A private placement memorandum (PPM) is a document given to prospective investors who are considering investment purchasing a security as part of a private offering. The PPM describes the offering, the terms, and the financials, and conveys the risks and disclosures the investor needs to know before making a decision.
These days investors have various ways to put their money to good use and generate passive income and may receive many private placement memorandums on each. Many still rely on the stock market as a means of building wealth. Other more sophisticated investors may become angel investors in various businesses. But more and more have started diversifying their portfolios with a broad range of real estate assets.
Historically, real estate has been one of the biggest fortune generators globally. Over the years, the industry has evolved to a point where almost anyone can invest in the property market, whether they want direct involvement with their assets or not.
In recent years, real estate syndication has experienced a surge in interest on both sides – syndicators or sponsors wanting to put together deals and investors looking for big returns. But in real estate, as with everything else, some deals are made public, and others are kept private for various reasons.
Before going into detail about the private placement memorandum (PPM), it’s essential to clarify the concept of a private placement. You need to understand what it means, who it benefits, why you need a private placement memorandum, and where the PPM fits into this discussion.
While on the surface, the notion of private offerings may seem like less of a hassle, whenever securities laws are involved, we can assure you that things aren’t as straightforward as they seem.
For that reason, this article will focus on navigating the private placement market, with an emphasis on the real estate syndication sector and what it means for you as a syndicator or sponsor.
Unlike a public offering, a private placement is an offering of securities to a select group of potential investors that don’t have to be registered under state or federal securities laws. Although private placements involve the sale of securities, similar to an IPO, there’s no need for registration with the Securities and Exchange Commission (SEC.)
The registration exemption happens because these offerings are usually issued to accredited investors and are provided through Regulation D of the Securities Act of 1933, which was passed during the Great Depression in response to the 1929 market crash.
But what is an accredited investor?
An accredited investor is often an individual or business entity with a high net worth or at least a high level of sophistication and knowledge in navigating investments. Typically, banks and investment companies easily fall under the accredited investor category. However, individuals can also fit this description if they have a net worth of $1 million or higher or a minimum annual income of $200,000.
It’s important to understand that private placements are called private because they’re not able to be marketed to the general public.
Say, for example, that a company wants to expand into a new market. It needs more capital for growth and development. So, the company launches an IPO (initial public offering.) This means that anyone can buy stocks once the business is listed, thus helping the company raise the money it needs.
In contrast, a private placement is only presented to select and often handpicked investors.
For great examples of private placements, we can look at Goldman Sachs.
During the 2008 Global Financial Crisis (GFC), most if not all investment banks dealt with a period of hardship. Right after Lehman Brothers collapsed, other Wall Street giants found themselves in the same boat.
Goldman Sachs reached out to renowned investor Warren Buffett. The bank offered Buffett a 5% stake. This offer was presented to Buffett’s investment group in private and was at no point advertised, listed, or shopped around to the general public.
In this example, Warren Buffet was issued a private placement offering. It was a smart move at the time because Buffett’s reputation persuaded other investors to follow suit, which saved Goldman Sachs.
Securities don’t extend only to stocks and bonds. Real estate equity also qualifies for sales and offerings in transactions that meet private placement requirements.
So, what’s the purpose of private placement in real estate?
A sponsor, or syndicator, puts together a deal to buy a large property. Usually, this is an income-generating property that the syndicator will rent for a set timeframe, also known as a deal term or offering term.
But buying a large property, such as an apartment complex or commercial building, isn’t cheap. Therefore, syndicators raise money from one or more investors through private offerings. As a result, multiple parties become limited partners, pool their resources together, and make substantial investments.
The same exemptions and requirements apply to real estate equity as they do in other securities offerings.
That means that as a syndicator or deal sponsor, you can’t advertise your private placement offering to the general public. While you don’t have to register with the SEC, you still have federal and state guidelines to follow.
At the same time, you have restrictions regarding the type of investor you can bring in on the deal. Depending on what SEC Reg D rule you follow, you could present your offer to accredited, non-accredited, or both types of investors.
The good news is that private placement offerings allow you to raise unlimited capital if you’re only working with accredited investors. This enables you to create sizeable multi-income-producing property portfolios and generate substantial amounts of money.
With that in mind, let’s go over some of the key aspects involving private placements.
The question on most syndicators’ minds is this – How do you handle the documentation and navigate the legal field?
It seems fitting to discuss the most obvious culprit: the PPM.
Under state and federal securities laws, any securities issuer (company or individual) isn’t allowed to make misleading statements to prospective investors when selling securities. This has been the case for decades, and the law is applicable regardless of the type of offering – should it require public registration or not.
