The fix-and-flip industry reached a new high in 2016, with 6 percent of all homes sold, officially designated as fix-and-flips. All of these projects create billions of dollars in capital demands each year. Demands that are especially well-suited to and met by the private lending industry. For lenders, having the available capital to fund as many qualified deals as possible is just part of the challenge. Determining which mix of funding sources to use is another ongoing adjustment that private lenders have to make. It can be a bit like a balancing act, to not only keep capital levels roughly equivalent to project pipelines, but to also maintain the right mix of the many different sources of capital available.

Capital formation and development by lenders often starts with a relatively simple family-and-friends network of equity investors, and generally becomes more sophisticated as the lender grows. But keep in mind there are benefits, challenges and restrictions regarding all types of funding sources.

Funding Sources

As far a funding strategy or blueprint for private lenders, newer companies typically start with equity funding (from the principal and his/her friends and family), then often move to bank participation, followed by selling loans and then creating a fund. Only the largest and most savvy private lenders create funds. Although investment funds provide the most flexibility, they require the most work and resources to compete effectively.

Here are the basic pros and cons of the most common funding sources for private lenders:

Self-funding: An entrepreneur interested in making loans to real estate investors might begin by contributing personal money, as well as money raised from family and friends. This forms the company’s initial capital base from which it funds deals.

Pros: The informality and small size of a self-funded company gives the lender unparalleled freedom to choose which deals to fund. When it’s your own money, it becomes a matter of personal preference.

Cons: Growth is limited by the money available. That’s fine for lenders who want to keep things small and simple. However, lack of diversification means that one bad deal can sink the company. Growth-oriented lenders need to look for additional sources of funding.

Bank participation: Many banks, whether local, regional, or national, are willing to form agreements with small lending companies to participate in loans. Typically, banks will put up 80 to 90 percent of the loan funding, with the remainder contributed by the private lender. Some agreements specify table-funding by banks, which eliminates the private lender’s need to front the bank’s share of the capital even for a day or so.

Pros: By participating with banks, a small private lender solves the problem of limited capital. Banks have plenty of money, although they are picky about lending it. A private lender can mitigate the notorious slowness of bank lending by creating a partnership ahead of time.

Cons: Banks are sticklers for documentation. Borrowers will likely have to cough up more information to private lenders who are funded by banks than that required by self-funded lenders, resulting in slower deals and probably higher rejection rates. Another con is that a bank can terminate its participation in further deals, leaving the private lender high and dry.

Sell the loan: A quick way to get the loan off of your books and free up funding for another deal is to sell it. You can sell loans to Wall Street firms specializing in buying and servicing private loans. Another option is to sell the loan to a peer-to-peer lender. The P2P can then maintain the loan in its own portfolio, or more typically crowdfund it, either wholly or in chunks, to individual investors.

Pros: Selling the loan creates rapid turnover. A private lender can make more deals this way. You can set up platform sales with the Wall Street or P2P companies that provide you with readily available funds.

Cons: Lower returns and contingent liability meaning in some cases the private lender may have to repurchase the loan.

Create a fund: The most ambitious option for a private lender is to create one or more 506(b) or 506(c) investment funds. Investors buy shares of your fund and you use the equity capital to finance real estate deals, such as fix-and-flips.

Pros: The fund manager decides where to invest, subject to any limitations imposed by the fund offering statement. The amount of money raised by private investment funds provides flexibility and growth potential. Basically, the sky is the limit

Cons: Although less expensive than an IPO, creating a 506 fund is costly and time-consuming, and you have to market a winning message to attract investors.

Challenges to Raising Fund Money

SEC Regulation D sets out the rules for selling unregistered securities. Rules 506(b) and (c) provide two different ways to solicit buyers. They differ in two significant ways:

1. Offerings under 506(b) can be made to accredited investors and to no more than 35 sophisticated non-accredited investors, whereas only accredited investors can invest in a 506(c) offering.
2. The fund sponsor can market 506(c) offerings to the public, as long as the fund sells only to accredited investors. Public solicitation of 506(b) offerings is not allowed.

From the outset, a private lender is faced with the decision whether to choose 506(b) in order to accommodate non-accredited investors, or to select 506(c) to gain access to public marketing. Obviously, it is easier to market 506(c) funds, as all the normal channels are available, including websites, advertisements, brochures/collateral, social media, email campaigns, even press stories. However, the lender is faced with accepting only accredited investors, a task that requires due diligence and patience. Many CPAs or wealth managers can be reticent to sign accreditation documents which makes the process more challenging and time consuming. With a 506(b), the lender can pre-screen prospects before sending out marketing materials, which have to be requested rather than broadcast. As long as the fund takes care to accept only self-proclaimed accredited investors, the decision as to what information to offer prospects is up to the lender. However, 506(b) non-accredited prospects must receive exhaustive documentation similar to the prospectus associated with an IPO. This would seem to defeat the purpose of making a private placement to start with, so it’s not uncommon for 506(b) sponsors to exclude non-accredited investors.

