A Check List for "Reasonable" Due Diligence "The Scorecard"

As a securities expert witness, I have been using the ScoreCard in arbitrations and mediations to evaluate literally hundreds of private placement limited partnerships, LLC’s, TICS, non-traded REITS along with all types of Public Offerings including REITS and L.P.’s, In addition to real estate offerings, I discovered it works very well for equipment leasing and oil and gas programs as well. I have found that an arbitration panel has a much better and more organized grasp of the offering by walking them through the ScoreCard. The ScoreCard naturally breaks down into two sections. The first section, deal points 1 to 3, evaluates the Sponsor or program manager. The next section, deal points 4 to 15, analyzes the structure of the offering itself. So, of the 15 deal points or questions, each one has 5 possible answers, with up to 5 points possible for each, or 75 total points possible. Each deal point is graded with 5 points being best and 1 point being worst as shown on the ScoreCard master template. After the grading, the points are added up. A passing grade is 52 points or 70% of the possible 75 points. Passing is to say, that based upon the PPM or Prospectus and marketing brochure only, the program qualifies to enter the formal diligence process. In other words, the deal passes muster to the extent that it should meet “reasonable basis suitability”, i.e. it should be suitable for at least some investors. Remember, then, that the ScoreCard is a precursor to formal due diligence, not a substitute for it. It is the initial independent due diligence done by the broker-dealer. If an offering fails to meet the minimum grade, the ScoreCard should be forwarded to the sponsor in order to improve the program so that it can be improved to qualify to enter the formal due diligence process at some future date. When you think about it, to conduct a full due diligence review on every direct participation program that comes in the door would be a very inefficient process. Only those that, on their face, have a chance to succeed should enter that process. It is important to note that the ScoreCard is “for broker-dealer use only”. It is not to be given to investors under any circumstances. It is primarily for the due-diligence department of the broker-dealer. It is an example of meeting the FINRA requirement for independent due diligence. It can also be used for the training of registered representatives on a password protected website. Once on the Website, after logging in, the AE can review the ScoreCard on a “read-only” basis. Since we have been using the term “due-diligence” in this article repeatedly, maybe it’s about time to define it. This is especially important since the Securities Act provides no specific definition other than to call it an “independent investigation”. FINRA adds that the investigation must be “reasonable”. My definition is this: “Due-diligence is the process of reasonable investigation that independently evaluates and verifies a sponsor’s accuracy, competency, financial strength and organizational depth. It is adversarial in nature and utilizes quantitative and intuitive means. It includes a comprehensive analysis that challenges the deal points, assumptions and projections used in each direct participation program (DPP) examined. The process examines and determines the probability of the transaction achieving its stated objectives”. Let me just for a moment describe what independent due diligence is not! It is not a collection of 3rd party due diligence reports. This is because these reports are paid for by the Sponsor, and on their face are not independent. One provider, Snyder Kearny, LLC stated, “We specifically note that given the limited scope of our representation, we may not have independently verified factual statements contained in the PPM. Further our review is subject to the budgeted hours and may or may not be sufficient to consist of a “reasonable investigation” or “reasonable care” as such terms are defined in Sections 11 and 12 of the Securities Act of 1933, as amended. Unless expressly indicated in a separate legal opinion identified as such, we will not provide any opinion or legal advice regarding the adequacy of any investigation performed by us or the adequacy of the Offering disclosure”. With such disclaimer’s, broker-dealers should never rely solely on these firms to visit the property. Rather, they should do it themselves. Further, these reports are outsourced and not considered to be part of the broker-dealers own reasonable independent investigation. With that background, let’s examine the ScoreCard one deal point at a time. Question 1 – Sponsor/Manager Experience - Here, we analyze the sponsor or manager’s syndication experience. While it is helpful to know that the principals of the sponsor have “cumulatively” had many years of productive real estate experience, there simply is no substitute for a promoter’s direct experience dealing with acquisition and financing of properties in a packaged program where investors pool their capital and receive tax-deferred cash flow, equity buildup and growth of principal. Further, it is helpful to know that the syndicator has had experience dealing with a large number of investors, reporting on the programs progress from an investor services perspective. So, what I am looking for here is the number of years a sponsor or manager has in syndicating, acquiring, financing, managing and selling direct participation programs for investors. This kind of experience rises well above merely buying and selling properties by one’s self. You will note that it takes 20 years to earn 5 points in question #1. However, one point can be added to the score of this deal point with some extensive personal real