PPMs That Scare the Sh*t Out of Me (Real Investing Horror Stories)

If I put in that PPM, I have no idea what I'm doing in this business, and you're an idiot if you invest, then you can't later come and sue me to say you're an idiot and you should never have done this business. I say, I agree. And that would be completely legitimate according to his PPM.

Not all PPMs are created equal. In fact, there are very few similarities between PPMs many times.

Hey, welcome back, Future Billionaires. When you invest passively, you almost always get what is called a PPM or a Private Placement Memorandum. It is the official offering, but here's the thing, it is long. In some cases, is this is over a 100+ page document packed with legal jargon and complex structures that make even seasoned investors say, oh shit. There's real no industry standard. I mean, the reality is it's still the Wild West out there, and that's why we're here today to walk you through the red flags you need to spot before writing that check. Let's dive in. All right, Ben, so I'm gonna ask you the first question. As the Chief Investment Officer, you see and write a lot of PPMs. Let's just start with the basic— what is the actual purpose of a private placement memorandum?

Yeah, well, there's really a few purposes, um, the first being description of the business plan, right? So this is where all the, um, you know, the business plan, the, the market analysis, the here's all we're going to do to this property or with this fund, and it lays out exactly what the sponsors plan with this asset or this fund is, and it's all right there for you to read. The other purpose is to describe all the fees, how they get paid, how sponsor— or how the limited partners get paid. And then ultimately, at the end of the day, it's a legal document that is really designed to protect the sponsor at the end of the day, right? This is really why they're drafted. There's a lot of language in there. There's huge sections on risk factors, usually about all the things that go wrong. If you read that, You think, why would I ever invest in any deal? But it's really to, one, clarify what the deal is, clarify who gets paid and how, and then protect against lawsuits. So, it's important for investors to understand that going in. They're usually written with those ideas in mind. And so, you have to really dig through a lot of the legalese to understand what's normal and then what's outside of the realm of normal.

The idea is that, so if I put in that PPM, I'm a sponsor and I write in the PPM, you know, I have no idea what I'm doing in this business and I really shouldn't be doing this business. And you're an idiot if you invest, then you can't later come and sue me to say you're an idiot and you should never have done this business. I say, I agree. And that's— and you signed the document saying I was an idiot and I should never invest and you still gave me your money. And so that's the idea, is that presumably that anything, as long as you as a sponsor do what is in the PPM, you have reasonable assurance that you're not gonna, you don't have liability to your investors. Does that make sense? So that's the idea. So from a sponsor's point of view, it really is about protection, you know, from, and then also, as Ben said, describing the business.

So Bob and Ben, do you think, 'cause I think this was a realization to me you know, the more I got into private alternative investing, that most investors realize that the PPM is heavily weighted in favor of the sponsor. I mean, cause that is the reality, right? The sponsor is writing this. I mean, they're the one paying for the PPM to protect them. How much do you think investors realize this? And, you know, I mean, and is that true?

Well, I think anyone who's ever read one realizes it, right? Cause it's pretty, you know, and it's written by the sponsor's attorney whose job is to protect their client. The sponsor. So, um, so there are also important legal disclosures. So all the caps, you know, all in caps at the beginning, are legal disclosures. And these are generally required by state law or federal law, or these are, these are things that have been determined from case law that are designed to protect the investor, right? And so the lawyers, you know, stick that stuff in there to say, hey, we're, we're, we're, we're, we're giving the appropriate warnings and concerns to the, to the investor. So Yeah, it's a hodgepodge.

And I think, I think too, I mean, you know, this, this is when the sponsors are writing these, there's a reason that they're putting all these protections in there. But for, for LPs and investors, this is a passive investment, right? I think a lot of people, you know, they don't fully grasp that you're handing your money over to a sponsor and they are going to be held to the standard that is written in the PPM. And so that's why it's so important to, to read the PPMs and, you know, in our discussions with a lot of passive investors, and this feels like a really big just hurdle for people because it is written by attorneys. It does in certain parts of it feel difficult to understand, but it's still very important to get familiar with the structure and the important sections, which we're going to talk about here and the why behind it. And so this is a passive investment. You're putting a lot of trust in the sponsor and what they're saying they're going to do. And, you know, understanding the, the ways that it could go wrong and what they're disclosing in that PPM is very, very important.

