Real Estate Fund Formation Masterclass Video Recording Transcript

This is the full transcript of the Real Estate Fund Formation Masterclass, featuring Dennis Doss (Doss Law), Matt Burk (Verivest), and Boris Dorfman (LBC Capital). Timestamps and subheadings are included to identify key moments throughout masterclass.

Welcome and Introduction

[00:00.5]

Now, I’m going to bring up our next speakers and I want to tell you that this is the time for you to take out your notepad. We are excited for this. We’re going to bring up, we’re going to bring up Dennis Doss, who is a legend in our space.

He’s been also known as the godfather of hard money. 40 years in the industry. You guys, we got Matt Burk, founder, CEO of Verivest, and Boris Dorfin. Guys, give a round of applause for a master class in private lending.

Good morning. You look at that agenda, you go, my God, it’s a lot of stuff to get through today. But, you know, that’s why I agreed to become one of the founding sponsors of our conference is, you know, you go to a lot of these others, and we go to all of them, most of them. It’s a lot of fluff, a lot of promotion.

I said, matt, I want to be part of this organization. If you provide education, I want people to leave our conferences smarter than they came. And for that reason, we participate. Because I come from California, we have a trade group there called California Mortgage association, and we emphasize education, education, education, not fluff and promotion.

So, if you come to these conferences, be professional, prepared to be educated, not promoted. And I think that’s what sets us apart from the other groups out there that are promoting themselves.

Legal Structuring, Compliance, and Fund Setup

[01:30.0]

So today a lot of you do one offs, one offs means you match a borrower to a private investor or two. And it’s the way hard money started. You know, some guy had some money to lend, somebody needed it, and then he brought in a friend to provide some extra money.

And the hard money business was born. And there’s people who stick to that model. There’s limitations on that model. We’re going to talk about kind of the graduate school of private money today with the mortgage fund, the debt fund, those terms are synonymous.

And we’ve got some great people here to talk about it. I’m going to handle sort of the legal part of it, the structural parts of it. Matt Burk here is with Verivest. They do fund administration. Think of them as kind of your back-office brains making sure everything runs smoothly.

And we’ve got a real fund manager over here, Boris Dorfman. I’ve known Boris for, I don’t know, I started his fund maybe 15 years ago. Boris 14. Yeah, yeah. About 15 years ago, he walked into my office in Irvine and said, “I want to start a mortgage fund.”

And he did. And he’s got a successful mortgage Fund in Los Angeles and he’s a guy you can pick up the phone and call and ask a question. He’ll take your call, and he’ll answer your question. He’s a lot of fun to party with too. But first let me ask my panelists to say a little bit more about themselves than what I’ve given them.

Matt, can you tell us a little bit about what you do? Yeah. So, by way of background, I’ve started in the hard money business back in the early 1990s and brokered loans, did a lot of private, as Dennis mentioned, one off matching.

Individual investors figured out that limitations of that model and decided to do a pooled investment fund. So, in 1999, 2000, I did my first fund. Since that time, I’ve done 11 different pooled investment funds, most of which were debt funds coming out of the Great Recession.

As we were winding down our then largest fund, I had a lot of people asking me for guidance and advice on how to set it up from a business standpoint. So, we’ve about 2012, 13, we started helping other aspiring managers think through how and why and when they might decide to do a fund.

And that kind of gave rise to doing a lot of the back-office work. So today we’re a fund services business. We help people think through setting it up, working with lawyers like Dennis to put together all of the structure and the offering documents and then we do the back-office administration, which is calculated, producing the financial statements, calculating the allocation of income to the investors and so forth.

Fund Administration and Operations

[04:17.5]

So Verivest Fund Services works with folks like you to help you be more successful and minimize mistakes. Kind of big, big value prop for us I think is that I’ve been there, I’ve lived it, I understand what the challenges and the issues are and that’s kind of what we do.

Okay. Boris Dorfman, LBC Capital Income Fund thanks for having me guys. Like Dennis mentioned, he helped us create a fund about 15 years ago. I’ve been a broker initially, then we started lending with one-off investors and we created a fund.

Best thing we’ve ever done. We’re a California based lender, we’re bridge lender but we will finance in most major metro cities around the country. We’re fast. We can fund deals as close as fast as three, four days.

And that’s one of the benefits of having money under management, having your own fund then that’s what we’re going to talk about. So, thank you. A bit more about me. I’ve been a lawyer since probably some of you were born. I was born in 1952.

I’ve been a lawyer since 1978, been practicing law for 47 years, exclusively, almost exclusively for private money. Although I did do a stint with the subprime lenders in Irvine and Orange County, which was the epicenter of the subprime movement.

I represented all of those companies, saw them come and saw them go. But I still kept my roots in private money during that entire period of time. I’ve created dosdocs.com myself. I coded every line of that program. Started at age 69, so don’t ever tell me you’re too old to do something because I started coding at age 69 and now it’s.

We have well over 200 regular users on our platform and it’s growing. Our law firm represents lenders and brokers. That’s all we do. We don’t handle divorces, drunk driving, anything else. All we do is represent lenders and brokers.

So, we’re in Irvine, we’re spread all over. We’re virtual. We have attorneys in other states and so if you ever need help in California or in some of the other states, let us know and stop by our booth. So, our presentation.

I’m a big believer in mortgage funds. Having seen, you know, private Money over the 47 years I’ve done it. When I first started in practice in California, the structure of a hard money loan was 10%, which was the maximum limit at that time under our constitution.

So, loans were done at 10% with 13 points. It was the golden age of hard money. Our, our constitution was changed in 1979, a year after I became a lawyer and eliminated the 10% cap and loans pretty quickly went to 20% and 20 points.

Background and Experience

[07:18.5]

And of course, the Fed stepped in and slowly ratcheted down a lot of those numbers. Competition did as well. Back in those days, we did a lot of consumer home loans, second trust deeds. That’s all kind of gone now. And we’ve been put into the business Purpose Capital arena by regulations.

So, the objective of our fund today is three different viewpoints. One legal, which is why I provide, I create over 100 mortgage funds, represent some of the largest funds in the West Coast. Fund manager, which is Boris, he’s a real-life, you know, fund manager and very experienced and knowledgeable one.

And then we’ve got the fund administration and you’re going learn more about what services they can provide. Because when you’re doing a fund, you can’t do it all yourself, you know, you can’t Be loan servicing, raising capital, handling your distributions. You’re just done if hours in the day guys, and then you still try to do deals.

So, you’re going to have to have vendors, you’re going to have to have lawyers, you’re going to have to have accountants, you’re going to have to have fund administrator and you’re going to have to have loan servicers. You’re going to have to have a table so you can focus on what you do best, which is making deals. That’s how you make money is making deals and bringing in capital, selling the money into your operation.

That’s the two things you’ve got to focus your life on. Not all the back-office stuff. The back-office stuff’s got to get taken care of or you’re going to get taken down by regulators. But you can outsource a lot of that stuff and focus on what you do best, which is bringing in the borrower, bringing in the capital and overseeing that process.

So, what is a debt fund, a mortgage fund? Well, the easiest sense is kind of a picture. You see this kind of bubble, this bubble is a limited liability company typically, and it owns, has title to mortgages.

So, pay to the order of mortgage fund on the note and deed of trust, okay? At its head is a manager. That’s you. You’re the manager of this bubble, this pool or collection of loans. And your investors are your shareholders, that is they take the profits out of that bubble balloon of loans.

So, in the simple way that’s what it is right now you’re sort of in the managerial level by putting the deals together and overseeing it through the servicing, but you’re not overseeing it in the same sense. So instead of having their eggs in one basket, one borrower, their eggs are in this large basket of a collection of loans.