Rule 10b-5 of the Federal Securities Exchange Act of 1934 mandates that all information given by securities issuers to potential investors has to be accurate and may not leave out crucial material facts that would make the issuer’s claims misleading or false.
Remember that the Securities Act of 1933 was issued to help control the registration of public or privately sold securities and stock markets with the SEC. One year later, the Federal Securities Exchange Act of 1934 built on the Act’s framework and introduced new regulations to control the trade of those securities. Hence, a series of rules determined the proper conduct of issuer to investor interactions.
This issue of compliance essentially gave birth to the private placement memorandum (PPM) document.
In investing circles, it’s also referred to as an offering document, private placement offering memorandum, or offering memorandum. While the designation used is less relevant, it’s important to remember that it’s a vital legal document. It’s drafted with the sole purpose of disclosing the objectives of an offering, the risks, and the terms under which the issuer wants to sell a security or raise capital.
Within the real estate industry, this is a document often drafted by a real estate syndication attorney. It informs prospective investors about the industry, the issuer’s business, management plans, financial statements, risks, and offering-specific material facts.
Although we’ll focus more on the syndication aspect, understand that a PPM can be leveraged for other types of private offerings such as, but not limited to, real estate investment funds, crowdfunding, private real estate investment trusts (REITs,) etc.
The reason why even a PPM can be confusing is that sponsors have many real estate syndication documents to consider. Unfortunately, most of these papers, while different in purpose, tend to touch on similar topics. Hence, it’s not the easiest aspect of syndication to navigate. As such, most syndicators hire syndication lawyers to prepare their Regulation D private placement memorandums.
Some may confuse it with a prospectus.
However, a prospectus is a public document created and offered when issuers decide to register their securities under federal laws and make them available for anyone to buy. A summary prospectus is often issued by mutual fund companies before making a sale.
Its structure reads like an abridged version of the main prospectus document that discloses investment objectives, goals, expenses, strategy, and other pertinent elements to investors. Moreover, the summary prospectus is easier to digest even by investors with little to no legal expertise.
At its core, the PPM isn’t a public document. It’s something given out to pre-screened select investors in an attempt to solicit their involvement in an offering.
Another common misconception is that a PPM is the same as a business plan. Due to similar topics being discussed in both documents – which we’ll cover shortly – it’s understandable why someone working without the guidance of a real estate syndication lawyer might confuse the two terms.
Once again, we look at the function or purpose of the documents. A PPM and a business plan don’t have the same scope, although they share similarities.
The primary goal of a business plan is promotion. It’s a fleshed-out document discussing some business aspects but mostly emphasizes forward-looking information. Companies purposefully focus on the future, promises, forecasts, and other types of data that will engage potential investors and make them interested in buying stock or making an investment.
To all intents and purposes, a business plan is a marketing tool. Yes, it’s a complex document and can be very fact-based, but it’s generally built around a different premise and data points.
Examples of these may include:
Looking at a PPM, this document tells a different story. If you’re a syndicator who wants to raise capital from investors via a private placement offering, the PPM acts as your disclosure document. It will have a more descriptive and informative nature as opposed to the purely persuasive style of a business plan.
For example, you can seriously downplay the risks of vacancy rates in a business plan by touching on a management plan or advertising strategy that would mitigate the risk. You can’t do that in a PPM.
The idea behind the PPM is to fully clarify the risks, rewards, and other aspects of doing business with you, to potential investors. Thus, they can make an informed decision on whether or not to buy what you’re selling. Essentially, it enables an investor to analyze the merits of your offering.
When drafting a PPM, it’s important to remember to emphasize facts and thoroughly address any external or internal risks regarding your company, the offer, and the industry as a whole.
Naturally, the wording is everything when creating a PPM.
While legally you’re bound to full disclosure, that doesn’t mean that you can’t use it to skew an investor’s judgment. The secret to writing a good PPM is balancing all the disclosure requirements with marketing elements, such as those contained in a business plan.
Let’s bring this back to the aforementioned vacancy rate.
Say you’re looking for investors to buy a Class B or Class C property asset. Class C properties are notorious for attracting low-income short-term tenants, which pose a serious threat to your projected cash flow. Similarly, Class B properties may attract tenants who aren’t willing to pay too much for amenities or might not appreciate the location. Again, this poses a risk to your cash flow’s stability.
As you create a PPM, these are the types of risks you have to disclose and explain their potential impact on the investment deal – delayed payment of the first principal, lower rent, periods of instability, long-term profitability issues, etc.