Yeah, I think that's great. I think the, the way to summarize this first section, what we're trying— what I was trying to do here is help people realize, you know, if you're the— if you're not the one paying the attorney, the attorney doesn't represent you, right? And I think that's, that's important to know when reviewing a PPM. And so, um, I want to talk about examples or maybe even personal stories about PPMs that have literally, you know, the title of this is PPMs that have literally scared the shit out of you. So, you know, deals that you thought were safe until, of course, you read the PPM. And so, Bob, you know, as the veteran, I might let you kind of start here. Give us a horror story, right, of a PPM that you were really surprised by or have been surprised by in recent years.

Yeah, well, I'll give an example. And there's a company that was, you know, a guy who is a friend or an acquaintance and was offering 20% returns to investors. And it was a land development play, which I know can be quite lucrative. And so I was curious and took a look at that and 20% returns. And in there, the use of funds was his overhead. So literally, you think about his investment company, the offices, his staff, his wife, you know, who is on staff, his marketing team, his due diligence team, his, you know, land development team, all of his expenses, his masterminds, his travel to Cabo to meet clients, all that stuff was a legitimate expense of the business. And, and that, that freaked me out. I mean, you know, so literally we're paying him, you know, it's like a venture capital deal where we're paying him to go run his, run his business. And yeah, if it works, we're going to get 20, we get, we get the first 20%. But really we get the second 20% because he takes all the expenses first. And there was no limits on any of the expenses. He literally could say, you know what, I'm going to do an all-expenses-paid trip to Cancún for a year. And I'm gonna bill my investors for that. And that would be completely legitimate according to his BPM, right? So, you know, holy cow, you know? So just to give you an example of the way Aspen does it, we have a set fee. So we have maybe an acquisition fee, we have maybe, you know, a carried interest if there's profits, a profit share if there's profits in the deal, and maybe we've got a little bit of management fee. So there's a couple fees, they're usually fairly small, but we can't bill our expenses. I, if I go hire a new marketing guy, I can't build a fund for that, right? That's my op, that's my management company expense.

Yeah. So clarify that. Where do those— because clearly Aspen has all those same expenses. We have marketing and we pay for travel for events and things like that. So if that's how, you know, what's the difference there where you say he can't be, you know, using investor capital for that? To explain the difference.

Well, the difference is we— that comes out of our management company. So I have to pay that out of whatever the fees that I happen to be charging for the different funds I'm operating and managing. So if I had a big exit, then I got paid from these funds, then I can pay my marketing staff. Or if I did an acquisition and I was— I had a right to an acquisition fee, so I could take that. So I have to very carefully manage, you know, the income, whether, you know, I have to anticipate the fee income we're going to get from our fees and be— and carefully manage the expenditures to make sure we're not overspending. But the point is it protects investors because investors know what they're going to pay, right? There's no— there's just not fuzzy. It's not, ah, yeah, we had a, you know, we had a big corporate retreat. Sorry, you know, versus, you know, there's a, you know, a 1% acquisition fee or, you know, 1% management fee. They know what they're going to pay, right?

And to the investor in that case is there is really no response. There's no must responsibility of that sponsor to pay a return to the investors because it's just a pref. It's not guaranteed. So to your point, they could have spent all the money on overhead if they wanted to and made no money in the investment. Exactly.

To the investor, you get, you get 20% of no money, which is nothing, right? And, and be completely legally in line because they signed people, and you could sue them, and the judge would go You signed it. You signed it. You agreed that he could, he could spend your money on his corporate costs. So what are you complaining about?

Right.

Wow. He spent it, you know.

