
It is very important to have your ducks in a row when starting the syndication processes. The last thing you want as a syndicator is to progress with the Due Diligence only to find out that you are short on money to close on the deal. If you can’t complete the raise, and you will need to refund your investor’s money. Because you were short on capital, it is going to be difficult to bring back those investors back on your next deal. Not to mention the loss of credibly in the Brokers eyes.
One way to mitigate the risk of being short on the capital raise, is to have cash or some assets that could be converted into cash easily. If money raising was slow, you could still close and then you could continue to backfill and raise money.
Communication Is Key
When an investor places their money with you, they want to know where it is and how it is going to be handled. This will probably involve them calling to ask questions. Some may want to talk to you directly and not your associate, so be prepared to be there for them – within reason of course.
Communicating with your investors on a monthly basis will make them feel at ease. Some Deal Sponsors who are on their “second or Third round “ with investors may communicate with them quarterly. That is because the investors already have the experience of investing passively and feel comfortable with the deal sponsor. Until you build that level of trust, monthly communication is best.
The First Hurdle
Most investors will want to know your experience. Have you made a big deal before? That will make them feel as though they can safely invest their money.
The truth of the matter is, everyone has to start somewhere. Every Deal Sponsor had to make their first deal at one point or another. The key is doing your due diligence and getting that first deal across the line so that you can answer that question with confidence on the next deal.
Don’t quit your day job just yet. You are not going to make a lot of money on this until you get into bigger properties and you get more of them. Run your syndication as a business. Remember, you have someone else’s money and you have to manage that money responsibly.
On every deal, but the first one especially, ensure you are backed by a professional team. Contacts that are able to work with lenders, attorneys, property managers, and title companies. Choosing the right team will help to make your deal a success.
Syndication can seem complicated, so at least you now understand the basics. If you enjoyed this two part piece, then sign up to receive our newsletter for more great information on Multifamily investing.
The Information provided here is for general education only. You must seek professional legal advice concerning the U.S. Securities and Exchange Commission law. Federal and State securities laws may differ by state or the nature of the transaction.