The members or your investors own a piece of all of those loans. And their yield is derived by the collective return of that pool of loans. So their money is sort of spread among all the loans in that balloon. That’s the easiest way to look at a mortgage fund.

For the investors, the advantage is it’s not ups or downs it’s waiting for the monthly payment to come in. Their yield is determined by the collective yield of the whole fund. So, every month they get a nice little ach to their checking account and they go, oh, oh honey, the ACH came.

Yeah, it’s about the same as last month. And life goes on. They go play golf, do something else. So, there’s none of this back and forth waiting for borrower’s payments. The manager alone makes investment decisions you don’t like. Send big packages to the investors waiting for their decision.

Yes, this second guess. They think they know more than you and they tell you you’re doing it wrong. No, you make the investment decision, and you live or die by your investment decisions. Because if you don’t make good decisions, your pool is not going to do well and you’re not going to do well. So you’re motivated to put good loans in your pool.

Technology and Legal Roots

[11:03.0]

You don’t want to ever have to report to an investor that you’ve got a high delinquency rate that’s a negative. So, you want to keep good clean loans in the pool. And many of you, when you start your pool, will still do one-offs. Well, you know, put your best loans in the pool, sell your one-offs to the people who you don’t like that kind of thing.

Most of them are open-ended. That means there’s no termination date. The fund just grows and grows, grows and grows and gets larger. I’ve got funds that are 30, 40 years old. Some of them predate me, they’re that old.

And so, there’s no time limit. They’re typically structured for 20 years with some extensions at the discretion of the manager. So, it’s a baby that if you take care of it and nurture it just gets bigger and bigger and bigger and bigger and life gets easier as you get that momentum.

They’re structured so that investors can come in and go out. There’s initial lockup period when they first come in, usually a year to two years and then thereafter they can withdraw on a best efforts basis. That means it’s not a fire drill. We’re not going to liquidate assets; we’re not going to go borrow money.

If and when payoffs come in or we have extra capital, we’ll take you out. So, it’s a very orderly withdrawal process. So, if they’re not tied up in there forever, so it’s at most a year to two year commitment and then if they want out, they typically find a way to get them out. They’re most structured as limited liability companies.

Occasionally we use a limited partnership, but most of them are LLCs. The originator is the manager. Typically, the manager brings the deal in, either goes one off or it goes into the pool. They’re the traffic cop in that highway.

The manager typically as the originator gets the points out of the loan escrow like you do now. No member approval of loans. The manager alone makes a decision. The fund is typically A direct lender. That means it’s named on the note in deed of trust and it collects the loans directly if it wants to self-service or it hires a servicer.

A fund can be run with a simple checking account. It doesn’t need anything more exotic than that, the fund typically holds loans for any investment income. Although you can create a fund that sort of like temporarily holds loans and then sells them off. But that’s rare because mostly it’s like I don’t want to sell this loan.

I’m getting nine and a half, 10, 10% on this loan it’s performing. Why would I want to sell it? You know, so you, the idea is to accumulate loans, not sell them off and give somebody else that beautiful income stream, keep them and grow. The investment is a security when the investors give you money.

Fee Structures, REIT Benefits, and Tax Treatment

[13:39.0]

It is a security under state and federal law. So, you need to provide some disclosures. We can help you with that. You typically have to do a private placement memorandum. The investors are typically going to have to be accredited, which means either they have a million-dollar net worth exclusive of their home furnishings and automobile or $200,000 annual income as an individual, $300,000 as a couple, which, you know, there’s a lot of people out there that are accredited investors.

So, I don’t think you’re going to have a problem finding those people. One of the beauties of mortgage fund is that the manager is typically paid an asset management fee. That’s a beautiful thing in a mortgage fund. An asset management fee is a monthly fee, a percentage of all the loans, all the assets under management, which consists of mortgages, performing and nonperforming cash and real estate that you’ve taken back in foreclosures.

So, three things that are on your balance sheet as assets, you get a percentage of that typically 1 to up as high as 2.5% of all assets under management. And you take 1/12 of that per month. And that includes assets that you acquire through leverage.

Some funds get a credit line and actually borrow some money on the security of the mortgages in their pool. So you can you get the asset management fee as a fee. Income you get income hell or high water. It’s a first thing that gets paid out of the fund.

So out of that typically a manager will cover his own, his or her own overhead, will cover loan servicing expenses. And we try to keep them kind of skinny in terms of what expenses are passed on to the investors. The pool will only typically pay its own, you know, administration expense.

It’s income tax return, preparation, auditing expense, you know, insurance, not a lot of stuff, not a lot of back-office expenses passed on to the pool. Normally that’s absorbed by the manager out of the asset management fee.

Most funds start off as an unadvertised fund. That is they raise and start their operations with what I call the low hanging fruit, which is your friends, family and people on your Rolodex. Guys all remember what a Rolodex was.

We used to have those things on our desk. And you turn it, the cards flip over. Well, you call them out, contact managers. So it’s people you know you raise the money from. The people you know, they trust you and know something about you. And that’s how you price the pump and get track record.

Track record means you’ve got a yield; you’ve got a loan to value ratio, you’ve got a default rate, you’ve got geographical dispersion of your loans. Now you’ve got something you can sell and then you can become an advertised fund, and you can advertise Facebook, Wall Street Journal, local newspaper, email, you know, doesn’t work much because filters, but postcards.

You can do all kinds of things to raise capital from accredited investors. Once you have numbers, you have to have numbers to sell because the investors are going to say, what’s in it for me? How many loans do you have in default? So, you’ve got to be prepared to answer all those questions.

Last structural point. Most funds pay either a preferred return or split profits with the manager over a preferred return. So, the way that works is this. The money comes in from the borrowers, the asset management fee gets paid say 1.5%.

Then the next money goes to the investors up to a preferred return, let’s say 7%. And then anything above that is split 50, 50 between the manager and the investors. That’s one structure. Another structure is we charge an asset management fee and everything else flows through to the investors.

That works too. And there’s variations on that. There’s the 80, 20 model. Money comes in, 80% goes to the investor, 20% goes to the manager. Simple. But we don’t try to make it complicated, you know, with striations and series and no, investors like life, simple, boring.

Something they can understand on a 8 and a half by 11-inch piece of paper. If you can’t explain your fund on one little piece of paper, you’re never going to sell that fund. So, it’s got to be simple. So, there’s different ways of structuring that. But at the end of the day is what is the number, because funds today are typically spinning off somewhere around, I don’t know, seven and a half to maybe a high end of eight and a half.

There’s some exceptions. There’s some funds at 11, they’re doing higher risk loans. But the par for a mortgage today, at least in the west coast, is about 10%, maybe a little between nine and a half and 10. So when you take off the asset management fee, there’s only so much left and you’ve got some expenses.

Accredited Investors and Legal Framework

[18:41.2]

So, if you’re clicking off somewhere close to 8%, you’re a rock star. And today, what are you competing with? What’s the stock market done this year? What’s it going to do the rest this year? It’s in the tank. So, you have no competition really out there.

The only competition is the 4% money market yields that banks are paying and the stock market’s paying. There’s nothing else out there. An 8% yield with 60, 65% loan to value on loans. You’re set exactly where you want to be and you have no competition today.

It wasn’t like the last two years. The stock market was wild and crazy and doing well. Not anymore. Not anymore. So, who wants to cover REITs? I will. During President Trump’s first term, I’m going to be polite.

