Fund Formation 101: Structuring a Fund for Success

Kevin Kim, Esq.:

Morning everyone! My name is Kevin Kim. I'm a partner here at Fortra Law. I lead the firm's corporate and securities division and I am a nationally recognized expert in fund formation in private lending, but we also do securities work and offering work in other arenas. One thing that we're going to talk about today that's really important is not just the legal aspects of building your fund and all that kind of stuff. We're going to talk about some core structural items and get through a little bit of the misnomers out there. The goal is to really keep this a high level we'd love to go over, but we're available to do consultations and get into much more detail if you're interested in learning more about fund information. We also teach a class for the American Association of Private Lenders and that's the Certified Fund Manager course online. You can take those classes for a fee with a PL.

A little bit of housekeeping before we get started. If you'll look at the bar in Zoom, there's a little q and a function, a little hand there. Please make sure you put your questions there. We'll make sure to get to those. And also this webinar will be recorded and so you're going to get access to this later out on the website or on the YouTube page. Beyond that, I do have a quick little announcement to remind everybody about our upcoming conference, Fortra Conferences, twice a year. Our upcoming conference is going to be in Las Vegas, March 30th to the 31st at The Cosmopolitan Hotel in Las Vegas again, and that's going to be coming up pretty soon and I understand that standard pricing will be ending soon as of Feb six, so if you're interested in attending, it's a good conference, it's a great conference especially for private lenders.

Alright, so let's get started. Today's agenda first I want to have a little bit of a level set on expectations regarding funds. I think there's a lot of misinformation about funds and a lot of misunderstandings about what they are and what they aren't and so we want to make sure we cover those items. Next big meat and potatoes items for the webinar today is going to be structuring your fund, right? We're going to go over some legal stuff. We're also going to go over some business items and some economic items, common mistakes, and then some operational best practices, guidelines for operators. So let's just jump right in. All right, so fund formation. So first things first, let's really lay the groundwork. I get this, A lot of folks throw around the phrase or use the word fund a lot and it's actually very limited in what it is, right?

A fund is not a offering of promissory notes, right? A fund is not that which offers bonds to investors or stock in an operating company. It is a specific vehicle that follows what we call the LPGP model. You create a fund, LP or LLC, the investors buy into that. That entity is a portfolio vehicle. It's designed to acquire and hold assets and it is managed by a separate entity, the GP or the fund manager, and that's going to be where you usually sit. You as the sponsor will usually sit and this is a very commonly used structure, hedge fund, private equity, real estate, our industry, they kind of all follow along the same core fundamental precept. This is not a known offering and that's really important to differentiate. A lot of folks will throw that phrase around, so I want to make sure we level set from a sponsor expectation standpoint, when is this a good idea?

And it's not always the best idea for everybody. I'll tell you it's not a good idea for what I would call, I call them hobbyists lenders. They're really investors. If you are just funding your own funds, you have no origination pipeline, you have no going concerned business, you're just funding loans others bring to you and you're just a solo operator and you're kind doing this as a part-time thing, you've got a full-time nine to five. There are lenders like that. I don't know that a fund is really the best next step for you. If you want to begin your journey as a professional lender and build out the framework and infrastructure because there's a few things that need to happen first, including deal flow.

This is really a really good tool for those lenders who want to go direct. So the key thing is they're not brokers. They're not interested in being a broker. They're interested in being a direct lender, borrower facing, they're interested in being and having some discretionary abilities to make loans and typically speaking, they're also phasing out or finding a need in their business where syndicating or doing fractional or multi beneficiary loans or using institutional counterparties as a table funding or correspondence programs leave things to be desired. The fund is really just a tool. The idea behind the fund is it's supposed to solve a problem for you and it's supposed to solve a capital problem. And the key thing there is does your business, does your lending business or your real estate business, does your business require discretionary capital where you're not necessarily limited by someone else's investment criteria and you need to have more discretionary capital?

That is kind of the key choice, the key decision making factor. Another thing that we find that lenders go and real estate professionals too go in this direction is they also want access to leverage. They typically are syndicating and obtaining a credit facility may be difficult to do if you're doing that, if you're offering trusted investments or offering investor notes to your investors and it just doesn't work that way with credit facilities, they typically do not like to interact with those types of programs and they prefer to interact with a fund and that's pretty well known across the industry and so that's definitely a driving factor as well. So if you're interested in pursuing a warehouse line, you're syndicating a fund is probably a good idea from a next step standpoint. One other thing I want to make sure we level set on expectations is that a fund is not going to solve all your problems.

The key thing here is going to be you as the sponsor need to have the operational capacity to be able to do this and run this. And so first things first is that this is not something for the faint of heart in the context of the idea is that this is just going to operate on its own. If I build it, they will come maybe, but it is going to add to the workload. You're making an investment in your business and so it is going to add to your workload. You're going to have to invest in resources. So it's not something where you should jump into it thinking, oh, it's going to be super easy. It is going to add to your workload. You likely will have to hire vendors including legal to operate it properly, but also you also need to be able to raise the money because especially for an emerging fund, a new fund, first time fund manager or emerging manager, that first round of capital is going to have to be what we call that friends and family round.

And so you as the sponsor need to be able to do that. If you have no track record of raising money, I would request, I would be honest with myself and say, Hey, maybe this is not the right time to do it. Maybe we need to build that book of business. You also need to make sure that you have really solid deal flow because what you can find yourself in any capital structure if you're having discretionary capital, is that you don't want to be in a position where you're going to have to go out there and chase deals to the extreme degree where you're going to have to take on more risks than you should. But also some other things that need to be discussed here is that fund managers have additional exposure, right? You're operating a fund now you have SEC compliance to deal with.

