Key Takeaways

• Nearly immediately after the JOBS Act passage in 2013, crowdfunding sites began to appear to take advantage of the new rules allowing investment managers and private funds to publicly advertise their investment offerings. However, quality has been all over the map, and investors continue to have trouble distinguishing a good deal from a bad deal.
• Crowdfunding websites often have attractive deals that draw investors in, but once invested, these sites may fail to meet investors’ expectations for reporting and updates, leaving the investor to try and hold their individual sponsor accountable.
• A recently proposed SEC rule requiring private fund managers to provide investors with quarterly statements would theoretically help bring greater accountability to certain managers post-asset acquisition.
• These rules, coupled with advancements in investor portal provider technology, are steps in the right direction toward the transparency investors deserve, but they aren’t a foolproof solution on their own.
• Many middle-market investment companies will struggle to comply with these rules that are already investor relations best practices, often due to lack of resources, knowledge, or expertise.
• While these SEC rules and rapidly-advancing online investor portals will help facilitate transparency, investors must continue to seek and demand transparency and clear communication from their investment and fund managers.

Matt Burk — Founder’s Perspective

I read an article in the Wall Street Journal the other day about a new SEC proposal that would require additional disclosure rules for private investment funds.¹ Among other things, the new requirements would mandate that “private fund managers provide their investors with quarterly statements detailing fund performance, fees and expenses, and manager compensation,” as well as undergo annual audits. The article goes on to discuss both the pushback from large institutional fund managers (naming KKR and Blackstone as examples) as well as the support for the proposed rules from investor constituents and advocates of greater governance.

The article and the SEC proposal got me thinking about the amazing evolution of private real estate funds over the past decade, particularly in the small and middle market real estate space, where the investors are almost entirely comprised of accredited, high net worth individuals and family offices. While there is a relatively small number of very large institutional funds, there is a very large number of much smaller funds using one of several SEC registration exemptions to market their offerings, primarily Rule 506 Regulation D,²  which would be affected by the new rule. These smaller funds use the same exemptions as the larger ones and thus the rules apply equally to both, regardless of size. The best private real estate investment managers are already doing all (or most) of the things the proposed rules may require, but many others are not of sufficient size, scale, sophistication, or operational capacity to do them. All of this should be of great interest to any investor considering an investment in private real estate funds or individually syndicated deals. Let me first provide some context.

The JOBS act passed, and real estate crowdfunding took off.
Since the JOBS Act passed in 2013, the market for investors to locate and gain access to private real estate investments has been flooded with more opportunities than ever before, both in the form of individual syndications and pooled investment funds. This development has been both good and bad for investors. For most investors, their options are limited to much smaller deals and funds that are not run by institutional managers. Nearly immediately after the JOBS Act passage, crowdfunding sites began to appear — in progressively larger numbers — to take advantage of the new rules allowing managers to publicly advertise and solicit these exempt offerings for the first time since 1940. To no one’s surprise (certainly not to mine), the quality of the deals made available by these sites has been all over the map, making it difficult for investors to discern the good from the bad.

Crowdfunding website practices don’t always align with investor needs.
Many crowdfunding sites had, and still have, business and economic models that are misaligned with investors’ interests. They are also frequently not involved in post-closing asset management, thus accountability for monitoring and reporting to their investors is then left to the issuers of the securities (i.e., the sponsors or managers of the individual investments). Investors have been attracted to crowdfunding sites because they have open deals available for investment.  In my opinion, this model is not conducive to providing the real value proposition that investors need either before making the investment or afterwards. Based on my limited read of the SEC’s potential new rule as it is currently proposed, it seems it would not apply to crowdfunding sites even if it would apply to the managers of individual funds. In my opinion the proposed rules would also not particularly help solve the problem of where, how, and with whom to invest in the first place, but it would theoretically help bring greater accountability to certain, but not all, managers post-closing.

Sponsors and fund managers aren’t required to communicate well, but technology has helped.
One of the biggest differences between public and private investments is the nature of the reporting requirements. Private investments do not have the same disclosure and reporting requirements as public investments and have historically been opaque and difficult for investors to understand and track. Real estate sponsors and fund managers are not required to provide anything at all to investors about the opportunity those investors have invested into — not distributions, financial statements, reports, audits, updates, or anything other than a K1 or 1099 at the end of the year.  It has historically been very common that an investor would not hear or see anything at all from their sponsor or manager after they had invested except that K1 or 1099.

The lack of any requirement for investment managers to provide any information following investment means that investors do not have any way of knowing how their investment is performing, nor any real recourse to gaining that information other than to not invest again with that manager in the future. New tools are allowing managers to attempt to communicate more effectively with their investors, but they still have a long way to go and a lot of inertia to overcome. As technology has improved, the situation started to change. This evolution became most apparent somewhere around 2015, as the market saw an increasing number of investor management software providers that allow managers to communicate better with their investors, a trend that continues today. While a step in the right direction, there are still no global solutions to what I believe are the foundational issues facing investors in the alternative, private investment space.

Sponsors aren’t always equipped to follow the rules, and technology can be used to distract and seduce investors into deals they might not understand.
As I alluded to above, an even bigger issue for investors is understanding how and with whom to invest in the first place. Having originated, acquired, and managed investments in the private real estate asset-based alternative investment space for 30 years now, I have seen and underwritten thousands of deals and sponsors. With deep, firsthand knowledge of the dynamics of middle market real estate syndicators, private lenders, and fund managers, I can confidently state that most accredited investors do not have the access or tools to perform what I would consider to be adequate due diligence and underwriting on the private investments into which they invest. It is not because they do not want to — they do, and they try — or because they are not intelligent, diligent people — they mostly are. It is because the market is highly fragmented, highly inefficient, and has not had the tools and technology to make available the actual information that investors really should demand before investing, or the legal reporting requirements after investing (which this new SEC rule is attempting to address).

Technology is disrupting this historical status quo, as it is in many industries. This brings both greater convenience and greater problems, especially when the technology is still relatively new. In many ways, it has hurt investors as much as it has helped them. I hear stories every day from investors who have been disappointed or even burned by managers or deals that, if they really knew what they were getting or had access to the right information, they would never have invested in the first place.

If investors continue to demand proactive transparency from sponsors, the market is likely to change.
Understanding what is important and what is not is hard to do, but people tend to be attracted to high target IRRs and fancy marketing and fail to ask the right questions. Even if they do, they often cannot get the necessary information to corroborate representations. A big part of the problem is that historically, the manager or deal promoter has not faced market conditions or expectation that they would provide that information, and thus they could get away with not providing it. Technology is rapidly changing the conditions in the favor of investors.

The very best sponsors and managers embrace the new market conditions and proactively provide the information that matters most to investors, both in advance of the closing of the investment and on an ongoing basis after investors have invested. As more investors start to demand improved communication and transparency and the technology becomes available to make it a reality, the market will not have to rely upon rules imposed by the SEC. A less opaque and more transparent market is in sight, and this is good news for investors.

* This blog post is being provided for informational purposes only and is not a solicitation or investment advice. All views expressed in this article are based on Fairway America’s beliefs and experiences about the markets and regulations described. No investment decisions should be made based on the information presented in this article. Please consult with your professional advisors to understand and assess the risks associated with any investment opportunity.

¹ https://www.wsj.com/articles/sec-to-propose-broad-disclosure-rules-for-private-investment-funds-11644418801
² 17 CFR § 230.506