So in the PPM, literally put that into writing. So for clarity, for folks reading PPM, where would a section like that hide for folks to know where to go look?

That was in the use of funds.

Okay. So use of funds is a section in the PPM that folks can go read and understand what people are actually using the funds of the investor for.

That's right. And again, this is such an important point that not all PPMs are created equal. In fact, there are very few similarities between PPMs many times. And it's so important to read because you can see this little clause in there, "And any overhead expenses," right? It's just an extra sentence under use of funds. And that materially changes the risk profile. And what we've done in the book, Investing Like a Billionaire, is we go through each of the fees and we describe what they're for. Sponsors still have to get paid, so it's okay for there to be fees, but they just can't be onerous. And one of the things that you start to build this confidence of and familiarity as you read more PPMs is understanding what's a normal range and then what's way outside of a normal range or a normal expectation for As an example here, the use of funds.

Bill, let's— I want to— I know you and I look at a lot of deals. You send me stuff, I send you stuff. Uh, we have a lot of internal chat about things we see. Give me some things. I know over the last year, especially if folks are maybe trying to kind of climb out of a pretty tough real estate environment, I know we've seen some wild things. What would you say are the wildest things that you've seen come you know, or maybe even be hidden in— sometimes not hidden, it's the first paragraph, but are just in PPMs.

Yeah, well, that's the great thing with PPMs is you can't really hide, right? Because it has to be disclosed and it has to be, you know, written down. And so, you know, hidden in the sense of maybe it's in a section that's more obscure, but it still all has to be disclosed. And, you know, one of the things that I saw last year, and there were several groups doing this that, you know, we've talked about other, uh, podcasts about these rescue capital pref funds, right, where they go and effectively raise capital, new capital from investors, and to infuse that capital into older projects that they're trying to either finish stabilizing or they need to extend, you know, the, the hold period for, and they need more cash for a variety of things.

It's rescuing deals that have gone bad, basically.

Yes. And, you know, there are cases where it makes sense to do that, right? And there's reasons why it would make sense to— hey, we think we have a good potential outcome here, but we need to extend the loan. We need to get a new loan and, you know, wait for the market to recover. So it can be okay. But one of the big red flags that I started to see is you go to the use of funds, right? And this is one of my favorite places to go, the sources and uses, and they break down where's the capital coming from and what's it being spent on.

Right.

And as a banker, that was something we spent a lot of time on when we're underwriting deals is really understanding what is the capital being used for, because you have to disclose where it's going. And the, the majority of the capital that was being raised in this rescue capital fund was going to pay back member loans. Or these were loans from the general partners that had been putting capital into these deals to help them, you know, help them along with their negative cash flow. And they're paying back significant portions. I mean, this was multiple millions of dollars and a large percentage of the overall capital being raised to pay back the GPs so they can get their skin out of the game. Yes.

Right. And now so, so they can put all the risk back on their investors and then they don't have— they don't carry any risk.

Yes. And so that's a pretty big red flag. And I think, you know, we talk about this in the book, but one of the most important things is you want— as you're reading through the PPM, you're looking through the sections that we outline that you go through. One of the biggest questions is alignment of interests and skin in the game, right? These are two critical things that you want to look for and to be able to trace through, you know, all these different areas, whether it's fees, whether it's the waterfall and how cash gets dispersed, whether it's the sources and uses of funds. All these things can be indicators of, is there real alignment of interest between the GPs and the LPs, or is there not? And skin in the game is lacking. In this case, that's a really big red flag if they're now shifting the burden of risk from themselves to limited partners that are signing these PPMs agreeing to do this, like we just talked about.

