Due diligence: the deal structure

by Edward Robertson
[Note: this article was re-published under the title: "Deal Structure: A Key Concept When Exploring Private Investments" for The Private Investor Issue 21, July 2017.]

As investors, we can question the due diligence process applied by Exempt Market Dealers (EMDs) to the investments they offer. Due diligence has to do with the care a reasonable person should take, and addresses material information, which affects the perceived value of the investment. In this article, we will review a few elements of the deal structure that can directly affect the investor’s decision.

This, of course, is not a complete method: a comprehensive review would consider not only the deal structure, but the firm, the management team, and the business model. Moreover, due diligence is not the same as risk assessment, which identifies and qualifies future uncertainty. The following notes on eight aspects of the deal structure are therefore not exhaustive and should be used only as a basis of discussion with an EMD representative and other advisors.

Elements of the deal structure

1. Term. Somewhere Robert Kiyosaki asks: “How soon do I get my money back?” He wants to recover his original capital so that it can be re-deployed; moreover, the uncertainty associated with accomplishing planned objectives rises with time. The length of term can range from one to perhaps ten years; 3-5 years is common. As the term extends, it becomes a question of the management team’s ability to read the trends in its market sector, execute, and eventually exit, through changing conditions.

The exit strategy is the plan for the asset sale, divestment or wind-up in order to pay out investors. Rather than rely on a vague "buy and hold" mentality, the investor should seek an exit plan in the OM. It can take many forms depending upon the underlying business. Even for income-oriented products, a provision to return investors' capital should be evident. Cora Pettipas identifies "an innate conflict between the exact defined timelines the EMDs would like to see, and the real world circumstance that market results cannot always be timed and predicted"[1]. The management team may wish to use its discretion to pick the best time (within a window) to exit.

2. Minimum investment. $5,000 and $10,000 are typical minimum amounts; yet many products have a lower bar (e.g., $1,000 or even $500). One cannot arrange for periodic payments from a bank account to fund the investment. A lump sum purchase is needed, perhaps financed through a line of credit (itself repayable with automatic monthly instalments). Check my post “Is investment loan interest always tax deductible?”. Check also service and transaction fees charged by trust companies: they are rather high.

3. Projected return and risk. Projected returns should be linked to the business operation and its stage in the evolution of the project. Early stage projects will typically offer higher returns. The question is not merely one of project phase: we are looking for vertical maturity, which underscores the need for a stringent multi-criteria due diligence process addressing the financial strength of the firm, the background of the team, and so on. An issuer passing such a test and showing a good track record should give the investor more confidence that the projected return is realistic. The investor can have extra assurance by co-investing with pension funds whose audit teams have already vetted and selected certain private market investments.

What are the risks associated with the projected return? The OM does not appear to employ a risk methodology, as such. There is no systematic identification of uncertainty, and no estimates of probability of occurrence or severity of consequence, nor of mitigation undertaken. It simply gives an unqualified list of issues, painting a uniformly dark picture. The investor will have to use inquiry -- webinars and issuers' presentations are good opportunities -- to gain a more nuanced picture of the risk profile to inform an investment decision.

4. Type of earnings and payment schedule. The earnings will take the form of periodic distributions, or a single payment (return of principal plus capital gain) at the end of term, or a combination of the two. This is governed by the nature of the underlying business and share structure. Distributions may be monthly, quarterly or annually, and are typically either interest income or return of capital (ROC). Here the considerations of the appropriate account type -- registered (RRSP/TFSA/LIRA) or non-registered -- and tax treatment enter the picture. Note that investments that are primarily equity (growth) plays may still offer periodic distributions as well as dividend reinvestment (DRIP).

5. Provisions for early redemption. A common caution regarding exempt market investments is that they are illiquid. That is not strictly true: while there may be limited or no secondary market, many have provisions for early redemption at a discounted value, and with some lead time.

6. Provisions against loss of capital. Maria Lizak, in her article for prospective investors, recommends asking: “If the assets have to be sold off before the project is completed, how much of investors’ monies have already been spent…?“; and on the issue of distributions: “Has the issuer set up an interest reserve account that is pre-funded in order to make the interest payments?” [2] If the project is already cash-flowing, this can also help to ensure distributions, even if the asset improvement does not go according to plan. We can ask for clarity in the pecking order of repayment of debtors in case of insolvency. So far, I have not seen insurance guarantees such as the ones attached to segregated funds.

7. Management compensation. The intended use of funds described in the OM should be oriented more towards the needs of the business rather than to excessive fees, vaguely defined expenses and undue management compensation. In real estate development, one form of overpayment to watch for is “the difference between what the issuer paid for the land, and the price the issuer is selling it at… called the lift.”[3] These items, like the Exempt Market Dealing Representatives' commissions, are not out-of-pocket expenses for the investor, but the totality of costs may have an undue impact upon the profitability of the enterprise.

Of particular interest is whether a hurdle rate is specified. This is the provision that the target return for investors is to be obtained before profit is taken by the issuer. Moreover, profits exceeding targets can be designated for a split, say, 70/30 or 80/20, between investors and management.

8. Principle of alignment. The foregoing points (item 7) speak to the unity of management and investor interests: this is the principle of alignment. The hurdle rate, split, controlled expenses and fair compensations all contribute to good alignment. Another indicator of alignment is “skin in the game” – the personal cash invested in the project by management team members themselves.

Summary

The reader will have noticed some striking features of private assets compared to mutual funds and other public market investments:

  • Exit strategy is preferred, as opposed to having an indefinite "buy and hold" approach;
  • Minimum investment amounts, lump sum requirements and account management fees are not very convenient;
  • Returns are often far better and generally less affected by the volatility of the publicly traded markets;
  • Risk assessments are rather monolithic; the list of risks is informative, but there is no nuanced risk profile with planned mitigation;
  • Distributions may be ROC or interest, and possibly partly protected (as in the suggested "interest reserve account");
  • Illiquidity is either absolute, or mitigated by, for example, a 60-day penalized early redemption feature;
  • Loss of capital provisions do not seem common as explicit elements of the deal; I have not seen insurance guarantees;
  • Management compensation, fees and expenses, as well as commissions and the lift in real estate deals, need scrutiny for fairness;
  • Hurdle rate provisions compare favourably to mutual fund MERs, which are charged regardless of performance;
  • Alignment can be evidenced especially by a hurdle rate and degree of management's "skin in the game".

Conclusion

Major categories of due diligence are outside the scope of this article; i.e., analysis of the issuing firm; review of the management team's background and track record; and evaluation of the business model and how it is situated in the economic context. At a minimum, the investor can begin to assess the quality of a prospective investment by examining the deal structure. In doing so, we may find we are carrying out far more due diligence – and learning more about business – than we ever did when investing with simple blind trust.

Sources

[1] Cora Pettipas, “Which way to the exit? The importance of a well structured exit strategy in private placements” The Private Investor (formerly Exempt Edge) Issue 14
http://theprivateinvestor.ca/which-way-to-exit/

[2] Maria Lizak, “Interested in private equities? The six key elements you need to know before investing” The Private Investor (formerly Exempt Edge) Issue 6
http://theprivateinvestor.ca/private-equities/

[3] Zack Siezmagraff,  “Not all real estate investments are created equal” The Private Investor (formerly Exempt Edge) Issue 7
http://theprivateinvestor.ca/created-equal/

Keywords:
exempt market investment; private market investment; offering memorandum; deal structure; investment risk