In a business plan, you could focus more on how you tackle vacancy issues without making investors fully aware of the risks. However, a PPM is designed to enable investors to determine if an offering fits their risk tolerance profile.
You can and should still use your PPM as a marketing tool. Projections, estimates, management plans – all of these things are found in syndication PPMs. You simply can’t use them as the focal point of the discussion. Any negative or risk factors require full disclosure.
Now that you have a better understanding of private placements, and the scope of a PPM, let’s go over some of the topics you should flesh out.
It is helpful to have a checklist for what goes into a private placement memorandum.
Every document starts with an introductory section. Although usually brief, you should include one in your PPM to provide a short overview of your business and the investment opportunity. It will ease prospective investors into the more elaborate sections that follow.
Building from what you’ve outlined in the introduction, the investment summary section should go into great detail about your offering. You should cover important property details and other relevant highlights that allow the investor to assess your proposal.
Contrary to a business plan, the PPM is more about disclosure than anything else. Therefore, a professionally-made PPM will contain a very elaborate risk and challenges section.
Best practices suggest splitting this portion of the material into three sub-sections:
The real estate industry has some very specific challenges and risk factors associated with it. But given that many investors you reach out to might not know the real estate sector, you should inform them of what can go wrong and how.
Industry risks can contain human-made disasters, natural calamities (sometimes referred to as Acts of God) and other uncontrollable events.
The company risks sub-section will likely touch on risk factors affecting your syndication company directly. Things like debt, management changes, employee rosters, and anything else that would affect your company’s operation enough to negatively impact the offering’s profitability.
When talking about offering risks, this is usually the moment when you discuss the property in question. For example, you should disclose the challenges with buying in a certain area or attracting high-quality tenants, building problems, infrastructure, and other elements of this nature.
After outlining what can go wrong, it’s time to go into more detail about your company. Investors need to know what they’re buying and who they’re buying from. You should provide more detail about your company, track record, finances, and other entities involved, whether employees, partners, or third-party businesses.
What do you plan to do with your investors’ money?
Investors have a right to know what they’re paying for and get more context about your strategy to make them more money. It’s essential to disclose your use of proceeds and provide the reasoning behind your decisions.
Things such as renovation work, advertising, property down payment, and other similar topics can be discussed in this section.
Once you notify investors of who you are, the risks involved, and how you’ll use their money, you have to offer terms. You can’t make a deal if you don’t discuss what you want and what you can produce in return.
In this section, you may explain the minimum investment threshold, including all investor classes, if you’ve structured the deal in such a way. From there, you can touch on the expected rate of return and preferred investment term length.
If you’ve created a real estate syndication waterfall with multiple tiers of investors and return threshold, you should explain it to prospective investors.
Various fees exist in private placement syndication offerings. Acquisition, loans, asset management, and other types of fees can find their way into a contract. It’s essential to disclose all of them so investors know exactly what to expect.
Almost no private offering is envisioned as a lifetime investment. Sure, they can be long-term, but the process is pretty much always the same. You buy a property, rent it, distribute cash flow profits, and liquidate the asset at a later date after it appreciates in value.
Investors need to know what they’re entitled to upon liquidation.
Similar to the risk factors disclosure section, this part of the private placement memorandum notifies investors of potential issues.
Say you’re not at your first syndicated real estate offering. And you could have an interest in a similar property that competes with the new one for tenants. It doesn’t have to be you either, as a conflict of interest can stem from one of the third-party companies you work with or an employee.
Investors should know these things.
Not everyone will meet all criteria required to become a limited partner in your real estate private placement offering. Your PPM should clarify these requirements, perhaps explain the notion of an accredited investor, non-accredited investor, and so on.
Should someone decide to fund your deal, they’ll need to know what procedure to follow. Therefore, the PPM can offer a brief guide and list the necessary subscription documents.
If this outline seems a bit slim, it’s because it is. It’s actually an oversimplification of one of the most crucial real estate syndication documents, but it’s enough to give you a general idea of what to expect.
Furthermore, no two PPMs will feature the same structure or information. There are general guidelines to follow when creating this documentation. However, each private placement offering has very specific details that are addressed differently on a case-by-case basis.
Frequently, it’s not the concept of the PPM that makes things challenging for syndicators. It’s actually creating the document itself and meeting all the compliance requirements while still having something effective as a marketing tool.
Hence, many syndicators end up partnering with specialized accountants and real estate syndication lawyers to help them draft good documents and secure investments.
Although a real estate syndication attorney is well-versed in navigating securities laws and can guide you on what to choose between Reg D 506(b) vs. 506(c) offerings, there are other ways to get your hands on a PPM.