Yeah, really great example. Going back to the book, the Invest Like a Billionaire book, and again, this is Chapter 18 in the book. If anybody wants to go back to the book and read this, Navigate a PPM in 30 Minutes, you know, you guys, you guys quote, experienced investors pay more attention to the risks than the upside potential, which is why we're, we're talking about this today. Another section of the book, you say key thing to look for are fees. Now that's obvious, right? If someone— you've already said this— if they're charging exorbitant fees, that's an immediate red flag. But here's something that I know we've seen a lot, Ben. And I want you to comment on this, like we were looking at a deal earlier and the returns seemed pretty modest, right? 6 to 8%, depending on how long you were locked in the deal. Okay, that doesn't seem very hard to do in some type of real estate asset. But then we looked at the PPM, right? And they're charging a 1% to the manager fee and they're paying 4% to the broker. And all of a sudden you start to realize, okay, in order to pay the investor 6 to 8%, Now we're actually now in the low teens just to hit the return, and the sponsor isn't even getting paid yet. So now the underlying asset is not as conservative as you thought. Talk about that and why that's important, right? I mean, because we're seeing a lot more of this.

Yeah, well, there's different types of fees, right? And these should all be outlined, and I'm not going to go through all of them and the purposes. We do that in the book. But the one you're referring to is a sales fee Or a placement fee. This, I would say, is, you know, it can be common, especially for more institutional deals. The way that a lot of these firms raise capital is through placement agents and broker-dealers. But at the kind of syndication level and the lower middle market, it's actually pretty uncommon to pay placement fees. It's not necessarily a red flag, but it would definitely be something I would dig into more because Basically, what they're doing is saying, "We are raising capital and we're going to hire third-party broker-dealers to bring us capital, and we're going to pay them an upfront fee for doing so." In the case of the example you just mentioned, they're paying 4% to a broker-dealer for the capital they're raising. It's not 4% that comes out of the GP's pocket, it's 4% that comes out of the fund. So as an investor, even if you came to the sponsor, not through a broker-dealer, you came to them directly, you're still going to have to pay part of that fee with your capital. I would say it's very common ranges for this fee would be somewhere between 1% to maybe 3% on the high end. 4% is definitely very high. I mean, especially in this particular case, it's a debt fund and they're 1- and 2-year notes. So they're basically going to be paying that fee likely every year as the note matures and then gets a new note, replaces that. There are also cases where we've seen recently, this is another example of a deal actually in the oil and gas space that we saw last year, where there are upfront fees, or they're sometimes called loads, of 10%. 10%. That, that is completely absurd. That means for an investor, if they invest $100,000 into a fund or a deal, only $90,000 of that investment's actually going into the investment. $10,000 going to pay all the people that are taking these fees upfront. And it's a huge issue of alignment of interests because all those fees get paid in cash as soon as it's funded. It has nothing to do with the performance of the asset. And it actually reduces the amount of capital that is being deployed into the assets.

It's basically a commission. You're paying the guy who is selling you this investment. And do you want to pay your salesman? You want to pay him off the top out of your pocket, and it just massively increases the risk. Risk. I've seen deals as high as 10% too, and it's a huge red flag. I mean, maybe I'll pay 1 or 2%, you know, but not, not 10. And here's the other thing about a 10% sales fee, and why are they charging that much? So a lot of times these are really the stinkiest deals that in order to convince the broker to sell the deal, you've got incentivize them with these crazy, uh, crazy fees. And it tells you the higher the fees, probably the shadier the deal is or the worse the deal, the harder the deal is to raise for. And so the broker-dealers are saying, all right, I'll raise for this, but you're going to have to pay me 10%.

Yeah, that's a great point because it's so outside of market that there's a reason that they're having to pay that to incentivize the brokers to raise the capital, right? But, but broker-dealers, I mean, we've talked about this in past podcasts, but they don't necessarily have your best interest in mind. They, they get paid up front in fees and they're not They don't have the same levels of fiduciary responsibility that investment advisors have. And so, you know, it's important to know how they get compensated and who's paying for that.

