Here’s how one lender is navigating the daunting task of establishing a private money fund.

Last spring, I began meeting twice a week with a longtime friend and colleague, Eric Saiki, to pursue the establishment of a private mortgage fund. Saiki is a litigation attorney who represents businesses in a variety of matters.

There is a process to managing a fund. Fund managers must be disciplined, responsible, organized, and trustworthy. If they lack any of these characteristics, eventually a link in the chain will fail, mistakes will result, and the damage to the fund will be irreparable. Just having the characteristics isn’t enough though; fund managers must nurture them. Investors need to know their managers are working hard to make safe investments with strong returns that cannot be realized elsewhere without more risk.

Researching the Issues

Our initial goal was to identify issues. We listened to private lending podcasts, found online articles, and watched webinars. We also spent a day at the Los Angeles Law Library watching two legal seminars, and we reviewed vendor websites. We were even able to obtain private placement memorandums, which helped us understand some of the subissues that exist.

The American Association of Private Lenders (AAPL) was without a doubt the major source for our research. Its broad online education portal provides hours of informative educational material.

AAPL’s two fund manager certification courses helped us see the forest through all the trees.

In addition, AAPL’s annual conference offered a strong selection of educational opportunities designed to deal with all aspects and levels of private lending. On the final morning of the conference, AAPL hosted small private lender and fund manager roundtables. At the fund manager roundtable, we sat with experienced and respected participants—attorneys, accountants, fund managers, and brokers— in the private lending field who tackled a long list of important issues.

The practical responses we heard from participants gave us a good jolt of reality, punching holes in the idealistic vision our ivory tower research created. As we sat in the airport waiting to return home, we discussed the next steps. Our main areas of focus going forward would be legal, tax and accounting, technology, and marketing.

Let’s take a closer look at the four issues we agreed to focus on.

Legal Considerations: Entities

Establishing a private mortgage fund requires establishing two entities: One manages the private mortgage fund, and the second is for the private mortgage fund itself.

Management Entity. The management entity is run by the manager(s), who manages investor capital retained inside the private mortgage fund. Managers deploy investor funds according to the terms of a subscription agreement. Inside the “four corners” of the agreement are the rules the managers must follow. Failure to do so can lead to liability for the management entity.

It also oversees origination of loans, servicing of loans, regulatory filings, licensing, investor relationships, and distribution of profits.

Determining the structure of the management entity requires considering many variables that can vary from state to state, including taxation. Working with experienced lawyers and accountants helps with making the right choice.

Management compensation and investor return are two other major components to be decided. Some managers seek investors looking for a fixed return. In a “fixed” return fund, the investors receive an agreed-upon distribution. Any excess goes to the managers. This can be a very conservative approach for the investors, with envious returns to management.

In an effort to distribute the earnings more equitably, a “waterfall” approach can be used. This approach creates a “pecking” order in which distributions are allocated between managers and investors. This strategy often pays managers a small fee and prioritizes distributions to investors. Excess profits are then paid out to both managers and investors pursuant to a formula that incentivizes the managers to maximize fund profits.

A third common way of structuring management compensation and investors’ returns is through a “split return” approach. Some argue this approach is the best for aligning the interests of management and investors. In general, expenses of administration are paid, and managers split the profits with investors.

It appears there is a move toward the split return approach to align interests better. Investors are becoming savvier, which can lead to disputes or resentment. Because there are many variables that can lead to additional income or expenses, it is an area where the problems arise.

Some of the variables include the annual management fee, origination fees, payment of referral fees, receipt of referral fees from loans that do not fit the box, loan servicing fees, or construction management fees. There are other variables as well, including who receives gains arising out of REOs, whether payment is to be made to outside services from the profits versus payment by the fund managers, and whether managers should receive the late payment fees or default interest.

If fund managers are making two points on origination and two points on management fees, investors will not stay around if managers are taking revenue from other sources or reducing profits by running other expenses through the fund’s returns.

The Fund Itself: Private Mortgage Fund Entity. More complicated is the structuring of the fund entity. It requires a legal team to help guide managers through the various exemptions to the Securities Act of 1933 since a mortgage fund is a security—a financial asset with value that can be traded or sold.

Generally, securities require expensive and time-consuming registration with the Securities and Exchange Commission. For mortgage funds, however, private placement exemptions exist that allow these smaller securities to avoid the costly filings. Three common exemptions mortgage funds use are Reg D Rule 506(b), Reg D Rule 506(c), and Reg A, Tier 2.

By analyzing and weighing the desired characteristics of the fund during the fund’s formation, managers can arrive at an exemption that best aligns with it.