A law was passed that changed the taxation of real estate investment trust. It’s called 199A and it’s being debated in Congress right now. You know, we want to extend the 2017 Tax Act.

It gives investors in mortgage pools a 20% tax reduction. That means they only pay tax on 80% of the yield they get out of your mortgage fund if they’re a taxpayer. Of course, pension plans are not taxpayers, but, you know, otherwise.

So, their 8% yield, you know, after tax is going to be higher because they’re only paying tax on 80% of that. Of course, you know, it costs America a lot of money, which is what they’re debating Congress. Do we consider that, you know, all the political stuff about the extending of that, but that is like, it’s pretty much certain that is going to continue.

It’s supposed to expire at the end of this year, and Congress is working real hard to extend that with, you know, everything they’re doing. So it’s likely to get passed. So you can say to your investors, listen, you’re only going to pay tax on 80% of what I distribute to you. What?

And so, they’re going to be really happy with that. If you elect to be a REIT a real estate investment trust. There’s some baggage that goes with it. You have to have 100 members. So, if you started today, you’d have to have 100 members by January 31st of next year. You can buy these investors, they’re called penguins, and they put $1,000 each.

And there’s a company that sells you these penguins to get to your 100 number. Or you can grow organically. So, the other aspect of funds, the legal aspect, is that it can’t have more than 25% ERISA money, which is pension plans, 401ks, things that are subject to ERISA, but not IRAs.

So, 25%, you’re limited to 25% of that. Most funds distribute earnings monthly by ACH and we covered the yield. Many secure a credit line, a small credit line to help manage cash in a mortgage fund.

Cash is a dead asset. You’re getting a little bit of money out of the bank, but you don’t want to like take a bunch of money from investors and have it just sit there in a checking account. You’ll die. Your yield is going to drop. So, if you’ve got a credit line, you can, when a loan request comes in, you can empty your checking account or whatever’s in there, pull the money off the credit line, fund the loan, and then wait for payoffs or dial for dollars, try to get more money in to pay the credit line down.

So, that way you keep the checking account low, you know, three digits, six digits or less, you know, 100,000 or less. And you’ve got this credit facility which means you can pull the trigger instantly to fund a loan. That’s the perfect world. And you’re going to be paying probably 7, 7.5% to the bank.

You’re making a little bit of delta there on the difference between that and your note rate. But you don’t do it for that reason. You do it to manage cash. So, you can get that kind of a credit facility when you get to maybe five to $10 million in assets and have six months of performance under your belt.

Making Money as a Fund Manager

[22:43.4]

So what? How do I make money in a debt fund? Morris, you want to cover this one? Yeah, I’ll take that. By the way, show of hands, how many brokers are in this room who brokers loans? Okay.

It’s a natural. Well, first of all, thank you guys. And it’s a natural progression for some of the mortgage brokers to start lending and become fund manager to open a fund in the future. At the same token, I’ve seen a lot of brokers, they make money, more money than the entire fund.

So, it doesn’t mean that every broker has to strive to become a fund manager, but it’s a great path. You become a lender, then you, you start making, you open up a fund. Personally, I don’t like fractionalized investing model where you put 15 investors on one note.

So that’s what the mortgage pools are for. How do you make money? Obviously, you originate and there is origination, there’s fees associated with the loan. Then as Dennis mentioned, there is a management fee and servicing fee.

Or you can combine those into one. The biggest benefit of having a fund, these management fees, servicing fees, this is residual income. Once you have assets under management and if you lock in with these borrowers for a period of time, if you don’t originate anything, you’ll still get a paycheck every month, every quarter.

It depends on how you structure. So, this is residual income. Sometimes brokers or even originators at the mortgage pools are hurting. Again, this gives you consistency. So, originations, fees, management fees.

And as a lender, there are forbearance fees, there is extension fees, exit fees. Again, you guys can get creative, but you control the paper, you control the narrative. There’re different models out there. Somebody likes to do 30-year loans with long prepay.

Some people do six months loans and get in charge on extensions. So, the biggest thing, you are in control of the narrative as a broker. Sometimes you rely on other funds or sometimes when you start off with one off investors, you rely on them.

You have a certain structure and then the structure may change a year from now. So, you really managing entity for the fund controls the narrative and you make money on everything or on whatever you want to make.

How you carve those fees up matters a lot, both to you as the operator, because this is your income and then your operating company expenses that you have as an operator matter, right? So, you’ve got your income and expenses, but it, it impacts your ability to raise capital.

Because savvy LPs investors are going to look at how you make money. How are you making money? How are they making money? How are the fees structured? Are they aligned? What are the profit splits? All of these things matter tremendously when you actually have to go out and raise capital for the fund.

And basically, the more sophisticated the investor, the more they’re going to look at those fees and how they’re carved up for them to consider an investment in the fund. So, you know, Dennis rattled off a ton of stuff that all of that is accurate.

Revenue Streams from Fund Operations

[26:36.1]

There’s a huge amount of depth of information that he rattled off in, what, 10 or 15 minutes. Once you get into it and you start having to live all of those things, of course, you can’t absorb all of that in one moment.

The layers reveal themselves in the fund of how you have all the things that you have to deal with. And I would tell you that one of the biggest lessons I’ve learned with clients, with myself running 10 funds and with clients, is that running a fund is a business unto itself.

I mean, it is not the same as just brokering loans or even matching up one, one at a time. And I’m sure Boris can attest to it. It is. It is a business. And you need to commit to learning and. And running that business over a long period of time if you want to be successful and get it to, you know, a critical scale that, I don’t know, Boris is at close to 100 billion.

I mean, that’s, you know, that’s a good size. Thank you, Matt. A hundred million. But thank you. So, anyway, how you structure the fees matters to both your ability to raise capital and to your financial reality of the ability to execute on the business.

And you need to balance those very carefully. Yeah, you can’t. You can’t be a pig, because at the end of the day, it’s a number, and the investors are going to be swayed by the number. And if they perceive that you’re a pig, they’re not going to give you money. So you’ve got to be able to explain it, rationalize it, and sell it.

So don’t go into it thinking that you can just load up and people are just going to give you money. And it doesn’t work that way. And it can evolve. You know, you do it certain way, and you can always change it. And even if it’s not in your private placement, you can always pay your investors more if you feel like it, or, yeah, if your return dip.

And if you don’t have a line of credit, for example, to manage cash, sometimes you will have those days, months where your investor is not getting what he thought he would. And it’s okay to share some of your profits with them if you choose to.

But it’s an evolving model. You can pay them more if you choose to, but you cannot pay yourself more if you choose to. Right. So you have to be thoughtful about how you structure it in the first place so that the income that’s coming in is sufficient to be able to operate your business.

Because once it’s baked. You cannot change the fees in your favor without the consent of those investors. Yeah, there are things you can do. If you set a preferred return, you could adjust it annually. You can adjust your, if your documents allow, adjust your asset management fee.

And you can always defer a portion or defer or forgive a portion of your asset management fee. I tell my new fund managers you’re going to be kind of on a diet for the first year or two. So you may, you may have one and a half percent in your documents, but you’re not going to get one and a half percent because you’re going to be doing everything you can to drive good numbers into the yield because the yield is what’s going to help you grow your fund.

So, you’re going to be on a diet. And once you get the momentum, then you can, you know, go back to a normal diet and even adjust it. Of course, if you have to build that into your documents. But what you don’t want to do is like hard code a fund.

Let’s say our yield is 8 and a half percent, come hell or high water. Well, we saw what happened to interest rates 10 years or five years ago. You know, I saw 6.99% hard money loans in California. If you were hardwired at 8 or 9%, you know, you have to pay that out to your investors or your debt.