Well, and that's a good point, right? Because it does feel like, especially if you want to, you know, if a company is trying to get liquidity, the last place to go is the retail market. And so what you guys are saying is, you know, to go pay— if you want to go get more access to the retail market, the best channel to go do that or the largest channel to go do that is through RIAs. And how do you get RIAs to go promote, for better, you know, for lack of better language, a shit deal is pay them a higher fee. And so that's probably a decent way of like even just looking at the, the, the nature of this deal is how much are they having to pay to go sell this?

Now, just, just to be clear, RIAs can't get compensated for, for, for promoting a deal like BDs can. So those are different. BDs are registered investment advisor and a broker dealer.

Right. And also, to go back to another point that you made that I do think is important, and we're going to be doing some more content about private credit and when to avoid it, but it is an important thing to just look at and just, does it pass the smell test? Right? So in this case, they're paying between 6% and 8%, and they're saying it's first position real estate loans. So hard money. Okay. That seems reasonable. But then you add in this 5% fee load of the acquisition fee plus the sales fee. Now, you're up into the low double-digit total cost of capital. And then that's before the sponsor's getting paid. For them to get paid, they probably want to make 2% to 4% on that capital per year. So now, you're just having to ask the question is, Can they earn that much on the investments that they're making without taking an inordinate amount of risk and still be able to pay all the preferred return and the fees and the sponsors still get paid and it still makes sense and still be a viable business? In another more extreme case, we've seen some credit funds, I put in quotes, that are paying 18% net to the investor. And they're promoting this as, you know, first position, uh, secured loans against commercial real estate, right? Well, we operate in that business. I don't know who in their right mind—

18% loan, right?

But hey, think about it, it could not be—

no, they're paying their investors 18%, which means they're charging 25% No one in their right minds is going to pay 25% for a loan. Right.

And if they are, those are not the deals that you want to be investing in. To Bob Fraser's earlier point, those are the deals that are just about to—

they're circling the toilet bowl and just about to go down. Right.

Right.

And that's the deal you want to invest in. You know, reach your hand into that toilet bowl and grab that puppy.

So it's just one of those things where as you're going through the PPM, just start using common sense to put two and two together and just Does it pass the smell test? Does this make sense that this actually is feasible? And it's in its— the, you know, being clearly the risk-adjusted return fits the profile of what they're describing.

Right. One of the ones you and I were looking at, Ben, they were paying— I think it were maybe this one— they were paying, you know, 18% to their investors. And we went on their website and they're offering loans to real estate guys. At 10%.

Yes.

So I'm like, how are you doing that? How are you receiving— your revenues are 10%, but you're paying your investors 18%.

Well, there's only, only two ways. And I— we actually have this conversation in our school, our school community, because there are people asking about these credit funds. And I went and just found it online, and it was exactly that. They're paying 15%, but they're charging their borrowers 10 to 12%, right? It's backwards, but here's the only way they can do that. One, they're using a massive amount of leverage so that that 10% that they're actually charging now is 20% or 25% gross on a levered rate, which then massively increased risks. Or two, it's a Ponzi scheme. So those are the only two ways.

They just like to lose money. They're excited about writing checks every—

yeah, or they're just good Samaritans. They're happy to just fund a business that is not profitable.

Right, guys, I want to wrap up here. I want to ask each of you two different questions. Ben, and for a takeaway for an investor looking at this, you know, or about to make a private equity or private placement deal, what— just when you get a PPM or you get investment, just summarize for us the sections your eyes go to just if someone's got a PPM in front of them right now, give me kind of the 3 or 4 areas and what those are called inside of the PPM that you would go to first.

Yeah, well, we actually in the book go through each general section that's in most PPMs and describe— should you pay attention, do you pay attention, or what to pay attention to. The ones that I go to are first the business plan. I want to have a good sense of understanding what is the goal of this fund. Is it a pooled fund? Is it a single asset? You know, is it a blind pool? Is it a recapitalization of an old portfolio? Portfolio? That's the first place you go because then that gives you the framework to understand what are we working with here? What's the deal? And is this something that, one, I'm excited about, I'm interested in? And then it also informs all the other sections of does this make sense with this business plan? The next sections I go to are fees. I want to understand fees right away. Do these look in line with industry standards? We already mentioned sources and uses. This is a very, very informative section because you see exactly where the capital is coming from, where is it going, and that's very, very instructive. And then the other one is the waterfall. And this, we haven't really gotten to this much on this conversation, but it shows you what is the plan of distributing the cash. If this is a profitable investment, how does that get distributed? It's very important to understand how that works and Who gets paid first and when and based off what types of calculations.