Every decision made—or not made—sets off a chain reaction of other decisions. Here are some private money fund characteristics to consider:

• Ethics. Fund managers have a fiduciary duty to investors; that is, they have an obligation to exercise loyalty and good faith and act in the best interests of the person to whom they owe a duty.Investors should disclose all material facts that one would find useful in making a decision. The disclosure should be updated when material facts change or arise.Often, great deals arise the fund cannot handle. What does a fund manager do with that deal? Best practices suggest offering the deal to all investors and entering into a side agreement to disclose in writing the material aspects of the deal.Conflicts of interest arise frequently, especially when fund managers establish alternate funds that may impact originations in their other funds.Ethics is an area to take seriously. When issues arise, and they will, a fund manager must be able to spot them. Knowing the answer is not required. Engage counsel who can advise the proper course of action. Seeking counsel is money well spent, because many shareholder suits against managers include causes of action for breach of fiduciary duty, failure to disclose material facts, and conflicts of interest.
• Open or Closed. Most funds are “evergreen” funds; that is, they are open-ended and can continually receive investor funds. Closed funds can be good for liquidity because they pressure potential investors to make funding decisions. Restrictions on withdrawal of said funds is another characteristic of closed-end funds. However, open-ended funds can accomplish a similar result by using lock-out provisions—with gates for early exit. If you start up a closed fund, one day you may need to start up a new fund that will require more time, money, and headaches.With open-ended funds, the private placement memorandum and financial disclosures must be updated annually. This may help avoid a claim for failure to disclose material facts arising out of changes that occurred during the prior year.
• Investors. Investors can be accredited or non-accredited. Accredited investors are “sophisticated” investors who meet certain net worth or income thresholds. Verifications from accountants or attorneys regarding their accredited status can be relied upon in good faith.When non-accredited investors are in involved, there are landmines to avoid. Advertising to non-accredited investors is not permitted under Reg. 506(b), so managers should not meet someone at a cocktail party and discuss the fund. Doing so may be an inadvertent violation of securities laws.Under Reg A, advertising to non-accredited investors is less restrictive, but the fund’s capital limits are also restrictive.Beyond deciding whether to work with accredited versus non-accredited investors, other investor decisions remain, including whether to take in-state investors only as well as the issues that accompany taking out-of-state investors or even offshore investors who are willing to take a smaller return.
• Warehouse Line of Credit. These LOCs are great for cash flow and help solve liquidity crunches. Short-term liquidity crunches are common while waiting for older loans to pay off. A line can provide capital to fund new loans while waiting for pay offs.Warehouse lines can also be an effective tool to increase profitability through leverage. If a fund is paying 9% to investors but borrows part of the debt from a warehouse line at 6%, the cost of funds falls and profits inside the fund will rise.There is a black cloud over warehouse lines. Terms can be very onerous and cause the fund to implode when economic downturns occur. Fortunately, many of the onerous provisions can be negotiated away. One such provision is “mark to market.” It allows a bank to revalue property and then call the loan based on debt-to-equity valuations that no longer adhere to the bank’s guidelines. Imagine a strong set of performing loans being revalued downward, requiring the fund to pay down the warehouse line.Provisions in lines concerning delinquencies and aged loans are of concern as well. Negotiating the basis for calling delinquent and aged loans is prudent. To allow a bank to call such loans without specificity can lead to disaster.The term of a line is another important feature often overlooked. It is risky to establish a line that is good for one year when the loan term is 18 months.The same can be said for adjustable-rate lines that secure fixed-rate loans. In this instance, terms should be rewritten to prevent shocks in the market from turning a fund’s delta upside down.
• Self-Directed IRAs. Self-Directed IRAs are a popular source of fund capital. Fund managers must be aware that Unrelated Business Income Tax (UBIT) applies to an IRA when it leverages its purchasing power with debt. If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as unrelated debt financed income (UDFI) and it causes UBIT.Self-Directed IRAs generally defer income and capital gains tax on growth. No such privilege is afforded when it leverages using the money of others. Once a fund leverages through a warehouse line and the Self-Directed IRA generates growth or income, the investor may be required to pay taxes on the fraction of growth or income attributable to the leverage.Another area of concern is when large investors pull out and the fund is left with too many IRA investors. In this instance, a management team can be treated as plan administrators, subjecting them to increased regulation similar to that of financial advisors.“Penguins,” or potential investors approached for the limited purpose of balancing the fund to meet regulatory requirements, can be hired to help reduce the percentage of Self-Directed IRA investments in a fund. The fund generally hires a firm to find these investors. Like penguins, investors start lining up on the beach and talk to each other about the opportunity versus risk of getting into the water. If one penguin goes into the water, often all the other penguins follow suit. There is a price for hiring “penguins” and potentially legal fees to make this workaround happen.An alternative to “penguins” is a SubREIT inside of the fund. This provision can be created at inception but not used. The provisions can be awakened at any time.
• Classes. Classes can be created inside a fund. Treating founders better incentivizes a team of initial investors to jump-start the fund. Classes can also be drawn to accept various types of investments (e.g., first loans and riskier second loans).
• Reserves. Reserves for possible losses can be written into the agreement as well as liability clauses that limit management liability.
• Non-Origination-Based Activities. What about buying loans or selling loans to and from the fund? How about buying distressed properties, rehabilitating them, and flipping them? What are the various licensing issues for each of these activities?
• Underwriting Guidelines. Each fund must estimate its tolerance for risk and weigh it against reward. Revisions of this strategy should occur when changes to the market are on the horizon. Some investors want big rewards and seek out funds that are willing to invest in riskier investments, such as junior financing with higher combined loans to value.One of the challenges here is when the market takes a wrong turn. No manager wants an investor suit filed against them even if they lent pursuant to the “four corners” of the agreement, complied with their underwriting guidelines, and reassessed regularly in keeping with the standard of care.
• Loan Origination. Business-purpose loans for cash-out, bridging, fix-n-flip rehabilitation projects, construction, and debt service coverage ratio are the main vehicles. How will these vehicles be sold? Will there be only a retail component to origination? How about a wholesale division? If so, will the wholesale division seek licensed or even unlicensed brokers to originator loans? Establishing correspondent lenders is also an option.
• Licensing. Licensing rules vary from state to state. Some of the areas that fall underneath the licensing umbrella include origination, loan servicing, and buying and selling loans.In California, licenses from multiple entities may be required. Because entities have different rules and often overlap, managers run the risk of complying with one department’s guidelines while violating the others. During formation, consideration must be given to whether (1) the management entity and/or the fund will be required to be licensed with either or both departments, (2) lending with out-of-state investors will take place, (3) there will be any licensing issues outside of California, and (4) reporting will occur in or out of state.
• Liability. There are ways to limit fund manager liability. During formation experienced securities counsel use various techniques to protect managers. Here an ounce of prevention is worth a pound of cure.