estate acquisition and management experience of one or more of the key principals of the company. Question 2 – Financial Strength - With this deal point, I am looking for tangible net worth of the sponsor or manager backing the deal. It is important to note, I would give little credit to would-be sponsors who are undercapitalized affiliates of a separate, main company sponsor, or parent company, which is not backing the deal but has simply loaned money to the affiliate in the form of a note to inflate the would-be sponsor’s net worth. Again, what I am measuring here is the tangible net worth of a sponsor on a GAAP basis, where 20% or more of its assets are liquid and not an empty shell number! To meet this requirement, many sponsors provide financial statements that are not audited. This is true especially in private placements. However in the mid-2000’s when deals by the carload were being offered, several large sponsors did provide audited financials. Examples were American Realty Capital, Vertical Financial Group (Mortgage Funds), DMMS and Argus, who all provided audited financials during that time period. Noted Ponzi schemes like Provident (Shale Royalties), Med-Cap and DBSI provided unaudited financials only. While audited, certified or reviewed financial statements help, they are no guarantee against fraudulent activities but they’re better to have than not, and it should be mandatory for sponsors raising millions of dollars to provide them. Note that it takes $15 million of tangible net worth to obtain 5 points on the ScoreCard, and as a rule of thumb, I feel that the sponsor should have a net worth of no less than 10% of the sum it has raised in outstanding deals to date, including the one you’re considering. Question 3 - Resale Activity – Here, I am looking for the sponsor’s track record of re-sales and refinancing. What is usually listed in the profile of weaker sponsors is the number of programs, the number of investors and the total dollar amount of monies raised along with the cash flow distributions of prior programs and the cumulative number of years of experience of the firm’s principals. Clearly, these items do not constitute “track record”. Track record breaks down to two items only; re-sales and refinancing of the properties syndicated as shown in the PPM, nothing more! It is always helpful to list the re-sales and refi’s of the principals and one point can be added when warranted. Please note that it takes 30% if the sponsor’s properties syndicated to have been sold or refinanced to warrant the top score of 5 points. Question 4 – Sponsor/Manager Compensation – In this question, I am looking for all the sources of compensation the sponsor receives and whether it is reasonable or not. Then I look for subordinations. I am not so concerned with how much the sponsor or manager receives as long as he gets it after we do. That’s called subordinated compensation. While profits to the offering are usually subordinated, most other fees are not. It is refreshing when a sponsor subordinates some of its compensation to the projected investor return. Examples would be selling commissions, leasing commissions, construction management fees or project management fees. Score it up if the sponsor requires a cash distribution target to be met before he gets his share of compensation. Most sponsors charge both a property management fee and an asset management fee. I increase the score if there is only one of those fees are charged. Question 5 – Load Factors – Here we look to determine what percentage of the equity capital raised goes into the property(s). This can usually be found in the “Use of Proceeds” section of the offering document. Many sponsors want to call “load”, only the dollars that go directly to the sponsor. One sponsor of a large REIT, in the “Use of Proceeds” section, failed to show any acquisition fees in the front-end load. This was because the deal was a “blind-pool” and the acquisition fees (6%) would only be incurred when the sponsor actually purchased the properties later on. Hence, all acquisition fees were shown as ongoing operational expenses. Nonsense! These are clearly one-time, front end load expenses and would be incurred on every property purchased. They are not like management fees that are paid annually. I suggest that load includes the following: Sales commissions, organization and offering costs, non-accountable marketing and due diligence expenses, acquisition fees, loan placement and other fees along with closing costs. The remainder goes into the property. One chairman of an arbitration panel once asked me if large wire houses were selling these private placement TIC real estate deals. I explained that they did not because of the loads involved. Typically, it is the independent broker-dealer community that sells these deals whereby only 73 – 76% of dollars raised goes into the property(s). The public funds like REITS have lower loads whereby 84 – 88% goes into the ground. Total compensation (commissions plus non-accountable marketing and due diligence fees) are in the 5 – 6% range as opposed to 7 - 9% range for the private offerings the independent’s sell. (Exhibit B) Question 6 – Guarantees – In looking for some kind of operational guarantee for the property(s), a Master Lease or strong personal guarantee would be examples. Then there is the repurchase account. In larger funds, after one year or 18 months, the program will accept repurchase requests, in writing, of up to say 5% of the capital raised on a first come, first served basis. Then there is the small print buried deep in the PPM! It will say under no uncertain terms that the sponsor will honor these requests only if they will not endanger the program financially. Further, this repurchase account may be terminated at any time by the