How can you do that in an environment where there’s people doing seven, seven and a half percent loans? So you always want to make sure that whatever numbers you put in there are flexible and change with the change. Changing market Strangely enough, in the last six months, interest rates in the private money business has actually gone down.

So, you know, the market moves, it moves slowly, but when competition rears back up. So you’ve got to make sure your fund is built for the long haul with the ability to adjust numbers like the asset management fee, any kind of preferred return so that you can survive changes in the market.

Yeah. And I would argue, Dennis, that that’s a hard thing to sell to savvy investors. Right. Having the manager have the ability to unilaterally adjust key economic outcomes to them over the life of the fund.

The savvier they get, the less they will agree to giving the manager that kind of authority. So there’s, I think legally there’s a lot of things that you can do. I think practically there’s a lot of things that you probably shouldn’t do because you’re going to have practical limitations and impact to your ability to raise Capital from people who really understand how these private investments work.

Now, your friends and family and so forth, they might go for that. But depending on how broad your base is of friends and family, most people hit the outside edge of that relatively quickly. And that might be at 2 million or 5 or 10 or 20, depending on, you know, who you know.

But once you get outside that group and you’re now having to go out to people you don’t know and raise money, the more you can set it up where you can tick every box that they’re going to ask about alignment of interest, the better.

Balancing Structure with Investor Appeal

[32:20.1]

To Dennis’ point, it’s tough on the manager because if you box yourself in too tight and market conditions change, interest rates change, you know, competition changes, it can mean even though you have a fund that is evergreen in nature or open ended, you might find yourself in a position, and I found myself in this position before where it’s, the fund is functionally obsolete and doesn’t work anymore because I made some mistakes in the decisions I made on the front end that the fund can’t get past.

And then, you know, that’s the point at which you wind that fund down and you set up a new one. I mean, and that happens all the time. So, it very much is an art to understand all of the moving parts of, you know, the balance of legal and accounting and capital raising and origination and competition and so forth.

I always say it’s like a wheel, and there’s spokes on that wheel and you’re at the center of it as the fund manager, you’re the hub. But you need to figure out how to balance each one of those considerations effectively or the wheel will not run smoothly. And it’s just hard to know what all of those things are, especially early on, because until you’ve lived it and experienced it, it’s, you know, it’s new.

So that’s, you gain the appreciation of this over time, as Dennis certainly has done and Boris and me. That’s, you know, that’s just part of it is it’s a learning process. Hooking up with good people that have been there and done that is very helpful.

That’s the value prop we try. You’re still selling yourself as a management team and you’re selling eventually your track record you can raise. Like Matt mentioned, you start off with friends and family, then you move on to your circle of influence.

You go outside and then you may or may not get to institutional investors. I prefer not to get in bed with Institutional investors. But sometimes it’s an easy, it’s an easier raise. They will box you in, right?

But eventually, you know, small dentist crowd investors, what we call it, you know, small, we’re talking about under $10 million per investor. They will meet with you, they will call you, you will call them on their birthdays, they will be with you, they will be checking your audited financials, and they will be buying your expertise as a manager and look at your track record.

So that gives you longevity as a fund manager. And you can later cater to different investors by opening different funds for different, with different risk levels. Like Dennis mentioned, 11%.

Somebody wants, you know, you have that kind of money and risk tolerance. Let’s open a fund too. Yeah. I agree with Boris that in the early days they’re going to look heavily at the documents because that’s all they have to go on. But as quarter over quarter goes by or month over month goes by and you deliver a return, eventually they look at those returns much more than they do at what was in the documents.

So, it’s a, again, it’s a balance. And the longer you go, the more you deliver, the less pushback you’re going to get on some of these other items. Okay, what are the benefits of this business model to the average private investor?

Investor Expectations and Capital Raising

[35:54.1]

What is your sell, so to speak, compared to the one-off model? One is diversification. We talked about that 365-day yield, I mean in our state, once a payoff comes in, you’ve got 25 days to return the money to the investor.

Investor goes, I don’t want the money. Hold it until you get the next deal. No, I’ve got to return it to you. So, all that’s dead time for the investors. They look at a 365-day yield. So, the money that when they get their money back or the payoffs, you know, in a waiting to be dispersed to them, it’s not making any money for them.

So, a fund offers a yield for 365 days a year, less paperwork, loan review. You don’t send out a bunch of packages, wait for the money, dial for dollars as I call it. Income is predictable, stable, even boring to the investor, which they like.

Some of the money can be shielded from income taxes if you achieve REIT status. And return is not correlated with stock or bond markets. Although when the market, stock market is weak, mortgage funds tend to shine. When the stock market is, you know, you’re competing with the stock market when like last year, I think S and P went up, you know, 20%, that’s kind of hard to compete with because funds aren’t going to spit that off.

But there are some benefits to them. Diversification is the largest one, especially when you’ve got some track record like Morris does. He can show a dot thing, showing his yield over a long period of time and the likelihood of that yield is going to continue.

They can just kind of project out. I can expect about so much for the next years that I invest with Boris’s fund. And it’s predictable. It’s predictable. It’s to say it’s so predictable, it’s boring. And investors like boring. You know, they’re wealthy people, they play golf, they travel, they do all this.

They don’t need to be looking at your big packages and you know, scrutinizing appraisals and stuff like that. Most of them are just income. I call them income junkies. They want the income. That’s all they want. They’re not so interested in all the other stuff. So that’s the difference.

Yeah, we can take our return again. If you have a track record over the 10 years, take somebody’s Fidelity or Charles Schwab’s stock market record over 10 plus years and see where it’s going to take you.

Right. The funds average 8% the give or take. Everybody that invests in stock market, in individual stocks, find somebody’s statement from 10 years plus and see what they average.

Less fees. That would be a good reality check for you and your investors on a good side selling point usually. Okay, what are some of the challenges of running a debt fund?

Raising Capital and Investor Psychology

[39:01.2]

I’ll take this. So, we managed about $100 million in one off investors before we jumped into the fund. And we thought that at least 10% of these investors that fund individual trust deeds or do fractionalize, they will jump into the fund.

And it didn’t happen for various reasons. Some people like to see their name on the note on a deed. Some people would like to see two or three years of audited returns from your fund. You know, there’s investors that have been investing in trust deeds for longer than I have been alive.

And the change is very difficult. Like I mentioned, I don’t like the fractionalized model. You know, it’s the same thing as the funds model. But you know, the old timers, that’s all they know. And change is difficult. Education takes a long time. You know, it’s like we joke in our office, raising capital, it’s like having a child.

It takes nine months from the first contact to an investor for them, on average, for them to bring money into the fund, you have to talk to them, you have to cater them. And you know, eventually, you know, some people are going to be too small for your fund at some point.

Some investors are going to be too large for your fund at some point. So, I guess biggest suggestion before raising a fund, before jumping in, pick up a phone, call your circle of influence, call your current investors and see how they can commit, at least verbally.

It’s not, it’s never set in stone, but. And you know, you’re not asking for people. You know, if somebody has $10 million, you’re asking for allocation. You’re not asking for their entire portfolio. You know, if your aunt Mary has one and a half million dollars and part of it is invested with Charles Schwab in S&P 500 fund, you know, you’re not asking her for even half of that.

You know, you ask people to get their feet wet. So, raising capital is challenging, but it snowballs. You know, we are over 100 million now. Two years ago we were at 42. Okay, so it does snowball.

First three years we were at 1.8 million. Friends and family, our money. Yeah, I would say raising capital is the number one challenge in my experience for the vast majority of managers. I agree with everything Boris just said.