And so from that perspective, you also want to think about do I have the right mentality to run this thing? You have to be able to put your investors first. You have to be able prioritize their needs because now you are a fiduciary and a steward of their capital. And you should also be always constantly thinking, is my approach here the right way to do things right? And we also want to do right things the right way, but doing things the right way is important not just from an ethics and gut standpoint, but there's a certain best practice that you should follow and cutting corners is not going to get you there and that we see this a lot not just in vendor selection and using what I'll consider very, very low cost providers, but also in how they operate when it comes to running their actual lending business.

They cut a lot of corners they choose to do for example, good example is they choose to close their loans with software when they don't have the capability to do that properly internally, they don't have a closing team or a processing team or an underwriting team. They don't have the capabilities, but it's nice and cheap. Well, I don't know that little bit of savings now may end up hurting you in the long term because what we find is a lot of mistakes happen there and those mistakes start to add up. Alright, so let's get into core structuring items. Alright, so we talk about the fundamental concept. Basically what a fund is, A fund really is that LPGP model, right? We're pooling assets, loans or real estate in this park politic context and we're buying into, investors are buying into that entity, they're buying equity in that entity.

They're buying membership interest or LP interest in that entity. It's a pass through vehicle typically and it have a third party management company if not a third party investment manager as well, right? That's a very common structure you'll see in the fund world. It is not repeat, it is not a structure in which we are offering investors notes as the investment. We're not borrowing money from investors. That's separate. That's a different kind of structure. It's a feasible structure, it's a viable structure. We do 'em all the time. That's not a fund. So that's the most important thing the investors are buying into as equity owners. They're LPs in the LP or members of the LLC and they have a state of return in accordance with the waterfall and fees and so on and so forth. But that also gives them certain equity rights, voting rights and certain decisions in accordance with the offering documents thing to talk about when you're going into fund, whenever we do a consultation, the number one thing we ask about is which way you want to go from a legal standpoint.

Key thing with the fund, you are offering securities, you are offering and selling securities. You are the issuer of the security, so you have to comply with SEC regulations or state securities regulations most often than not SEC regulations because we're raising money nationwide typically nowadays. And so in that arena we do have to make sure that we're compliant and one of the key things to be compliant is selecting the right exemption to offer those securities. We run into this a lot where especially for smaller outfits where they've been raising money from friends and family and effectively they have a fund and they don't even realize it. And I've seen those situations get unruly because, well investor complains, SEC comes to knocking and we don't have anything to protect ourselves. So first things first is picking that right exemption and it all revolves around investor eligibility, right?

So the questions that I typically ask a sponsor when we're dealing with a new emerging manager is who are your target investors? Who are we raising money from? Are we going after what we define the legal term accredited investors or high net worth investors? Are we going after more one level above that called qualified buyers or are we going after mom and pop investors? We call retail investors or the non-accredited investors? These are the key questions that you need to answer that will lead you in the right direction when it comes to picking the right exemption. Another fact pattern that you have to think about is how do we want to offer and sell these securities? We know we're going to sell these securities, we're going to offer them, but how do we want to do that? Are we going to do this publicly? We're going to raise the offer it and advertise it and promote it and go on platforms and this and that and seminars or is it going to be more what we call a country club deal where it's kind of all existing relationships and we don't need to market it and that's going to drive the conversation.

In the private fund world, there's kind of three commonly used exemptions, two of which fall under regulation D, that's 5 0 6 B as in Bravo, 5 0 6 C as in Charlie, 5 0 6 B was the stalwart. It's been around for 20 plus years and it was considered the, and it still is kind of main exemption that all funds would use to start out. So hedge funds would use them and debt funds would use them. And so it's still widely used, but it is the older version and it does not allow for marketing. It requires you to have a substantive relationship with the investor prior to solicitation of investment. It also limits you to, on the investor side, it gives you 35 slots for non-accredited investors, but unlimited slots for accredited investors with a maximum cap of 2000 pursuant to the 34 act. Now this is important because for smaller funds emerging, they may have the need to have those non-accredited and it's a very interesting solution for the startup fund, right?

The new fund, the emerging fund. Now the big thing is you won't be able to market it. You cannot just talk to anybody you want. There's some key restrictions there. On the other hand, 5 0 6 C, which is probably more commonly used today, was a product of the 2014 reforms we saw under the jobs act. And this allows for marketing. This allows the securities offering to go out publicly and market and talk to anyone you want about investing and solicit anyone you want about investing, but you are limited to the investors on the investors coming in. They must be verified accredited investors only. That's the give and take right now the rules have changed a little bit on verification, but the verification rules still require that before the investor comes in, you must get either a letter from a CP, a attorney, broker dealer or investment advisor that they are an accredited investor or you the sponsor take reasonable steps to verify their accredited status.

Self attestation is not sufficient. Now contrast that back to b, b is in Bravo that allows for self attestation. There's no verification requirement under BC requires third party verification or you to sponsor to do the verification. There's a carve out under the newest version of these rules. There was a no action letter that came out recently last year that loosened the verification rules for individual investors over a $200,000 investment entity investment over a million dollar investment provided that they attest to you that they did not finance the investment. And this changes the game a little bit and so this allows many clients to reconsider, well maybe the 5 0 6 C option is the better option because they are concentrating on the high net worth investor, the accredited investor, the family office investor. That's kind of the target audience, so why not? And the data shows it right About 70% of offerings we do today and we do about anywhere between a hundred, 150 a year.