Like ready-made “terms of agreement” templates, there are plenty of PPM templates online that offer the basic structure and allow you to fill in the details of your particular offering. This can save you some time and money.
Going alone is seldom a good idea. The legislation you have to learn on a federal level might not be scary, yet it can still take a long time. But after that, you have to realize that state laws, or blue sky laws, may also affect your offering.
Before drafting your investment proposals, you will have to research and learn the state regulations governing private placement offerings in every state you want to do business.
This is a monumental task and one that you can’t do haphazardly.
What you put in your disclosure document is what investors can hold you liable for in a civil suit. It may happen should they be displeased with your performance. Thus, your PPM is not only a compliance document. It’s also a way of covering yourself and limiting the ways in which an unhappy investor can take legal action after making a deal with you.
While you have many ways of approaching the creating of this legal document, taking the official route is usually best for all parties involved.
Now that you understand what a PPM is and how to make it, it’s worth addressing another burning question – Do you need it?
Let’s go back to the basics of securities laws. According to federal and state laws, securities issues (whether companies or individuals) are prohibited from selling securities without registering them with the SEC or unless they satisfy specific registration exemptions.
This last part is what you’ll want to focus on for now.
Securities registration is expensive and not even the best course of action in many cases. Hence, if you can meet an exemption requirement it’s a good idea to structure your deal in a way that enables you to benefit from it.
The most popular exemption is found in Section 4(a)(2) of the Securities Act of 1933. This is the framework that deals with private offerings. Under Section 4(a)(2), Regulation D Rule 506 and Rule 504 are considered safe harbors.
Reg D determines the objective requirements that an issue must meet to qualify for exemption and not have to register their securities.
This is where it’s crucial to understand the differences.
Rule 504 has considerable limitations in terms of how much capital you can raise. But it’s preferred in some cases because it doesn’t require disclosing potentially vital financial information to non-accredited investors.
Rule 506, with its variants, Rule 506(b), and Rule 506(c), don’t have caps on how much money you can raise. The differences between them are noticeable in terms of marketing and the number and type of investors you can solicit.
But here’s the interesting part. A PPM is mandatory only in some cases.
A PPM is legally required if you create an offering using Rule 506(b) to propose to non-accredited investors. Conveniently, the same legislation says that you’re not legally mandated to provide a PPM if you target only accredited investors.
Remember that the Securities Act of 1933 was passed to put an end to misleading and fraudulent information passed onto investors. Even though some exemptions are in place, where you’re not legally required to offer full disclosure, investors understand good business practices.
Therefore, a PPM is always required, even if it isn’t legally mandated in every scenario.
Simply put, investors might not trust you or give your offering a second glance if it’s not presented in accordance with the securities laws guidelines. Investors look at PPM documents and see them as a form of insurance. Syndicators can use a PPM as a way to cover their bases by having a disclosure document to fall back on, outlining all potential risks and outcomes of the investment.
Are you always obligated to create a private placement memorandum? No.
Should you strive to do so? Yes.
If you want to raise capital and be protected against litigation, then working with a real estate syndication attorney and creating an informative PPM should be a top priority.
Here’s some good news if you’re a syndicator with big plans. The exemptions made for private placement offerings are amazing. You can save time, money, avoid stress, and work towards raising unlimited capital to fund your deals without having to create a publicly-traded REIT, investment trust, etc.
You can handpick your investors, stay within your network, and still go after massive investments, generate returns of up to 20% or higher, and benefit from some taxation incentives at the same time.
Compared to public offerings, the process of creating a private offering is more simplified. But that doesn’t mean that everything is straightforward. You’re still dealing with securities laws when you’re trying to gain exempt status for your offering.
Many factors will contribute towards that end, from who you want to target as investors to how much money you want, what state you’re in, etc. On top of all that, you must understand that your success depends on your ability to comply with requirements that enable private offering exemptions.
Therefore, you still have to jump through some hoops and navigate the legal environment on a state and federal level before achieving your goal.
Even simplified, this process isn’t something you should risk tackling without proper legal guidance and representation. Civil lawsuits can quickly eat away at your hard-earned fortune and reputation and hinder your ability to make future deals. Leveraging the experience of a real estate syndication attorney is often the cheapest, quickest, and most efficient way to handle all your real estate syndication documents, especially the private placement memorandum.
Take the full disclosure approach and balance it with enough marketing elements to show investors how capable you are of generating a substantial return on investment, especially in the private sector.
Contact our syndication and private placement memorandum law firm today!