Second in a series detailing how one lender is navigating the daunting task of establishing a private money fund.
In Phase I of our fund management journey, my fund partner Eric Saiki and I relied heavily on the American Association of Private Lenders (“AAPL”) as a resource. AAPL provided the tools and connections to help us spot issues material to fund establishment. Integral to our research was our attendance at the 2022 AAPL annual conference in Las Vegas. There, we completed our Fund Manager I and II certifications. We spotted many large bandwidth issues, including the need for a management entity for the private money fund, the fund itself, ethical issues addressed by AAPL’s Code of Ethics, securities laws, taxation, marketing, licensing, and technology, to name just a few things we found valuable.
As we moved forward toward our goal, these issues were merely the tip of the iceberg. More questions were raised than answered. Fortunately, the more we learned, our intrigue grew and our desire to move forward gained momentum.
Phase II has involved analyzing various software platforms, identifying strategic pathways to build a brand while closing loans through white-label lenders, establishing the management entity, interviewing securities lawyers specializing in establishing private money funds, and licensing issues with the California Department of Real Estate.
Let’s work our way through each of these.
Technology
Eric and I decided to meet with the technology vendors in the fund management space. All of them attended the annual AAPL convention. Through these meetings, we hoped to find a vendor that provided the four major functions of software platforms:
- Client relationship manager (CRM)
- Front-end loan origination
- Back-end servicing
- Back-end relationship software
We were looking for a solution that provided efficiency through the integration of information. We did not, for example, want to update multiple platforms if an email address changed.
What we learned is that no one provider satisfied our goal.
CRMs can be immensely powerful, and we knew the CRM we selected would need to be a marketing workhorse. Some of the vendors we met with did have competent CRMs, but we were pursuing a solution that is purely focused on CRM and the marketing avenues it can open up.
Once we recognized a CRM would need to be a standalone vendor for us, we shifted to shopping for two providers that could meet our four areas of interest: one to handle CRM and the other to handle the remaining three functions, or so we thought.
We could have eliminated the need for back-end software by hiring a third-party fund provider with their own back-end software. But, because Eric and I intend to be more hands on, we decided not to subcontract back-end responsibilities. Our intention is to build strong bonds with investors and borrowers that will last for years. Because our investors and repeat borrowers are the lifeblood of our fund, we want to interact with them. So, we decided to hold off on selecting the back-end provider until later in our journey when our fund blossoms.
After analyzing the CRM and back-end issues, we had one decision remaining: Which platform would we select for origination? Before we could select one, another option emerged. We found a lender that has allowed us to “white label” their product, meaning we are licensing their product under our name and following their underwriting guidelines. They fund the loan. And, we use their origination software, but we do not have to pay for it since it’s included in the licensing agreement. We created this arrangement outside of a fund structure so we could begin establishing borrower relationships and get some cash in the door to continue building the fund.
For now, we are holding off on the front-end and back-end software for a few months. Ultimately, we will select a vendor that specializes in front-end software and a vendor that specializes in back-end software. So much for dreaming—instead of one provider, we are resigned to using three platforms after all of our research.
White Labeling
White labeling is like correspondent lending and table funding. It is using another lender’s platform and money to fund our borrowers’ loans. Their brand is masked, and our brand is used instead. Once our fund is established, we can still white label loans that do not fall within the parameters set forth in our fund’s private placement memorandum. The solution is a win-win.
Large lending operations that have a back office and other systems in place to fund their loans exist throughout the country. In an effort to close more loans, they have set up separate entities that mask their brand. These masked entities attract smaller, less established lenders who use the larger lender’s lending products and origination services.
The smaller, less established lender is permitted to apply its brand to larger lender’s products and services to make it appear as if the smaller lender produced the products and services. The arrangement allows the smaller entity to use its own logo, colors, and design without reference to the larger mothership company. Imagine opening a McDonald’s, but using your organization’s name and colors and being able to have your employees wear tuxedos while serving Big Macs.