That's pretty commonly used, about 70%. Now the other option on the table is for those of you who want to go completely public and not be restricted on the investor qualifications and go advertise and take as many non-accredited investments as you'd like, and that falls under either two choices, you can go with regulation A tier two is the advisable one to go with and alternatively you go register as a publicly registered fund. Most clients don't choose the latter. They typically choose regulation A tier two in that circumstance. Regulation A tier two has its own I guess requirements. The big thing there is while you are permitted to market and advertise freely and you're able to take on as many non-accredited investors as you'd submit to that 2000 investor cap, the issue with regulation A is that because it's a public offering, you have to maintain a lot of reporting and SEC approval, so your offering has to be submitted to the SEC with audited financials for approval.

They will send you deficiencies and comments and questions and so on and so forth and it's a pretty lengthy process. Once you get through that and you're approved to go out to market and offer, you'll have to maintain reporting and that's that annual amendment, annual report, semi-annual report, current event report and also maintain the offer and it's good for about three years on an ongoing basis or if you've raised the maximum of $75 million. And so that's a pretty commonly used option. What we've found is it's not entirely advisable for a newer sponsor, emerging fund manager to attack because it requires a lot more resources, it's much more costly to run. But on top of that, we find that in private lending, the average investor ticket size is significantly bigger than what you think right now, the average ticket size we've been told at least is right around anywhere between a hundred to $200,000 and that informs, that's informed by the business.

The business need is that we need larger tickets, we're not going to get away. We can't do much with $5,000 investments. Alright? So that's kind of the lay of the land when it comes to the exemption selection. Now there are other exemptions and I don't have the time to go through all the different local exemptions at the state level. Barely anyone uses those anymore. Federal is the way to go. Why? Because we're raising money in multiple states and federal law governs in that circumstance. Now let's talk about another key, key key item that's oftentimes misunderstood is are you going to structure an open fund or a closed fund or otherwise called evergreen fund or you're going to structure a closed fund, closed ended fund? Now they both have their virtues. I don't advocate one over the other, but I will tell you in lending and credit, open-ended funds are quite common.

Why? It's really informed by the business model and the asset class. So let's differentiate what these are. First of all, open-ended funds do not have a finite life cycle so they can operate in perpetuity for as long as the manager deems and it's raising money constantly over time and investors come in and out. There's a way to get out. Typically it's some kind of lockup period or redemption plan. There is no technical maximum. You can set the maximum, but you have the discretion to raise it and it is conducive to credit because loans are not, they don't increase in value, right? Loans do not appreciate in value loans just stay, especially bridge loans. They stay static in value, book value. That's how you value those assets. There's no big capital gains event. We're operating off of interest income and fee income, and so we're not relying on those large capital events right now.

You may ask, well hey Kevin, what about hedge funds? Many of them are open-ended, true they are. The difference maker is going to be about the liquidity and distribution frequency. Hedge funds typically are not distributing that frequently, whereas in the credit fund world, it's really a common tool to distribute frequently and valuation can actually be relatively easily struck in hedge funds because they're publicly traded assets typically. So that's the other item on the close ended fund. Close ended funds have a finite life cycle. So typically we see in credit kind of a three year lifecycle with option to extend a five or a five year life cycle with option to extend to seven, maybe even a 10 year lifecycle option to extend to 12 very commonly used in real estate, very commonly used for lenders who do longer term loans. In the world of credit and real estate credit particularly, we see it more oftentimes used in the world of commercial real estate finance as opposed to residential real estate finance.

Now, it was kind of the only model that existed for a very long time and this was the go-to and the reasoning behind it is because the investors are stuck there, you don't have any liquidity issues, investors are going to be there, they're not getting out. Typically with a close ended fund, you also have a different way of raising the money, right? You're going to have this kind of raise period that's going to extend over a period of time and then you're going to start acquiring assets toward the middle or tail end of that raise period. And then from there you'll go into what we call a harvest period where the assets get liquidated or sold or mature out. And so you can see where the asset class informs that. So on the real estate side, we do a lot more close-ended funds. Why? Because the assets increase in value, the increase in value.

So think about that, right? Because we have an asset that's changing in value, typically increasing in value, having an open fund becomes complicated for the investor that comes in later versus earlier because the value of his units is going to be significantly different. Whereas in a credit fund, the value of your units is going to stay static because once again, loans don't increase in value. And so we advocate closed-ended funds a lot more in real estate, we probably do the opposite ratio. 70 to 80% of real estate funds are going to be closed-ended, whereas almost 90% or more in credit are going to be open-ended funds because of those issues and the valuation issues of the portfolio. Now, can it be done as an open-ended fund in real estate? Absolutely it can, right? It's just a question of how do we deal with the redemptions and valuing the units and you have to change the way you value the units to make sure that you balance that issue.

Okay? Now some clients in the credit world have said, well, we've been burned in the past. We ran an open-ended fund in the past and we've been burned because of that exit issue in an open-ended fund, investors can exit. And so there's a redemption plan and we've seen it where sponsors get really stressed out and have to deal with crises that are associated with what we call a run on the fund. And so some sponsors have chosen, Hey, you know what? This is not for us. We're okay with the closed ended fund and we'll just do multiple vintages of funds, which is also a good idea as well. Alright, when you're thinking about which way to go with this, if you're a private lender, typically speaking, you're going to end up with an open fund. It's relatively easy to do. Creating a redemption plan is probably the most important thing and then how to operate that redemption plan.