Questions About Your Fund

• How can you get across the quality and value of the properties in the fund? The starting point is specifying the underwriting requirements for borrowers and their properties. For example, a hard-money lender might point out the following:
• How can you advertise your track record to potential investors? Although the fund shares are not registered with the SEC, the sponsor is still subject to the anti-fraud statutes that govern public offerings. You generally have leeway to use the calculation methodology and composite construction methods of your own choosing. As long as the portrayed results are not misleading, they are accompanied by adequate disclosure, and the calculations are consistent throughout. If you want to highlight the results of a “representative” account, you can’t cherry-pick winning accounts. You must use some objective criteria, such as size or length of holding. If you use benchmarks for comparison purposes, you must fully describe them. Your total-return track record should describe the effects of fees and dividend re-investments on net performance. You can provide hypothetical, simulated, or modeled returns as long as they are separately identified from, and not linked to, actual returns. For a deeper dive into advertising your fund, check out the Global Investment Performance Standard’s Advertising Guidelines.
• Under which SEC 506 Rule is the fund governed? As mentioned earlier, you have trade-offs between (b) and (c) funds. The decisive factor might be that you can cast a much wider advertising net with a 506(c) offering, notwithstanding the accreditation requirement. If you are attempting a large private offering and do not have the backing of institutional investors, a (c) offering might make the most sense.
• What is the size of the offering? Though theoretically unlimited, the size of your offering will depend on the nature of the fund, demand by investors, demand by borrowers, marketing budget, and the lending company’s comfort zone in terms of how much volume it is equipped to handle. After all, the bigger the fund, the more resources must be allocated to underwriting and management.
• If your investment company would like to sponsor a 506 fund for real-estate investors, ask yourself these probing questions:
  • You evaluate the real estate and the borrower.
  • You know your markets and the velocity of sales in those markets.
  • All property is over-collateralized.
  • You select only the projects with the greatest potential for success.
  • You require 15 to 25 percent equity investment from the borrower.
  • You perform due diligence on the borrower, even if you don’t use credit scores in your underwriting.

A Word About Accredited Investors

Most or all of your investors in a 506-fund offering must be U.S. accredited investors, depending on the type of offering. According to the SEC’s website guidelines on accreditation, “one principal purpose of the accredited investor concept is to identify persons who can bear the economic risk of investing in (these) unregistered securities.” The SEC’s website at investor.gov has clear guidelines regarding the accreditation of individuals or couples. Accredited investors are defined by the following:

• They have a net worth at the time of purchase of at least $1 million, not including their primary residence, or
• They have individual income in excess of $200,000 ($300,000 for couples) in each of the two most recent years, and they reasonably expect meet the same thresholds in the current year
• Most institutions and trusts with total assets exceeding $5 million also qualify as accredited investors.

Fund managers are required to take “reasonable efforts” to verify that their investors are accredited. Previous verification required only self-certification but new SEC rules specifically state the types of verification that are acceptable. Failure to properly verify your investors accreditation can have serious consequences with the SEC, including loss of your 506-exemption status. There are four accepted ways to verify these individuals, which include:

• The Insider Method: if the investor is a director, executive officer, or general partner of the issuer of the securities being offered or sold, he/she qualifies as an accredited investor.
• The Professional Letter Method: a letter of confirmation from a lawyer or accountant verifying the investors status. These letters often prove hard to get because many lawyers and accountants feel uneasy providing them and testifying to this information.
• The Income Method: the investor must provide proof of income such as tax returns or other financial documents, or a letter from his/her accountant or employer regarding income. Again, these documents can be hard to obtain because investors are often reluctant to share this information readily.
• The Net Worth Method: the investor must disclose his assets, liabilities and provide or authorize a credit report. The fund manager can then calculate the net worth with this information.

Bobby Montagne is the founder of Walnut Street Finance, a leading private lender in the Mid-Atlantic. Walnut Street Finance is the sponsor of the Walnut Street Finance Fund II LLC, a private $30 million private lending fund offered under SEC Rule 506. It allows investments as low as $25,000 and provides a preferred dividend yield of 7 percent. The fund sponsor is Walnut Street Finance, a developer and private money lender with more than two decades of experience. The loans in the fund’s portfolio are generally short term – one year or less. All loans are collateralized by the underlying properties, and each borrower provides equity of 15- 25 percent of the property’s value.

This article does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security.