sponsor. Clearly, these types of accounts are illusory at best and should never be counted on, especially in emergencies. You can be sure that if there are any clouds on the horizon, the repurchase account will vanish in a heartbeat! Anything that increases the investor’s protection would add to the score. Question 7 – Self-Dealing – What I am talking about in this question is of course, conflicts of interest. It is critical to know how many services the sponsor is selling to himself. At the top of the list is a sponsor that purchases properties from itself or its affiliates. This is especially egregious if there is a mark-up on these purchases. Then, some sponsors will have an insurance subsidiary who sells property and casualty insurance to the program at inflated rates. Finally, if the original property acquisition comes from an independent third party seller, it is important to know what the percentage mark-up is to the investors. Typical mark-ups range between 10 – 12% but I have seen them as high as 25% – 30%. While the numbers are usually disclosed in the PPM, only by subtracting the third-party purchase price from the loaded cost (equity raised plus the debt) will you know the true total of the mark-up. Finally, unsubordinated compensation is a conflict, and the tax opinion backing the offering must have at least a “should” opinion by counsel. In an LLC, the weakest of opinions is “more- likely-than-not” and a “will” opinion is best. The minimum standard is that the offering “should” not be treated as a real estate partnership, tax-wise. Question 8 – Investor Voting Rights – While the investors are passive and have no real voice in management, there are always some voting rights preserved even for passive investors. TICs, for example, require unanimous consent of all the investors for most voting rights One other “passive investor” voting right would be the percentage needed to remove the LLC Manager. The real question to determine is, must you have “for cause” only to remove him. This is usually very difficult to prove. Typically, willful misconduct must be demonstrated. Bad faith, fraud or gross negligence of the manager under the definition of cause are examples and must be demonstrated as well. Short of being a convicted felon, the manager is probably going to be able to tie the investors up in extended litigation for many years if they try to remove him. The best of all scenarios is to have an offering that only requires a simple majority to amend the operating agreement, approve the sale of all or substantially all of the properties, approve any “roll-up”, approve any change in the deal’s investment objectives, approve any refinancing of the property or fire the manager. Question 9 – Leverage - Most importantly, the percentage of leverage is the debt related to the original purchase price from the 3rd party seller. That is actual leverage at the real estate level. Then of course there is the ‘loan to value’. That is the debt divided by the appraised value and should also be determined. On my ScoreCard, an all cash purchase or debt of no more than 39% would achieve the top score of 5. Question 10 - Financing – Here we are looking at the terms of the loan. Fixed 30 year loans are virtually non-existent in real estate offerings currently. What we look for are 7 - 10 year loans with as many years of interest only payments as possible. The ability to prepay the loan after some period is additionally important. We also like to determine if there are any cross default or cross collateralization requirements by the lender on the part of the sponsor. Here, we would like to avoid having to deal with the sponsor’s problems related to other properties that would affect our property(s). Finally, we should determine the “bad-boy” carve-outs (recourse guaranty’s) on any non-recourse loans obtained. These provide for personal liability against the borrower and principals of the borrower upon the occurrence of certain enumerated bad acts committed by the borrower and its principals. Question 11 - Valuation Ratio – This important question deals with the percentage of the appraisal amount to the loaded cost of the offering. Take the “as-is” appraisal amount and divide it by the loaded cost to the investors (equity raised plus the debt). Many times I see this ratio at under 85%, which is unacceptable. So it must be scored down. What we like to see is a ratio of 95% to 100%, appraisal to loaded cost, which is the fairest to the investors. This ratio is one of the most important elements on the ScoreCard. Finally, always be sure that the appraisal is honest and straight forward and not made as instructed (MAI). Question 12 – Assumptions - This question is the very heart of the ScoreCard. First, it tests the projections by determining if any legal or accounting firm signed off on them, or if they were just un-reviewed as prepared by the sponsor? The latter is usually the case. Are the yearly rental rate increases realistic? A projection of annual rental increases of say, 5% every year is abnormally high and unrealistic. Sometimes I see just that. The next thing we look at is the cap rate on acquisition. That percentage is gleaned by taking the projected first year Net Operating Income (NOI) and dividing it by the loaded cost. What I usually find is a cap rate below 6% at acquisition. Given the speculative nature of most real estate offerings, this number should be at least 2 – 3 basis points higher than a quality corporate bond rate due to the high risk involved. Next we look to the terminal cap rates on resale. It is fundamental that these should be the same as the purchase cap rates, but they never are. They are backed into by sponsors, many times. Since the lower the cap rate, the higher the price, lower terminal cap rates, differing