But other things to consider there is how you're going to onboard that capital, right? Because you need to manage cashflow. It's very difficult in a lending business to manage cashflow because we have multiple different levers pulling on us from a capital standpoint. So you're having to manage the onboarding of capital. We prefer to use, we prefer not to use a capital call structure and we prefer to use what we call a subscription model where the investors' capital is captive as soon as they sign up. The most important thing in an open-ended fund is going to be planning out that redemption plan, right? Redemption plan is going to be very important. Well, whatever you want to put in, we recommend multiple what we call gates, right gates meaning that you have abilities to stop them both in ordinary course and in an emergency situation. And we found these gates to be immensely useful in crises In recent memory during the COVID crisis, we had a handful of funds that faced significant investor requests to get out.

Thankfully they had these gates and they were able to stop the investors and freeze redemptions. But other gates outside of the context of crises or emergencies are important to consider as well. We recommend annual gates maximum percentages per year. We also recommend that you be able to liquidate investors quarterly as opposed to in lump sum. A lot of things like that are important to install in your vehicle because one of the things to think about is even if you are able to set up a structure and bring in enough leverage to manage your liquidity, even if you still got to make sure you have those tools at your disposal. Now another key feature when it comes to redemption planning and policies is going to be your lockup period. And that's going to be dictated primarily by what kind of fund you're running. So if you're making loans that are about 12 months, then typically a 12 month, maybe a 16 month or 18 month lockup is a good idea, but funds who are making loans that are longer in term, for example, the longer term construction stuff, the longer commercial bridge loans, it might warrant a longer lockup period.

And this is important to think about. Now, some funds have done away with the lockup periods. There's no requirement by the law to have one, but it is a good idea. Now, I would argue that it's imperative that you have one, but we've had clients in the past get away from them and the one thing they have to manage and we have to warn 'em now liquidity is you're across the bear.

Our objective is to try to keep you, try to keep your investors sticky as possible. You've added an additional means to get out. So think about that as you're going through this. We've got a very well thought out one we use here as a default setting, but we're happy to customize. And an additional thing you may want to think about in your redemption planning as defaults are climbing as of late, is to think about what are you going to do with troubled assets and the capital associated with those troubled assets? Are we going to do any kind of restrictions on those holdbacks on those? Are we going to create side pocket accounts? These are going to be very important considerations as you plan your fund because think about an open-ended fund as an open-ended fund could theoretically run for 10 plus years. We've got a client that's running one for 15 years, and so when that happens, you have to think about the future.

You want to future proof this thing. So things may go sideways, things are hunky door right now, but have a plan for the future. Okay, so the other component is going to be, and this is really more after the sponsor has engaged us, but we want to make sure we think about this big picture. You should think about what kind of return model do you want to offer your investors? Some of the things that are commonly overlooked in this arena is the client just has a number in mind, but it's not informed by any kind of data. So yes, it's important to know what your investors will want, but if you can't get there financially, it doesn't make any sense. So one key thing to think about is, well based off of my historical origination background and local data, what is the projected coupon going to look like in this portfolio?

And that's going to dictate how we get to the end return with the investor. And if the coupon is too low, well that's going to have to have an impact on what the investors get in return. You may have to take a little bit less as the manager on top of that. What else can be added to the business, to the fund to engineer those returns? So a common thing in the lending world is obviously leverage and our philosophy is that leverage should not be used as a yield enhancement tool. It should be used as a cash management tool. Investors much prefer that. However, it does have the nice result byproduct of enhancing yield and so the arbitrage, right? So that's a very important factor, but remember, you're not going to have leverage out the gate. Most funds will likely have leverage later in life maybe a couple of years later, one year later, two years later.

You have to qualify so that you cannot rely on that when you're coming out the gate. Another factor to consider in figuring out what the yield is going to be, just big picture is whether or not you're going to sell loans and what the market looks like from that perspective because that can inform what the actual end coupon is going to be for the investors because all those yield spreads and premiums on the loan sales should go into the fund and factor into the investors and return. Other points to think about are going to be along the lines of the management company. What kind of compensation do you need or do you want? And this is oftentimes where we get into a little bit of a discussion with the investor or with a sponsor because you're trying to balance two things. Yes, you would like to make as much profit as possible, but if you're going to raise money in a fund, you want to do that in the most, I guess, transparent way, balanced way, in a way that looks as not just looks as it actually is.

You're putting the investor's interests ahead, yours. So a structure in which the sponsor, the management company, their income grossly outweighs the investor's income may raise concerns. Why? Well, any good fund is going to deliver financials to their investors. Those financials will demonstrate what they made and what you made. And so it's going to be relatively easy to find out if the management company or the GP is making say 15% and the fund is only making 8%. We've got a problem on our hands, it's an optical issue, it's a matter of profitability and a matter of fiduciary duty as well. You don't want your investors thinking that they got the short shaft right Now, the grant nice part in our sector is that most sponsors don't go in this direction. This comes up maybe once or twice a year, but you have to think about, remember you are a steward of these investors' capital.

