How to Use a Private Placement Memorandum to Evaluate a Private Equity Real Estate Investment
If you are a private investor, chances are you have heard the terms private placement memorandum, private offering document, or confidential offering memorandum – PPM for short. By definition, private investment opportunities are not public offerings. The investment research information that is generally available for publicly traded investments such as annual reports, 10Ks and 10Qs aren’t available in a private equity transaction. Instead, investors use the PPM to become familiar with the terms of a private investment and to evaluate the opportunity.
The private placement memorandum can cure any insomnia; it’s technical, lengthy (often more than 100 pages) and carries legal jargon and disclaimers that would pretty much scare anyone out of investing. If you have invested in a private placement but have not read the PPM, you are not alone. Most investors typically instead rely on a referral from a friend, marketing materials, a face-to-face meeting, or a phone call to decide if a private investment is for them. Generally, this strategy works if the manager does what he says he is going to do. It’s when an investment goes wrong that every word of a private placement memorandum is scrutinized. However, reviewing the PPM is one important step in the due diligence process.
The goal of this blog is to help you navigate the private placement memorandum efficiently as possible so that you can make a well-informed decision about a potential private investment.
To start, you should pay particular attention to any capitalized terms. Issuers may define terms differently, so don’t assume to understand the meaning of these terms without referencing the true definition in the referenced document. For example, Net Asset Value (NAV) may be defined by one issuer as the equity portion of the investment once liquidated, while another issuer may be referring to the entire property value including the debt. In this example, a 2% management fee on the NAV of equity will be far less than a 1% fee charged on the NAV of the property, assuming moderate leverage is used.
PPMs will vary by the type of issuer, the size of the offering, and the number and type of investors being solicited, but each private placement memorandum should at least contain the five sections outlined below.
1. Executive Summary
This Executive Summary section presents a condensed description of the investment. It usually includes the investment thesis, pricing, minimum subscription amount, investor qualifications, disclosure of management fees, and a brief discussion of the issuer’s governing documents. Be wary of disclaimers that allow management to have too much latitude or discretion and pay close attention to the conflicts of interest. This section should mirror what has been stated in the marketing materials and represented by company representatives.
2. Investment Strategy
The Investment Strategy section presents a thorough explanation of the issuer’s investment strategy, process, and criteria, as well as its deal flow sourcing and exit strategy. Included in this section is a description of the issuer’s key competitive advantages and resources in its specified markets. It will also discuss the industry, state and geographical focus of the investment.
Investors should review this section to learn how the issuer intends to achieve its targeted results and assess whether the investment strategy supports the issuer’s objective. Investment strategies that are well-reasoned and clearly written will provide investors with information they’ll need to make a fully informed investment decision. An offering with an investment strategy that is vague, unclear or that does not make sense is probably an offering that should be avoided.
3. Management and Experience
The Management and Experience section contains biographical and background information about the principals and key employees. It provides a detailed overview of the issuer’s history and how it has succeeded. This section often provides the issuer’s investment manager’s track record, which is generally presented in a record table format, outlining past fund sizes, vintage years, and IRR performance. More robust track records will contain additional performance statistics, such as realized/unrealized IRR and actual/projected gross multiples.
The success of an investment will be dependent upon the management team, so it is imperative that team has the background and experience to implement the investment strategy. Prior experience successfully managing similar investments supports the proposition that the management team is capable of implementing the investment strategy with positive results.
4. Summary of Principal Terms
If you only read one section of the private placement memorandum, this is it. The Summary of Principal Terms outlines the organization of the company, what fees investors will pay, what expenses the company will bear, how profits will be split, and a thorough summary of the business plan. A careful analysis of the Summary of Terms should provide most of the information necessary to fully comprehend the investment offer. If anything catches your eye in this section, then you can head to the section in the document that provides further detail. To see an example, view the Origin Fund III PPM featured below; the Summary of Principal Terms is on pages 63-77.
5. Risk Factors
Risk Factors is the section that will truly make eyes glaze over. Few investors need to be advised that, “in the event of war, no assurance can be given that the investment will meet its stated goals.” Nevertheless, this section is perhaps the most important component of the PPM because it outlines the factors that make the offering risky or speculative. While there are certain risks that are present in nearly all investments (e.g., civil unrest, bankruptcy, natural disasters, etc.), investors should pay particular attention to those risks that are unique to the investment opportunity given the nature of the issuer, its investment plans and the trends within the issuer’s industry.
In addition to risks inherent in the investment, there are risks associated with the offering entity and the management team. Perhaps the most significant of these are conflicts of interest. Certain conflicts to consider are:
Fees and expenses – Shifting expenses from management to the investor, charging management salaries and overhead to the fund, allocating transaction fees to the fund and not co-investors, etc.
Transactions with affiliates – Affiliate of management acts as creditor or lender to the fund, or the fund acquires an investment from a management affiliate
Competing funds – Management launches a new fund with the same strategy as an earlier fund, creating conflicts between allocation of investments between the funds
The above-listed sections are those commonly found in most PPMs, but it is not the exclusive list. Other sections, such as “Tax,” “ERISA,” “Legal Matters” and “Conflicts,” are equally pervasive and should also be read with considerable scrutiny by any prospective investor. As you are reading the private placement memorandum, if you find any information that seems odd, inconsistent, or otherwise incomprehensible, you should contact the issuer and the issuer’s management team should be available to respond promptly.