It’s hard in the beginning. It gets easier over time as you get better at it. I think the other big challenge, I would say for most new managers, is that it’s different than doing, than brokering or that matching one at a time or doing fractional. So there’s a big learning curve on how a fund works.

You know, the money pooling a whole bunch of assets, all the income coming in, sitting on cash, dealing with warehouse lines, managing the expenses. It’s just different. So there’s a learning curve that takes a while for people to.

To master. So, another point we put here, manager must get familiar with accrual accounting. Really, accounting and fund admin is another animal. And we made a decision in our firm that we’re not going to be concerned with a lot of things like accounting, fund admin.

We know how to place deals, we know how to do investor relations. We know how to keep our investors happy. We know how to originate. So met with Verivest. It’s a great example of the firm that will pick up servicing, fund administration.

Servicing is when your borrowers get statements, fund administration, when your investors get statements. So, there is a bookkeeping component. There is fund admin. Some people do it in house. Personally, I like checks and balances, and I like to use third party companies.

So, talk to Matt at Verivest. Also, you know the team that you pick on day one is going to be very difficult. You can change anything and anyone but it’s very difficult to change team and the way you do things like fund administration.

So, from day one as you growing, you’re only becoming bigger and more, your accounting gets more complicated. You know, you may get a line of credit, you may do securitization, you will definitely have more assets, you will have more investors. Your investors will be in different states and require K1s in different.

So it becomes more difficult. So again, you can change everything and anyone but it’s, it’s expensive and difficult. So, on day one, you know, Dennis created our fund a while ago and you know the fund documentation has to be constantly looked at, laws changed.

So yeah, so this is. And a lot of you guys and me including by the way I forgot to raise my hand because we broker loans sometimes not as much as before, rarely. But you know, you start managing a fund, you have to market, you have to raise, you have to wear different hats, investor relations and all of a sudden accounting and compliance.

And so you have to have team members beyond. You will have post-closing, you will be selling loans, you may be, you will have a credit line. At some point some of the fund managers will go beyond that and securitize their own paper.

So, these are the. You know, there’s growing pains. So, raising capital is challenging, but it snowballs. Track record. You know, some people would want to see 2, 3 years track record. Definitely bankers getting a line of credit without having two years of audited financials or pledging a lot of cash with a bank initially.

So accounting, servicing, fund admin, find companies that you would like to work with. Formation attorney. Also, you know, you guys can go on legal zoom and create the fund documents, right? I don’t recommend you do that, but you certainly can.

Capital Raising is a Process

[45:37.2]

I mean these are the documents that your investors attorneys will be looking at at some point, right. Like once you grow beyond a hundred-thousand-dollar investors, they will have their securities attorneys look at your fund documents, right?

So, then there is a structure in the fund documents. I mean there’s legal paperwork. But how, how do you structure. You structure it as 80, 20, structure it as a waterfall like management fee servicing. So you want to make sure the formation attorney or consultants that you work with can outline this structure for you.

And you know it’s typical, it’s simple but you know you need to have some time to think about it. There has to be guidance. So there’s growing pains. We’re talking about challenges balancing origination with the capital raising.

That’s, you know, that’s a fun one. It’s very difficult to run in different directions. So today, like I said, I know brokers. You know, there is a broker shop, an assistant and a processor.

And they do more volume than a lot of the funds. Their overhead is low. As you open a fund, you have post-closing, you have accounting, you have a lot of these things. When we started the fund, I mentioned we were, give or take 1, 1.8 million first three years.

I mean, we probably grew from 1.8 to 3 in the first three years. But part of the reason why it happened, while I’m trying to look at the marketing strategy, how to raise money, you know, I get a $18 million loan on our desk, we make couple of points on it.

And then I’m thinking we broker it. And then I’m thinking, you know, should I dump money into making 1.8 million into two and a half million or maybe I can run a campaign and get another 20-million-dollar loan and make couple of points on that. So, you know, it’s.

It also depends how big your team is and how much time you have, how many kids at home you’re neglecting while doing that. It’s very difficult to reconcile in your mind how many directions you’re going to without having a team. Managing expectations with investors is different.

You know, there’s people that are used to institutional investing. There’s people that invest in BlackRock. I had an investor that pulled money out because somebody from Goldman Sachs promised to sign him to a private club that he wanted.

He needed six signatures, so he moved part of his money to gold. I mean, Goldman Sachs, once you get into huge money, you know, nine digits, people are more concerned with tax strategies. So, okay, how can I get help? I’m going to cover this real quickly.

Legal. We talked about, make sure you have a lawyer that understands mortgage funds, have done a few of them. There’s lots of little structural quirks that you want to make sure it gets done. You’re going to have accounting help, fund administration, which Matt’s going to discuss more in about 30 seconds.

Loan servicing source. You can hire somebody at $80,000 a year, spend $30,000 on software, or you can outsource it. Outsource it. You know, get paid so much per loan, much easier. You’re not handling trust funds. You’re not down 1099s.

You’re not sending out monthly statements to your borrower. It’s a lot of unnecessary work that big operations can do for you. Until you get to a certain size, it doesn’t make sense to service your own loans. And then eventually you’re going to need a credit line as soon as you can possibly get there.

Now, why might I need a fund administrator? Let’s talk about that. Yeah, I’m not going to read all of these, but I would just tell you that the fund administration, as Boris said, is most people don’t really understand the pooled fund accounting treatment.

You have to calculate the net asset value. It impacts the share price. You’re allocating income across investors who are coming and going in and out of the fund at various points in time. It’s just a specialty function that most loan originators and brokers don’t have any account experience with.

So, hiring it internally, it becomes an operating company expense. So you’re bearing that cost and then you’re managing somebody to do a function that you yourself don’t really know how to do or you outsource it. It’s a fund expense. So the investors basically are paying for it as opposed to the manager, but it’s being paid for at a much lower rate than if you tried to do it yourself.

And frankly, most investors are more than willing to bear that additional expense because having a third party who is effectively implementing the rules of the road from an accounting standpoint in the operating agreement is worth it to them.

There’s a third-party paying attention; there’s oversight on the manager. It reduces the chances of fraud, misappropriation, or just doing it wrong. So investors in the institutional world, fund administration is table stakes. I mean, everybody does it.

It’s an absolute requirement. In the private small manager world, it’s not as much an absolute requirement, but it’s becoming more and more accepted that that’s something that people should be doing. So, in the past it was hard to even find an administrator at an affordable price if you’re a small manager, because most of the big admins don’t, they won’t even take you on because it’s just too, too small that’s becoming less so.

And I think today with some of the software that’s out there, investor management software, and some of the admins like us and others that are willing to cater to kind of the new and emerging managers, it’s, to me it’s a no brainer to do rather than try to do it yourself.

There are Some managers who’ve built up a lot of internal infrastructure that are capable of doing it and do a pretty good job, but if you don’t already have it, trying to build it out internally from the beginning is it doesn’t really make any sense. So, there’s the things you see on here, there’s it’s compliance support, making sure you’re doing it right, a lot of operational efficiency.

It’s expertise that is very rarely held by the manager themselves. So, my perspective, it pays for itself. Just the comfort you get from the investor. If an investor makes a decision, do this fund or invest in this fund, if they see this fund as a fund administrator, they get a lot more comfort from that.

So, I think it pays for itself. Checks and balances. Yeah. Because there’s another set of eyes watching it because you know, if Matt sees something going wrong, he’s going to speak up, you know, he’s not going to just sit there and let it happen. And they know that. So, I think it pays for itself.