We decided on this option for several reasons. For starters, the costs of establishing a fund can be large. Our white-label revenues can be invested into the growth of our fund. Also, during this time, we will not need to rush through the fund establishment process. Instead of using our time and energy making those decisions right now, we can focus on building borrower relationships. Those relationships will go a long way when we begin soliciting investors.
White labeling offers many other benefits that I won’t go into here, but there is one final one I want to address. Although the delay in establishing the fund is not ideal, there is no need to rush into lending our fund’s money. Currently, real estate values are projected to decline as the Fed’s interest rate increases maintain a stranglehold on mortgage rates. You may disagree with the “sky is falling” analysis, but the premise remains true. If values do fall, the loans our fund invests in will become riskier. Through white labeling, we can shift liability to the mothership while the economy corrects.
Ultimately, white labeling allows us to build our brand, generates revenue to pay for fund establishment costs and fees, shifts liability, and provides an avenue for us to close loans in the future that do not meet our fund’s guidelines. It makes a lot of sense for us.
As we moved forward toward white labeling, we prioritized establishing the fund management entity. This is the entity that will take loans to white label lenders, and it is the same entity that will manage the private mortgage fund down the line. Establishing the management entity involved selecting a name, researching entity options such as LLCs and corporations, establishing a corporation as required by the California Department of Real Estate, licensing it through the Department of Real Estate, and licensing my partner so that he can do more than sit in the back room doing nonlicensed activities.
After we formed our fund management entity, we shifted our focus to the website and logo. Our white-label lender has a plug-in we can use to direct borrowers to start the loan origination process. Domains, emails, and social media are all part and parcel of this process, so we will convey the desired look and feel of our organization.
Eric and I are not in a rush. We have our day jobs. We are methodical attorneys who like to overthink things. Accordingly, we are building our brand so that we hit the ground running during the white-label period.
Attorneys
As our brand takes shape, our presence goes online, and we generate white-label income, we will hire securities counsel. This means the hiring of the lawyers to establish our fund took a backseat for a couple of months.
Certain tax laws intrigued us, however, so we also bounced tax issues off a popular accountant familiar with the space. We learned that the legal issues raised in the private lending space are unique to the securities legal field. What we now know is that a general run-of-the-mill securities lawyer is probably not going to cut it for our needs. While most securities lawyers will understand the available exemptions under the Securities Act, there are components to funds that can make the fund more dynamic. This is where the lawyers specializing in private lending earn their fees.
We also learned about the importance of creating a sub-REIT along with our fund. By so doing, our investors can be paid out dividends. This is significant for two major reasons. First, our payroll-related issues will be much simpler because we only need to 1099 the investors after year-end. More importantly, under the current tax laws—laws that may expire in 2025—there is a 20% deduction for dividend income. I am not sure which is more significant: (1) not paying taxes on 20% of net revenue, or (2) being able to tell investors we will pay them an 8-10% return, 20% of which is not subject to federal income tax.
For those not interested in creating a sub-REIT, it is important to note that the provisions can be created during the fund establishment phase and put to sleep. Later, the sub-REIT can awaken. If we do not add a sub-REIT and want to later, we will need to go back to square one and begin the fund establishment process over.
There are many other issues that factor into the selection of counsel. Of course, legal fees are important as they differ among attorneys. As far as timing is concerned, they all seem to spend a few months to establish the funds and collect payment. A gray area is whether additional fees will be generated during the ensuing months as the fund managers try to figure everything out. Will you be billed for quick-and-simple questions not raised during the establishment process? How about reviewing marketing materials created after fund establishment? What about asking screening questions for accredited and non-accredited investors?
Although there are many minor issues that need to be ironed out before engaging counsel, Eric and I have concluded that we need to hire a team that specializes in private lending. We need to make sure that after our fund is established, we can call our attorney, ask questions, and not get slapped in the back of the head with a heavy legal bill.
As we move into Phase III, our issues will be paired down. Research will turn into action, and we will begin generating revenue under our brand. By the end of Phase III, we hope to have a brand, a track record, and a securities lawyer helping us establish our fund. Stay tuned!
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