You're putting their interests first. You are fiduciary. So think about modeling this that you guys make a nice profit, but you're not putting the interest of the investors as I would say second, right now, there's a lot of waterfalls, a lot of structures out there and we go in detail in my certified fund manager course, but the most common we see out there today, the most common is what we call kind of a two and 20 structure with a preferred return. So the way it works is you've got your expenses, you've got your management fee, which is an x percent on assets or equity, and then you've got some kind of hurdle rate, which is an annualized hurdle rate, say 8%, and then some kind of split on the backend, and we call that the carry or the promote. What's different in credit funds is that that layering does not have additional pieces to it like you ordinarily see in the real estate world or the hedge world or the PE world, for example, GP catch ups and high watermarks and return to capital because it's not advisable to have a return to capital mechanism because we are not able to make that type of return to the investor of capital because the margins we're not producing 20, 30, 40% returns to a point where we can start playing with house money like we would in real estate and real estate.

That's a very common factor and hedge is also a common factor. We don't see that as often in real estate credit because that capital needs to be redeployed into new loans, but also the returns are all relatively lower interest income.

You could do it, I just don't know if it'd be feasible to do in the long term. Same with the high watermarks and catchups. The margins just don't support that. And so it's not something we oftentimes see. The structure we ordinarily see in the waterfall structure is going to be that kind of preferred return and promote structure. Now, there are other models. There's models that follow debt and they structure it at, hey investor, you're going to get 9% or 8% and we get the rest that's out there. That's pretty common as well, especially for the emerging managers who are coming to market for the first time with their fund and they're used to debt and they like it and their investors like it and they don't want to rock the boat. It is doable. I just would warn the sponsor, one of the downsides of that structure is really going to be the issue of rate compression.

So you have to really think about what your plan is going to be to future-proof this thing if rates continue to decline. Another key characteristic is going to, we talked about it already, the idea of returning capital and GP catchups the characteristics of the income in your fund. So we're talking about both real estate and credit, primarily credit, but if your investments are more growth oriented, IE real estate, your fund should factor that in. Your fund should think about, well, we have growing assets, we have appreciation in our portfolio that needs to be reflected in the waterfall. The investors will expect that and also in the core structure of the fund, open versus closed versus income, right? Cashflow, which is the most common in the debt fund world. In the debt fund world, we are dealing with interest, income, fee income, a little bit of real estate income, but not a lot.

And this raises the question with clients of, well, do you want to structure your fund in a way that can do loans but can also buy real estate at market or buy, say, distressed debt When that occurs, the number one question I ask the client is, what's your projected ratio when it comes to these abilities? Because that will inform the waterfall. That will inform the ultimate cash flow. If we're structuring the fund as the assumption that it's a cashflow driven model, well then it may not be wise to allocate into those sectors because you're going to push returns down temporarily. We may want to think about adding in what we call real estate waterfall. So it's all things to be considered. Now here's the nice part, you as sponsors are not required to have all these answers. My job is to help guide the client through these structures and pick a model that works both for their business model but also for their required, I guess you can call it profitability. So one of the things that we see as a mistake oftentimes is the sponsor needs to have everything decided before they come to us. No, that's one of the biggest mistakes you can make because highest high likelihood is I'm going to take a look at that and be like, well, here's some changes that we think you should make, right? So I do not expect clients to come to the table with everything planned out. It actually could be counterproductive.

Alright, so let's talk about some common mistakes we see in structuring and planning. One of the biggest mistakes is in the planning of the fund and the actual structuring exercise is that they're shortsighted More often than not in private lending, we see clients create what we call open-ended funds, evergreen funds, but they don't take into consideration, well, how long is this thing going to run for? We see very, very high coupons. They don't plan to do certain things right now, and so they want those things to be removed. There's no flexibility. They're not accounting for things that might change in their business model. So one of the biggest things we see is, well client, you may want to change your model, you may want to make an amendment to your fund documents. So let's plan for that. Let's say in year three or year four or year five, you may want to do that.

What's the process going to look like? Well, if we don't think about that in advance, the usual default language is go to the investors for a vote and it usually has to be a majority vote. Well, does that make sense to you? Does that work for you? Is it too difficult to manage? It might be you might have 200 investors. It's a lot of work. So thinking about what standards are we going to put in place if there's minor adjustments that are not meaningful to the investors but meaningful to you, well does that mandate a vote? So thinking about that in the long term is important. Your provisions around amendments should be well thought out. Flexibility and the business plan is also one key important thing that we oftentimes get pushback on.

It needs to be thought out in a way where especially you need to have enough flexibility because you're going to be running this fund for a long time. The idea is that the business model needs to be you are going to run this business. You may start right now, I'll be concentrating on one to four RTL, but who's to say that you're not going to do ground construction suddenly? Or who's to say you're not going to be doing mixed use or multifamily? Also, who's to say that you're not going to do seconds and while you may never do a second, is it possible? These are things that you want to think about for future proofing. And I always tell clients what I write in here is not meant to dictate what you're going to do. It really is meant to dictate what you can do.

Other things to think about for future as you operate and grow your fund is going to be the ability to have different arrangements for different investors. Now, not advisable to do it all the time, it is something that comes up, especially with big ticket investors. And where I get this a lot is kind of a fund that's been done. It's been operating seven, eight years. They're now in a position to attract a big ticket investors and say, 15 million ticket, 20 million ticket, but they need a fee break or they need extra reps in warranties or they need additional things that the fund documents don't grant the investors. And then, well, the first thing we ask the client, well, let's look at the fund documents. Does it have side letter authority? Oh, it doesn't. Well you can't do that, right? So you got to think about that right Side pockets and sidecar, these are also all side related, right?