Yeah. And ultimately when test be speaking of paying for itself, I mean, if you’re doing the admin internally, that’s a cost that you’re bearing at the management company level. And hiring a good accountant to do pooled fund accounting is not cheap. So, you’re talking 60, 80, 100 grand a year for an accountant to do that versus paying far less than that as a fund expense that’s being borne by the fund, not by your operating company.

Exactly. Can I advertise to investors? Yes, I covered that earlier. You got to have a yield, good default numbers, good loan to value numbers and product types. If you’ve got a lot of land loans in your pool.

Finding Your Core Team Early

[53:07.7]

Yikes. If you’re maybe too heavy on construction, might be an issue. But ultimately comes down to, you know, are these loans performing? What is the yield, how is the fund managed? How long has it been around? What’s size? Is it? Do you have a good administrator?

Those are the things that make the decision. But it starts with yield and track record. I might add real quick, Dennis on this one that Even from day one, I mean, I won’t get into an explanation of 506B versus C. But you know, up until 2013, you didn’t have an option.

You could not advertise to investors. You have to deal with people with whom you have a prior business relationship. Now you can choose an option legally that Dennis could tell you all about that allows you to advertise from day one if you want to. To his point, it doesn’t mean that people are going to come running to you.

But it does mean that you don’t have to limit your ability to talk about the fact that you have a fund that exists. There are some additional requirements that you have to meet in order to be able to advertise. Namely you have to verify the accreditation rather than just take their word for it. But I counsel all of our clients that you might as well just do it from day one even if you don’t have the track record yet because it doesn’t hurt to have people know that it exists.

To his point, it’s going to be a lot better when you do have a track record if people are going to be more inclined to come in. But I don’t see reasons other than unless you’re trying to take non accredited investors to not set it up to give you the ability to advertise from the get -go.

And since we’re in advertising, marketing, I recently mentioned about the importance of having a good team as a new fund. You selling yourself and your team, but internal, right?

But you know, you have your fund admin, you have your formation attorney, you have your cpa. You know I use Dennis’s name a lot when talking about to my potential investors in the first year, right.

This kid that was a broker yesterday is like with no track record. Once you have track record out of the financials, all that. But you can, you know, having a great team around you and you know, you would have to get permission to advertise this and or whatever.

But you know, when meeting with these investors it’s very important to show that you have some muscle behind you. I’m sure you’re all wondering, so how long does fund creation take and how much does it cost? Well, you got the numbers up here.

Average time is 60 days. I’ve done a fund in a week. Mostly it’s getting the clients to read the stuff we write, you know, because they’re busy doing other things. Legal budget approximately 30,000 that gets everything done.

Software, if you’re going to try to do this yourself, it’s pretty expensive. As I say, you can outsource all of that. You don’t need any expensive software to run a mortgage fund. If you outsource to a fund administrator and a loan servicer also all you need is a checking account and even they manage that and your distribution.

So, you’re all cost. And the 30,000 that you pay, legal fees, you can get that back from the fund once it reaches a certain size. So, it’s an investment in your future that Mystery is solved. How can I predict if I could raise money to get my fund up and running?

This is the proverbial problem of the chicken and egg. How do I get the money in? And as the other panelists have mentioned, this is the hardest part. You gotta prime the pump with the low hanging fruit to get the track record. And then you can use social media, talking like Facebook, Google.

I was telling somebody last night, I’m too old to understand the artery system of America today. The artery system, today, America is social media, Instagram, all this electronic stuff. And I don’t understand.

I don’t have an Instagram account. I have 50, 50 friends on my Facebook account. But people that understand those arteries and how to get into those pathways are really prospering as companies. So you need to figure out how to get into the arteries of America to get someone’s attention.

And so don’t think you can just, you know, figure it all out for yourself. You’re going to need talent to figure out the new world that we live in. Dennis, if you can figure out how to code at 69, you can figure out social media. Yeah, I don’t know, but I think I’ve got enough of my plate right now.

But in my opinion, you won’t have an answer to this question until you open a fund. That’s right. You put a lot of effort in it. You will raise the money. Would it be worth it if you could have spent that money originating loans?

It’s up to you. Like I said, we personally, my company, we put capital raising on hold for first few years, not officially, but we concentrated on originations. So, open it and then hope it works.

Using Leverage and Managing Risk

[58:35.9]

And usually, it will. But until you open it, you will never know. Okay, some miscellaneous topics to toss out. Is leverage a good idea? I’ll say my two cents. Maybe the other panelists have some ideas. You know people that take on large credit lines.

Let’s say you have a twenty-million-dollar fund and you got a ten million dollar credit line from a bank is playing with fire. Why? Because the most unpredictable businesses in the world are bankers, you know. Oh, we had a change of vice presidents.

We’re phasing out our credit facility business now. You go, what? Yeah, you need to liquidate those $10 million worth of loans in the next six months. You go, what? So, it means all your payoff money goes to paying the bank back. So, I’m not a big believer in large credit lines or large leverage for that reason, because banks are unpredictable.

They change with the wind. So I Would not build my business model around heavy leverage from a bank. So, a small credit line to manage cash I think is prudent and absolutely necessary at some point. But heavy leverage scares me because nothing can put a fund out of business faster than a bank pulling the credit line.

And then your Persona non grata to all the other credit line lenders. Oh, that guy’s pulling the credit line. I don’t know if I want to touch you because you become then an untouchable. So, then you’re like liquidating, liquidating, liquidating, which means you’re not making any new loans and life really sucks at that point.

So, does anybody else have any thoughts on leverage? So? Well, leverage is very good. A lot of leverage is very bad. You won’t get to lines of credit in the first couple of years.

When you do, you will have little negotiation power first time around. But don’t be afraid to read the contract and negotiate the terms. There’s going to be buybacks, time, there’s going to be extension.

Don’t be afraid to give yourself, try to negotiate more time. Obviously when you have a track record of having leverage, you will have more leverage to negotiate with the banks.

Another thing you have to have reserves is and it also depends on what kind of garbage you’re going to put into your pool seconds. Third nonperforming land or you’re going to be doing 50% LTV single family houses that you can always sell to somebody.

So, you have to have reserves, you have to have backup investors willing to buy your paper. And in that case, you can get away with a little bit more leverage than you want. But you, if not for arbitrage is secondary.

But you have to have a line of credit for cash management. And if you do get leverage, make sure it has a term on it and that you know, you never let get any closer to 12 months before the expiration of that term. So, if you’re coming up on 12 months, you know in the future they could terminate the line, negotiate another six-month extension.

So, you know you’ve got 18 months. Always make sure that there’s at least a year ahead of you in your negotiations with the bank because they will honor their contracts. They’re good about that. But if you’re in one of those where they can pull it at any time or give you, you know, 90 or 120 days’ notice, you’re setting yourself up for failure.

Understanding the Risk of Bank Credit Lines

[62:21.8]

Also keep in mind that they don’t accept any assets as eligible collateral. They normally like the bread-and-butter stuff like you know, rental properties they may not like, construction projects, they may not like, you know, consumer bridge loans.

So, they’re going to be kind of picky about the type of collateral they will consider as eligible collateral. And if a loan is nonperforming, it drops out of the eligible collateral pool and you’ve got to, you know, pledge something else. Keep that in in mind. There’s going to be more paperwork reporting to them in terms of, you know, your financials.

They’re going to watch you really closely. They’re only going to advance 50, 60% of the value of the collateral that you pledge to them. It’s not like in the mortgage banking world where you know, they’re advancing 98%, 99%.