Taxation

Initially, we wanted to find a fund structure that would permit us to avoid audited financial returns. However, now we won’t move forward without them. Audited financials help build the credibility of the fund. Investors like to know they will be done and appreciate reviewing the audit results. For funds that use warehouse lines, the audited financials are the cornerstone for a strong relationship with warehouse lenders.

Yes, audited financials can be expensive; however, using a fund administrator who can handle the back end of running the fund can reduce audit costs.

Audited financials in the private lending world are most efficiently performed by auditors with experience with private lenders. As such, selecting an accountant who can work with the securities lawyers and even fund administrators is a crucial part of fund formation.

Identifying tax issues early is a pre-requisite to efficiently launching a fund. Each state has different income tax laws. There are also tax credits available to some and not others. Identifying these issues early helps managers formulate strategy for taking on investors.

Technology

Software can be helpful with client relationship management, origination of loans, post-close management of loans, and investor relationship management. There are many vendors in these spaces, and the fund manager’s job is to align its goals with the vendors’ technology.

With today’s software, an originator can completely set up the borrower’s experience in a few minutes. Loan applications and disclosures are created and emailed, a portal for uploading necessary documents is created, and e-signing is established to maintain compliance. The result is an efficient onboarding of borrowers and a shifting of processing burdens.

A byproduct of creating the friendly borrower experience is extrication of the management and origination team(s) from tasks that distract them from bringing in new deals and keeping investors happy.

Also important is post-close software, which includes servicing, financial reporting, and investor interface. For those resigned to hiring a fund administrator, post-close software may be less important and lead them to pursue providers whose platform is stronger in the origination sector. For those that like to do it themselves, the post-close software can function as a backroom billing and accounting department that can monitor every aspect of a loan and make virtually any report available to investors and tax advisors.

Those that make client relationship management a big part of their daily operations should look for a standalone CRM. For others, CRMs imbedded in some private lending software provider’s platforms can be used to manage client relationships.

Marketing

Marketing includes the origination of loans. It also includes bringing in investors. During the fund formation process, the strategy for marketing becomes a condition subsequent to the fund formation itself.

Once all the formation issues are decided upon, a strategy can be implemented. What we know now is that it will include a CRM, and our investors will be handled with velvet gloves.

In the meantime, I will continue to broker loans, fractionalize notes, and establish white label arrangements at various wholesale lenders so business is conducted on a parallel path with properly forming the fund.

As part of our efforts, we intend to contact several of the participants at AAPL’s broker roundtable to discuss some of the finer points of the successes and failures they relayed to us at the conference. We will also seek referrals to various lenders who have exhibited mentorship qualities in the past. Through these contacts, we hope to create a focus that will help us hit the ground running.