Other arrangements the fund may need to enter into a side car is typically having a separate vehicle built for a large ticket investor who does not want to commingle with the fund and the other investors, but wants to entertain the same business model and return profile. And it often may require the fund to get involved in the investment of the assets. Sidecars are very important. Side pockets are different side pockets to us. The way we define them is the ability to side pocket assets, particularly troubled assets and earmark them for restricted liquidity. This has become immensely useful as to defaults of becoming on the rise and assets are loans are starting to produce losses that creates liquidity issues. Site pocket authority is a very important thing. One commonly overlooked issue is especially when we get loan offering documents from other firms, is that they have not contemplated the ability to sell loans and private lending, selling loans is quite common now.

Selling loans has more to do than just to say the funk can buy and sell loans. It's more to do about the risk factors associated with the capital markets and is that factored in? And then the most important thing here is leverage. Do you have the ability to take on leverage? Is there clarity in all the documents that you can take on leverage in the fund? You'd be surprised how often managers come to the table and say, well, we don't plan to do this. And then a couple years later, oh, we want it. We don't want it for a yield enhancement, but we need it for cash management today. It's kind of the perspective are different, but it's definitely something to think about having the ability to do it. And if you're sensitive to leverage or your investors are sensitive to leverage, putting in limiters, putting in ratios to max out the abilities of the fund, it's very important factors. And to qualify with these different leverage providers, bank, non-bank, they're going to want to see that language in the documents too.

Alright, so another thing to think about when structuring your funds, oftentimes overlooked is also the business itself. Failure to build out protocol, failure to build out process and procedure, failure to deal with doing things the right way. One of the things, the number one thing that's oftentimes that's overlooked is really is investor relations and investor reporting. I hear this all the time. We get an investor complaint. The first thing I ask the client is, well, can I have a copy of your most recent investor report? And they don't have it. What do you have? You have statements. What does the statement look like? What percent they own, what their coupon is? It's not enough. So you as a sponsor required I think by law to deliver quarterly reports at minimum, and they should be financial reports, right? So this financial state of the company and portfolio reports, right?

So your loan portfolio will have certain things to report on weighted average coupon leverage, ratio allocation, geographic concentration allocation in different loan type allocation in different geographies. These are important default rates, delinquency rates. These are important and it'll also insulate you in the longterm if you're honest. So if you have good protocols built in on your reporting, both financially speaking about the fund's performance financially and the returns and all that, but also the portfolio's performance, it'll insulate you when things go sideways. I'm saying if things go when things go sideways, it's a forego conclusion that you will face foreclosures. I have yet to meet a fund that has never faced a default. Even there's a handful of funds that have just kind of faced one, maybe two, but still it's going to happen. Your investor reporting needs to be on point. Why? Because the investors, they should know about that.

They're entitled to know about that. And it's not hard to build out those systems and processes, especially in today's world where there's so many tools out there that are third party or software driven that can help you do this. Very important that you do this. Same thing when it comes to accounting. Accounting is a very, very important thing and should not be overlooked. Failure to do proper accounting in these funds can result in accusations of securities fraud. And I've seen it from the secs themselves. Why? Well, because you told them one thing and you did another ultimately. And so the accounting needs to be on point and fund accounting is not something that your average tax preparer for individuals is equipped to do. Fund accounting is very unique. There are certain rules under gap that you have to follow. We call 'em investment company accounting.

You can choose operating company account. There's certain things you have to do. And financial reporting is also very important. Delivering financials every year, quarterly statements, these are all part that puzzle. And if you're an existing manager and you're not doing this, I would strongly encourage you to start building those systems and processes internally right now because your investors will love you for it. And also create much more legitimacy beyond the nuances. The reporting though, right? One thing that we see oftentimes overlooked is the fund is not actually doing what it's supposed to do when it comes to, I guess you can call it tax reporting, right? So IRS reporting. So one big, big error we see out there is failure to deliver accurate and timely K ones to investors. I said in two ways, accurate and timely, right? So accurate. We see mistakes being made on K ones and that has to do with the accountants, the poor quality of the accountant, CPA firm and two really, really late.

And put your shoes in the investor's shoes. It's supremely frustrating if you're getting your K one in June because or in October, you don't want that to happen, right? Ideally we're getting it out in the first quarter, may be bleeding into Q2, right? So we want to get those out quickly. Why? Because the investors, they need to deal with their tax returns. But it also shows the quality of your team. Obviously you have to deliver K ones. For those of you who I've heard this once in a while, very, very rarely have heard they're operating a fund an LPGP or LLC driven structured fund. Investors are buying into equity, but for some reason they've been convinced by somebody to deliver 10 90 nines. No, unless that LLC is taxed as a C corporation or I guess an S corporation, God forbid that happens, but you are required to deliver K ones.

It's partnership accounting. All funds follow partnership accounting. Okay? So think about that. If you're not doing that correctly, this goes to one important factor, the team around you. My advice is to pick an industry professional that a CPA firm that actually has a fund accounting team going to your local CPA who does your tax returns individually is not going to cut it. The nice part is there's so many out there. If you're part of any industry association, they're usually there. Those events there at our events, buffet table of CPAs nowadays, and they're all incredibly competitive nowadays, ever since private equity has entered the fray. When it comes to cpa, a ownership, an additional tool will also be making sure that your day-to-day accounting is accurate. Because the CPAs, they do tax returns, they do K ones, they do audited financials, they don't do the day-to-day accounting. So that goes to a question of how are you doing that and is it accurate? So making sure you have all that in place. Now, one other thing that's not on this list but kind of falls in the same vein of investor reporting is investor relations.