No, they’re pretty conservative. Conservative, pretty low. They’re going to require personal guarantees. If you’re adverse to that, don’t even think about it. They’re going to want a personal guarantee, but you know, they’re at let’s say 50, 55, 60% on 65% loan to value ratio loans.

I mean there’s no way there’s ever going to be a call your personal guarantee. So don’t worry about giving one of those. I had a 50-million-dollar line of credit on our fund, our large fund at the time with Wells Fargo Capital finance. We were paying 2 and 2.75% to them and our average coupon was like 12.

So, we were making a huge spread. But then when the Great Recession happened and they decided not to renew, I had to extend it forbear, tell my investors I couldn’t pay them any money until I paid the bank back, et cetera. So that’s the double-edged sword of leverage.

It’s great when it’s good and it can be deathly when it’s bad. So. And the loan agreement, to Dennis’s point, they don’t advance on everything. The borrowing base formula is incredibly difficult to figure out. The loan agreement itself was 178 pages I literally couldn’t read.

I mean you’ll appreciate this as a lawyer, right? Each paragraph was about, I mean one sentence was about, you know, 850 words that you could, I couldn’t even read a single sentence that would let alone refer to some.

Yeah, so leverage. I heard my personal opinion hard, hard won experience with this is a line of credit for cash management purposes is great. A borrowing-based formula where you’re leveraging it to try to juice the yield is, is extremely dangerous.

Reserves, Reserves, reserves. And watch out for all the little fees they get you. They have Non use fees, funding fees. You think you guys are bad. You haven’t really met the pros when it comes to junk fees. The banks like to sock it to you. So use them with caution.

Fund Design, Fees, and Tax Benefits

[65:22.3]

Should I have profit splits the use preferred return or just take an asset management fee and pass through the rest. One of the largest funds I represented, formed 20 and a half years ago, takes a 2.5% asset management fee and just passes everything else through. And they’re at $700 million 20 years.

So, I mean, I can’t say there’s any right or wrong way to do that. The 8020 model seems to be popular. A preferred return, of course, preferred return is like, it’s not a guaranteed return. It’s what I call a chip shot return.

It’s kind of like an implied. Like we wouldn’t put it in there if we didn’t think we could hit it. So, you can’t set it too high. To Matt’s point, people are going to kind of hold you to it and they’re not going to, they’re not going to want you to adjust it. So, if you set it really high, like today, you set it at eight and a half percent preferred return.

Wow. You know, we could start seeing interest rates decline again. And all of a sudden, man, there’s your net profits after you pay yourself a little bit is under 8.5%. All of a sudden you’re negative. And then you basically either have to go hat in hand to the investors and get 51% approval to change and reduce the preferred return or, you know, close the fund, which you don’t want to do because you lose all that momentum.

So, either set it low enough where you think it can weather the changes in interest rates like say, setting it at 7 with splits above that. But don’t set it so high thinking that the world’s going to stay the same, because the world doesn’t stay the same. I mean, it changes.

Even private money world changes, you know. So, word to the wise, keep it as flexible as possible. I would tell you, on profit splits, here’s my answer. Personal experience, client experience. There is no perfect structure. Investors will always, some of them will always not like whatever structure you come up with.

Others will like it. So, you can’t please all of the people all of the time. So, you have to pick the least offensive way that that matches the economic reality that you’re going to be dealing with the fund in a way that the fewest number of investors will complain about it.

That’s My direct experience. And so, with profit splits to his point, in a mortgage pool fund, if you’re not using leverage and your average coupons 10 or 11, and you got fund expense, your management fee and fund expenses, you’re netting 8ish, right?

7, 8, 9, somewhere in that range. That’s just how the math is going to work. So if you give them a prep of seven and a half, a half or eight, that’s almost all of the money anyway. There’s probably only 50, 100 basis points of spread that you’re actually splitting the profits of.

So, a 50, 50 split has bad optics to the investor. A sophisticated investor is going to say, 50, 50 split. That’s crazy. That’s way too much, right? I want an 85, 15 or a 90 10, right? But in the matter of the actual dollars of that split on a point, you know, 1.1%, 50, 50 is only 50 basis points, right?

So, an 80, 20. So you’re talking a difference of 25 or 30 basis points. So, the point I’m making is that structure matters mostly as it pertains to your economic reality and the investor perception because it’s affecting your ability to raise capital.

So, you really want to be thoughtful about how you structure it and make sure you’re knowing that you’re not going to please all the people all the time. One other thing I wanted to say that’s not on the list up here, and that is communication to your investors. The most successful funds pump out at least a quarterly newsletter, and they’re detailed, sometimes monthly, and they’re full of pie charts and a narrative about the loans they’ve done.

Investor Communication and Growth

[69:09.9]

They talk about loans that they have a challenge with, maybe a foreclosure. They lay it all out black and white and they tell the investors what’s going on in the fund. They say the good news, the bad news. They have charts of the yield, annual yield. Beautiful communication.

This is how you sell and provide information and avoid surprises. I represented a fund during the last downturn that did second trust deeds. Terrible business to be in 2008. You know, they have $60 million worth of second trustees, mostly residential, and they lost half of it in the recession, got wiped out, values plummeted.

But you know, the guy who ran that fund, his name was Marty, he was a real communicator. He told the investors twice a month exactly what was going on in the fund, what was happening, all of that, you know, blow by blow by.

He just bombarded them with information, all truthful and didn’t hold back anything or sugarcoat it. And you know, he walked away, did something else, never got sued, lost half of the investors’ money. And so, communication and preventing surprises is extremely important.

And that’s your best money raising tools. When things are good and you’re hooking along and you’re doing great, you got to tell that because the investor that gave you a million dollars could have another 9 million sitting in his account waiting. He gets a newsletter going, hey, Mildred, why aren’t we putting more money in this fund?

This guy is really a rock star. So, you know, remember the communication is extremely important to grow your fund. A couple of other things and then we’re going to open up to questions and answers. How big should your initial offering be? We normally start them at 25, 50 million.

It’s just an arbitrary number. You, you can always raise it. It’s good to set it low and say, well, we over subscribe. We’re going to raise the size of the fund. But it’s all just numbers. You have to audit, you don’t have to. And they’re expensive. You’re talking 35, 40 grand a year which comes out of your pocket typically because you’ve got to sustain the yield to the investors.

So, you do it to help you get credit lines, you do it to help get credibility. You don’t have to do it literally, but, but it’s a good idea when you get to a little bit bigger size to start getting your financial statements audited. Gives you a lot of credibility.

CPAs usually will give you a break the first couple of years. Some of the CPAs when you’re small enough, less work. Yeah. So. And there are CPAs that specialize in fund auditing. It’s real important if you do with a fund also to get your K1s, which just the little paper they get for tax purposes, to get those out early in the year.

Because a lot of your investors do not extend their tax returns like I do. I file my company return in October. Typically, a lot of investors file it by April 15th and they have to get the paperwork to their CPA. So, work with your fund administrator to get those K1s out early in the year, which means getting your CPA into your shop in November, in December, to get everything, all the ducks lined up to finish the work in January and get those K1s out.

That’s another thing that’s very, very important that we learned pretty early in the fund process is managing the expectations of your investors. And most of them are not extenders. So, anything else we need to cover before we open up to questions and answers.

Questions & Answers

[72:36.8]

I think we’re good. All right, any questions about anything?

Can you speak up? You didn’t finish the rest of this. Oh, no. You don’t need to be a registered RIA. Funds don’t need a license. At least in our state we have if they, if they use a broker in our state, you can raise capital.