Got it. Bob Fraser, individual investors have this tension of going to a sponsor and they're only investing, let's say, $100,000 or $250,000, you know, on average, let's say, and they don't get a ton of time with a sponsor. But to your point, and you make in the book, it's important to ask these questions. But as we know, if an investor sends us 100 questions, we're probably not going to, you know, that's that's also a red flag from a GP standpoint. So if an investor is speaking with a sponsor, they can only have one question or maybe a few questions. What would be that question or those questions someone should ask a sponsor?

Well, let me push back a little bit and just say, you know, your $100,000 is a lot of money and, and it's a lot of money to you. How much, how hard did you work for that? Right. So if you can't get the time of the sponsor, I would pass. Okay. Just if you don't feel that connection and you can't and get satisfied with your answers. I'm talking with a sponsor right now and I've had 3 phone calls and I've got some small check sizes going in there and, and I'm just— but I don't really care. I am going to continue to make those calls and ask those questions until my questions are answered. And if that sponsor wants to opt out of that process, that's up to them. And then I'm out if they do that. So if they don't have the time for me. But back to your question, you know, so I think treat it like a business, treat it as a business investment and treat it as that this is really important. And don't have this, you know, well, my money is not that important to these guys kind of attitude. It's important to me. And if it's more important to me than it is to them, then I'm probably talking to the wrong guy. But back to the one question, it would be something that is actually not in the PPM. And that is co-investment. So for, you know, there's a load of, there's a lot of fees in the PPM and the fees generally align your interests or disalign your interests, right? So an acquisition fee disaligns your interests, a sales fee disaligns your interests. The sponsor is making money whether you're making money or not. The best fee in the PPM, the one you should be the most excited about as an investor is the carry or the promote, which is is the profits fee. So if you made money, they're making money. Your interests are aligned, right? But, but what happens is your upside is aligned by that fee. So if you make money, they make money. How do you align the downside? How do you make it— it's as painful for you if this deal goes bad, it's as painful for them as it is for you. How does that happen? The only way that happens is if they have money in the deal too, they have skin in the game. And that, by the way, is— I've never seen it in a PPM, but you need to ask how much money do your partners, you know, who are your partners? How much money are they putting into this deal? How much are they having at risk? And of course, if you see uses, well, they're pulling out $9 million, you know, paying themselves back a loan they have. That is, that is an automatic out. I am out. You know, we are, we are not aligned on the downside. So you want both your upside to be aligned and your downside to be aligned. You're, you know, so if you can't see that, then, then I would be gone.

Well, to bring this full circle, Bob, to your original example about the sponsor who is using money for whatever, you know, upon further due diligence can confirm that that sponsor also was not co-investing. So I think it's a great question because it's a huge red flag. If they don't believe in it, there might be something a little bit fishy, right?

Yeah. Fee generator deals, you'll never see co-investment. If a deal is designed by the sponsor to line their pockets and generate fees, and there is a lot of deals like that, by the way. Okay. A lot of deals you will never— you will not see a dime of co-investment. And that's a major red flag. If there's not a dime of co-investment, this is a bad deal and the sponsor knows it. The deal is designed to to shear the sheep, and you're the sheep. You know, as a famous investment banker once said, you know, called their investors Muppets, right? And so this is, this is, you know, uh, Muppet slaughter is what this is. So don't be a Muppet.

Hey, thanks for listening. If you enjoyed this episode, you want to explore more from iLab, head over to investlikeabillionaire.org. Let's keep the conversation going. See ya.