from the purchase cap rates are often chosen which are unrealistic. This is especially true when interest rates are clearly projected to rise over the next 7 – 10 years. That’s the next thing we look at – the holding period. During that time, I always give extra points to a sponsor that puts a limitation on the number of years of reinvestments. An example of a ‘good deal’ for investors pertaining to the holding period is, after 7 years, the reinvestment period ends. In other words, no more reinvestments in new properties with sales and refinancing proceeds, i.e., capital events, are possible. The deal stops here. After 7 years, all monies from capital transactions begin to be distributed back to the investors in a self liquidating fashion. Score it up as being most fair to the investors. Further, it’s in accord with the NASAA Guidelines. Finally we look for any “yield enhancements” or financial engineering used by sponsors. Examples would be interest rate buy-downs, deferred management fees, rental credits, negative master lease spreads, sponsor leased-back space/units, paying cash flow from reserves or an unsupported basis for projections/assumptions. These games played by sponsor’s will be exposed by the ScoreCard. Question 13 - Percentage of Supply to Demand – This question begins with determining what percentage of leases with tenants would expire within say, the next 5 years, 6 years, and so on. Then it is important to analyze tenant termination options for lease stability. Most important is to check with local real estate brokers to learn the actual vacancy rate for the same type of property you have within the specific sub-market you’re located in. Many sponsors tend to pick a number off a bus in stating what the occupancy percentage is, both current and projected. Finally, it is critical to determine what the competition is with respect to the type and location of the property you have. From the answers to these questions, you can easily determine a percentage grade for the offering you’re analyzing. Question 14 – Consideration per sq. ft. vs. the Competition – This is a simple comparison. We know that if we were a direct real estate investor, we should consider buying a suitable property with moderate risk at the highest. An example would be a triple net leased property guaranteed for 10 – 15 years by a Walgreens, CVS or Jared’s Jewelry. We could buy it for a fee that compares to a simple negotiated real estate commission, i.e., 5% on average. We wouldn’t actually pay the commission since the seller would pay that. The fee we would pay would cover the appraisal, property inspection, environmental study, engineering report and the loan fee and costs. The total expense would be approximately 2.5% of the equity invested and with 50% leverage, that would equate to 5% of the selling price. However, if we were buying a direct participation program through a broker-dealer, we would be paying a load of much more than that. Simply add the load from Question #5 to 100% and you have your answer. If the load is 25%, you score 1 point (125%) on the ScoreCard compared to 105% in the direct real estate marketplace. Question 15 – Risk Factors – Unquestionably there is risk in every real estate transaction. The question here is whether the risks in your particular transaction are greatly magnified above the norm. Examples would be an extraordinarily high mark-up on acquisition, an abnormally high load, unrealistically aggressive assumptions, investor credit impairment, a below 85% appraisal amount to loaded cost ratio along with an extraordinarily high percentage of leases coming due in 5 years. If some or all of these attributes described above exist, plus there are a number of items of unsubordinated compensation to the sponsor, the deal will probably score close to 1 point on the ScoreCard. So there you have it. An evaluation method that is really a due diligence check list; a quantifiable tool to evaluate direct participation program offerings. Of course this method is not perfect. In using it over 1,400 times since 1972, my experience with the ScoreCard due diligence analysis, reflects an overall 76% success ratio. In other words, over 75% of the time, when I have scored an investment offering below 52 points, it has not worked. The property has been foreclosed upon by the lender, the sponsor has been declared fraudulent, the loan is in default, it has been classified as a Ponzi scheme or it has stopped providing cash distributions with no hope of restoration. The same is true of offerings that have passed the check list. For the balance of the 24%, it is too early to tell in many cases. For example, something to really keep in mind at this time is that all those 10 year “due and payable” loans will now be maturing in 2015 – 2017. This necessarily will place a great deal of refinancing pressure on lenders in the real estate marketplace as well as finalizing many outstanding real estate deals. Some of the programs have come back somewhat, but may be wavering a bit with the final results still undetermined. I only count in the 76%, the program’s whereby a resolution has been finalized. Since a PPM or prospectus is hundreds of pages in length, the ScoreCard breaks the deal down into 5 or 6 pages in a logical format that the trier of fact can understand and appreciate. It makes it much easier for an arbitrator or mediator to verify the deal points of the program by hearing the ScoreCard presentation and then referencing the Table of Contents in the offering document. As Victor Hugo once wrote, “Nothing is more powerful than an idea whose time has come”. The ScoreCard as a reasonable due diligence method is one such idea. Mason Alan Dinehart III, RFC Securities Expert Witness http://www.fend.com FINRA Arbitrator #A30388 October, 2015