You can make loans as an unlicensed lender. There’s a fund in LA that’s 40 years old that has never had a license. Even the manager of the company does not have a license. Other states are different. And if you’re in the business of mortgage lending, you have to have a license.

I think there’s maybe only like a third of the states require a license for business purpose lending. So, licensees is usually not going to be an issue for most states. Of course, the state we’re in right now requires a license to be a lender. Arizona does as well, so.

But other states do not like Washington. There’s lots of states that don’t require a license for business purpose lending. But you have to figure that out before you go into some of those states. So, any questions?

Do we have a microphone, Matt? Yeah, we normally set it in there somewhere around the 50 to 100 range. The manager has the discretion to accept less. And some of the guys will go down to 25,000.

I mean they don’t encourage 25,000. They’ll put a number in there hoping they can get it. 250 to 100. I’ve seen 250. I’ve seen a million, but average is 50 to 100. But some people just kicking the tires and so if they want to open an account with 25,000 and they’re accredited, take it.

They just want to see what you’re doing. They want to get on your radar, get your reports, so you take their money. We started at 2515 years ago, we’re at 250 now, but we’ll take less if recommended by somebody.

It really depends on who you’re catering to. Which rooms do you find yourself and your initial. So, test the waters. Yeah, depending on what, how much your friends and family can contribute.

Do not guarantee anything. There’s no guarantees. There’s no guarantees. You’re not guaranteeing anything. The only thing you can be held responsible for is not following the guidelines in your PPM. Like if you’re making 90% loans and your PPM says you’re limited to 70, you’ve got exposure.

So, you’re not guaranteeing anything except you’re going to follow the rules that you get that was associated with taking the money in. If anybody has questions, if you please could come up to the microphone so everyone else can hear you ask.

The young lady in the front has a question.

So, you had said something about accredited investors and we had actually talked about creating a fund for the small investor, the people who are using their CISA or their HSA, things like that. But then you said something about you can only have 25% in those funds, so how do you balance that?

The fund isn’t made for people who are giving you their last dime. You know, that’s part of the reason why it’s limited to accredited investors. I mean, they only have to make $300,000 a year as a couple.

And that’s probably, I don’t know what percentage of America that is, but it’s probably a pretty high percentage. My state, it’s probably everybody. So we try not to take money from people who can’t afford to lose it. Not you could lose money in a mortgage pool, but so we’re kind of picky.

And you know, the rules are that they have to be accredited. That’s the federal rule. And the million-dollar standard for net worth, $200,000, $300,000 for income is fairly low. And they talk about raising it, but so far no one’s had the appetite to do it.

Licensing and Regulatory Scope

[77:06.4]

So, it’s like with trusting investors, you don’t want to take money from people who it’s their last dime. They’re supposed to be diversified in where they invest their money. And a pool is no different.

That’s for a Reg D fund. Right. There are other exemptions, there’re other types of funds. You could do a Reg A fund that can take unaccredited investors. There’s a lot more. It’s a lot more like a publicly traded company. There’s a lot more requirements on the manager. For a Reg A fund, you can take smaller dollars.

I mean, I always. From a business perspective, it depends on what type of assets you’re doing. Because if the asset, if the average loan size is a million dollars, you know, taking money at $5,000 or $10,000 a chunk, just you got to have too many of them. It’s very hard to make it work. If you’re making fix and flip loans in a state, the Midwest, where the average loan size is $100 grand, a little bit goes a long way.

Right. And especially if the velocity of money is turning over pretty quick. So it really depends on the kind of fund that you’re running as to what kind of minimums and what type of fund you want to set up. If you have never done a fund before, I would not recommend a Reg A fund.

It’s just way too much compliance work I mean, you really need to know what you’re doing. Thank you. The cost of forming Reg A is about three times as much. And you’ve got regular reporting the SEC, but you can take $500 bucks from an investor in Reg A fund.

But you got to deal with all the red tape associated with which. This is not a Reg A room. No, it’s not a Reg A room. Although we do have Reg A clients that are doing this kind of thing. But it’s. This is their fourth or fifth fund where they’re, you know, now trying to take smaller chunks and they know they can raise it and so forth.

Okay, next question. What’s the recourse or liability if you’re not meeting the preferred returns? Recourse or the liability to the manager if you’re not meeting the preferred returns for, you know, multiple quarters? There isn’t any. I mean, there’s, there’s none.

You, you, your, your reputation, your reputation, your investors will go to me. There’s no. Yeah, but there’s no legal, I mean, there’s no legal recourse back to you if you’re not meeting a preferred. Preferred return just means that if there is income, the investors are going to get the first amount of that income up to the preferred return.

But that’s if there is income. But this is a common problem to Boris’ point. When you put a pref in there, investors confuse it with what they. What the amount that they expect you to pay them. So, if you put in a. So that becomes problematic earlier.

So, like some guy wasn’t meeting returns and he said he didn’t get sued by anybody. It’s not a promise. I mean it’s, it’s an expectation. Plus, you know, you, you go invest in stock market and you expect S and P to perform a certain way because it had over the past 50 years.

But it’s up and down. It’s an investment. There’s risk associated with, with it. There is no guarantee. Another question, outside of like friends and family, you’re just starting out. What are other good places to market to, to get investors, advisors or like, who are you talking to?

That’s a, that’s a, that’s a deep, deep. And we could do an entire panel on that question. But the short answer is there’s social media, advertising, conferences, you know, local groups, different things like that.

Minimum Investment and Return Expectations

[80:38.5]

I mean, the odds of a new manager going in and doing any systematic penetration of, let’s say the RIA space is pretty much zero. I mean if you know an RIA in your local community that you happen to be golf buddies with, maybe, but you’re, you have no chance really to go to like registered investment advisors as a brand-new fund and have them start doing it.

So, it’s individuals, it’s people you know, it’s referrals. I always say you start with if your circle of influence is this, you start here and you gradually go one degree out as you grow. But you can’t start out here because people just aren’t going to respond.

So, my original question was real similar to his. Just about where do you go looking for the funding, finding funding, whether you’re doing a fund itself or just trying to get things happening. Everybody’s doing that. Thank you. Taxes when invested into the fund.

So, investors, they usually would compare private equity fund versus let’s say stocks, ETF, Bitcoin, whatever they want. And usually they would say hey, but with stocks or ETF we can defer the taxes, let’s say in the next 10 years.

And with the fund you have to pay taxes on a yearly basis. The question is there any way to do like a tax deferred fund, invest through, invest through a retirement account or an ERISA account. But beyond that, in a mortgage pool fund there are some like opportunity funds that, that maybe have some deferral that would accept like 1031 exchange money.

I’ve heard, I’ve done a couple of those. But otherwise, it’s ordinary income to them. And the best they can do is the REIT exclusion. Only pay tax on 80%. I didn’t mention but most funds have a feature of automatic reinvestment which means that instead of taking the cash monthly, they reinvest it back into the fund and grow their capital account.

But they still get a K1 for the, but they still pay tax on the money that they roll back in. But they can open up two accounts with you, a cash flow account where it pays like say ten grand a month to meet their nut, their household nut and then the rest they put into a rollover account, so it accumulates.

But at the end of the day, they’re going to get K1 and they’re going to pay taxes to our government who you know, needs it because we’re running a massive deficit right now. Yeah, there are other fund types that can do it. Opportunities on fund DSTs, but that’s for ownership of real estate, not mortgage pools.

Right, right. Yeah. Not the mortgage field. Yeah, there’s some real estate funds that are tax deferred, but not the mortgage field. Good question. I wish there was. Okay, thank you. Thank you, guys.