Investor investing and investing in investor relations will pay dividends not only because the investors feel taken care of and their needs are attended to, but it will also allow you to have a process to deliver bad news, good news, easy, great bad news is the hard part. And there are going to be times where you have to deliver bad news. And the biggest mistake you can make from an investor relations standpoint is try to hide the ball. Alright? Hiding the ball. That's fraud in the long term. You'll get accused of fraud and you might have the right intentions, but transparency is very important. Investing in investor relations people, investor relations processes is going to save you a load of heartburn in the long term. So we talk about that very early on with the client.

And this goes to best practices. Alright, so best practices. Best practices. So first things first. Now I'm self interested in saying this full disclosure, but I'll tell you, do not cheap out on building out your fund, okay? I've seen, yes, we are in the world of the internet. We are in the world of chat, GPT. There's a lot of cheap options out there. The question is, you are investing in your business. Are you going to go about this the right way? Are you going to go about this the cheap way? So think about that. So be prepared to invest in your company's growth and operations and the fund is part of that if you're going to go down this path. So be ready for that. If you're finding yourself, oh man, this is too much for us to budget. We can't afford to do it. Maybe it's not the right time, we're not prepared.

Fund formation is not just legal costs on my end. We just talked about this, right? Vendor support's going to be a very important factor. There's going to be a lot of vendors that you're going to need over time. Legal is important, right? Legal is a very important factor. And also one consideration with legal is do they have the industry expertise, but also what's their philosophy on a client management and client relations. But also you need tax CPA firms to do the tax returns in K ones. If you choose to go down the path of audited financials, which I recommend audit firms, they're also CPA firms audited financial preparers, separate engagement, separate cost fund administration. These are professional third party administrators of the fund's accounting. They do the day-to-day accounting, they do the investor onboarding, they manage the p and l, they do the investor offboarding, they handle the distributions, they have line of sight into your accounts, very useful tool.

And today, many of them have come down to the middle market and are quite competitive in price and can save you a ton of heartburn trying to figure it out yourself. Okay? Investor portal, right? How do the investor interact with you? Is there a place they can interact with, get their documents, tax forms, get news, whatever it is. Many administrators offer investor portals. Many LOS softwares also offer investor portals. There are also a lot of standalone investor portals today, really good idea to invest in one of these loan servicing. If you are not going to service your own loans, which is a choice you can make, hiring a third party loan service or understanding how those costs interact with the fund and property management as well for your REO. So thinking about the vendor stack is going to be important. Why is this important? You may be thinking, hey, well I know that fund over there and they just do all that in house except the CPA part, right? Well, those funds have typically have years and years of experience and an army of people that are talented and experienced in doing these things and they're well situated. They were stood up probably when the industry did not have these resources. Today they do. And if you're a smaller team, why not invest in these resources? It keeps things easy, particularly when you're an emerging manager starting out, right? If you can outsource as much as you can, that lets you concentrate on the most important thing, deal flow and capital.

Other ongoing best practices in the fund world. We talked about investor reporting. Do not overlook this one thing and the financial reporting do not overlook this. One thing that we noticed is when times get tough, investor reporting also has to do with the culture of transparency. Internally, you may be doing this out of the goodness of your own heart to try to prevent bad things from happening to the fund. So if the fund's about to take on some really some defaults, some losses, you may try to insulate the fund by injecting cash and hiding the fact that the fund is facing these defaults. Not recommended that I have yet to see a manager be able to completely dig the fund out of any kind of hole like that.

But also the investors need to be aware of that. It's a material fact. The law requires you as a sponsor to deliver material facts and disclose material facts to the investors. So it's important to have that cadence of reporting, but also have that culture of transparency. And I'll tell you, I've seen it firsthand. Investors will typically be very forgiving to a sponsor that actually is transparent but has a plan, but they're less forgiving if you're going to hide the ball and kind of hide it from them. And especially in open funds. Here's why. If you knew that this fund was about to face a massive defaults and was facing losses, but you raise money into the fund knowing that, well now you've got a bigger problem because the fund is taking on new investors. And when you incur that loss at the fund level, the moment that loss gets incurred, everyone in the fund has to take that loss.

So do you have tools to prevent that? Do you have tools to maybe not raise the money temporarily? That's all goes to transparency and the capabilities in your document set. One other thing is what I would call the backbone, and this goes to all your vendors, particularly your tax and legal, and this goes to the culture of your counsel culture of your tax people. Do they have a culture of responsiveness and support, right? Are they going to be there for you in a crisis or are they going to kick you in the nuts on the billing every single time they even think about your file? It's important, right? And are they there to back you up when shit hits the fan? It's a very important thing. Do you have confidence that you can pick up the phone and reach your counselor or your CPA team and walk through a crisis? I think it's a very important factor because running a fund can be stressful and running a fund can be a lot of unknown territory, especially for a new manager. So ask yourself, do you have that ability?

All right, so let's open it up for questions. We have some right now in the queue, so I'll go through the first one from Joe LP versus LLC. Benefits. Drawbacks tax implications. Really today there's no meaningful difference. So technically speaking, LPs require the general partner to have a little bit more exposure but not meaningful. You can write around that. They do require the GP to have a minimum mistake. You can also write around that. LPGP is really just kind of what we call it, but today it was the traditional method. Before LLCs were stood up about 20 years ago or created the ability to have an LLC, right? 20 years ago they were kind of created. Today, LLCs are kind of the standard and the reason why LLCs are much more flexible. You can still do partnership accounting, you can completely outsource, have a third party manager with lots and lots of limitations and restrictions in the operating agreement.

And frankly, it's remarkably flexible in the context of tax too, right? So LCS can be taxed in any way it chooses. Default is pass through, but it can be disregarded, it can be an S corp, it can be a C corp, a lot of options. So typically in the fund world right now at least we end up doing LLCs more often. What clients are familiar with and the most flexible, and this is why in general, we see LLCs up and down the org chart, both at the fund level, the manager level, but also inside of the SPVs, underneath the fund. It's kind of our go-to. The only reason why we would go with an LP is it's the client's preference and usually from the fund world, historically, PE hedge and they're just traditionally used to using it and they use the phraseology, they like it, but there's no real meaningful reason to go in that direction anymore.

Next question from Jessica. What if you have a closed three year fund with real estate loans because your loans are all done, all one year loans, but the loan goes into an extension period beyond three years. Will we need to call the loans due or can we offer continuous extensions beyond the fund term? It sounds like you may need to deal with a fund amendment. I've faced this issue several times. What happens often than not is when we do a close ended fund, we'll bake in some extension periods and so if it's for a lending business, we don't really know how long those loans are going to last for. We have to bake in a little bit more discretionary extension periods in the life cycle of the fund. Generally speaking in this predicament where it's not contemplated and it's not properly written in, those have those features.

An amendment is contemplated and that may require a vote of the members of the LLC. Usually it's a majority vote. You got to check your operating agreement. Now, one other thing in planning for the future is bridge lenders traditionally fall into the camp of open because of this reason as well. But on top of the other reason we talk about today, you need more flexibility in the life cycle of the portfolio, and so it's typically not going to be conducive to a close-ended fund. It can be done, but if we're going to do a close-ended fund, I typically will have a lot more extension rights and also give the manager a lot of discretion to run extensions pretty much in perpetuity until the portfolio is wound down. What are the restrictions that it cannot originate in loans? So hopefully that answered your question. If you have more, you can feel free to give us a holler.

Next question is from Kurt. How often do you see mixed funds that are funding both first position bridge and also acquisitions? Do you often say pushback from investors on this hybrid structure? So generally speaking, I do not advocate for a fund that's, let's say on the allocation. The allocation is going to be 50 50. I don't advocate for that, and that used to be a thing. It was common a long time ago, but I don't advocate for it because A, it's confusing to the investor. What do you do is kind of the key question there. What is your business? Are you a lender? Are you a developer? What are you doing here? That's the first thing. How are you going to sell this thing? The second thing is that they don't jive at all, right? One's a growth and one's an income. If you tell me you have to have it, then we can structure it in a way that makes sense, but we have to contemplate the issue of redemption plans.

If we're going open. The nav is going to be different on the real estate assets. So I would ask a question to you is, well, what's your projected allocation in this asset class, right? Is it going to be 80, 90, 90 5% debt and a small smattering of real estate? Then I don't care. I can just build it as a real estate fund, a debt fund, because it's not going to impact the waterfall that much if we build a debt waterfall. But if it's going to start creeping past 10 and we're looking at 2030, we may want to think about separating the funds out or having a more close ended model just for ease of accounting. Now you're talking also about investor issues beyond the question of what do you do? The hard part is you have to manage the issue of valuation to their account, right? So their unit price in a debt fund, their shares don't increase in value. With real estate added into the mix, they're going to increase in value. So how are you going to deal with that issue if it's open? So that's why a closed structure may be more conducive. Your questions about cost, I don't do quotes over webinars. I'm happy to contact you after the webinar's over and send you pricing. We do a flat fee model and we're pretty competitive on that price.

All right, I think that's all the questions we have. If you guys have any other questions, feel free to contact us. Oh, here we go. Joe was asking another question. Redemption plan for loan loss reserves accounting, assuming you have zero distressed assets, are you obligated to distribute to the investors their portion of loan loss reserves? This is left to the discretion of the manager. Now, here's the real world issue with that loan loss reserve, which we call valuation allowance. Now, loan loss reserve is effectively a reserve of income, and if you withhold it, if you hold it in the operating account as a reserve to protect the pay for expenses in a loan situation, well that's taxable. So the investors are going to be taxed on that reserved income. But even so, just because you have no distressed assets doesn't mean that that's not going to be a good idea to keep.

I always tell clients the way you do this is really discretionary on your part, but the way you think about it's, what's the risk factors of this loan? Is this loan like or possible? What's the likelihood this is going to go into distress, right? And if that's the case, we should keep that money on the sidelines. If it's a 30 LTV loan in a prime area with a prime borrower, then maybe not who's repeated, maybe not. It's really on the sponsor to figure out what the best practice there is, but there's no obligation per se. Your investors will start to get annoyed with you if you start reserving a bunch of income and not distribute it because they're going to have phantom income on their K one. So it's a balancing act on the sponsors part.

Alright guys, I think that's about all the time we have for this webinar. Thank you all so much for joining us. You can reach me at my email there on the slide k.kim@fortralaw.com. You can find us by me on our website, on LinkedIn, and also on our YouTube page as well. We're happy to do consultations and walk people through the fund world that is fund formation. And if you have any other questions about what we do as a firm, we are full service and private lending. And if you're a real estate investor or sponsor, we also do securities work for you guys. So any questions y'all have, happy to walk you through it. You can also find us on all of the social media as well. Don't forget about our upcoming conference, March 30th to the 31st at the Cosmopolitan Hotel. That's for conferences. You can go on for con.com and learn more about that. Hopefully we'll see you guys there. That's all the time we have today. This is Kevin Kim signing off. Thank you very much.