Funds are a very important part of the business blueprint in the private lending industry. However, funds do have additional things to be cautious of and consider. This article will address 5 key pitfalls funds and fund managers face and suggest solutions to avoid them.
1. Failing to Manage Panic.
“Recession” is all over the news, and Wall Street is all over the place. With every economic downturn comes opportunity, and with the secondary market drying up, direct lenders with discretionary capital can seize on the residual loan origination that normally went to correspondents and conduit programs. It takes proactivity, vision, and strategic execution to succeed in times like this, as well as a strong will to avoid succumbing to the media-induced panic. While you may have to make some unpopular or painful decisions on behalf of your investors, presenting a confident plan to succeed and executing it will instill investor and employee confidence. We strongly advise fund managers consult with counsel, CPAs, servicers, and their executive teams to create a plan of action when investors start to freak out.
2. Insufficient Data and Reporting
Fund managers must see where they are currently and where they are heading to make informed and defensible positions. If you do not have the means to extract accurate data on the fund’s portfolio, it is like wearing a blindfold while driving in a snowstorm.
The Importance of Performance Indicators
These performance indicators will allow the fund manager to provide accurate reporting to investors, forecast and project future performance, and make important decisions to protect investors and the fund manager. Accurate reporting also instills investor confidence through transparency. It provides additional evidence that the fund manager is executing its fiduciary duty.
Performance data will also allow the fund manager to take certain assumptions and apply them to the data to prepare for worst-case scenarios and understand the true financial impact on the fund. This will allow the fund manager to make informed decisions based on data instead of investor sentiment or circumstances. Many fund managers are contemplating or have suspended redemptions from the fund, which is often within their rights. But it isn’t a decision that should be made simply because investor requests for redemption are increasing. Without sufficient data to support the decision and counter investors’ emotional responses, it is a recipe for disaster.
Some examples of key performance data are current redemption requests, weighted average LTV, interest rate, default rate, foreclosures, geographical concentration of loans, property type concentration, total loan volume, total assets under management, and average loan term.
Most fund administration and loan servicing software and third-party providers provide these data points. It is a question of whether they are easily accessible, accurate, and consistently available to the fund manager.
3. Failure to Communicate with Investors
One of the biggest reasons investors in funds get angry, seek counsel, and contact securities regulators is because the fund manager is not communicating clearly or frequently. The fund manager may have all the data, resources, and legal discretion at its disposal, but without a clear, transparent, and consistent communications policy, investors will lose confidence and seek to enforce their rights. Not only should a fund manager be reporting, but ensuring you are communicating regularly in writing via telephone calls and webinars.
We have seen too many fund managers operate in full compliance with the law but made the unfortunate decision to make blanket announcements via cold emails or investor letters. They did not include a personal touch to their approach or answer investor calls, and did not give the opportunity to ask questions or present a clear strategy and plan to protect their capital. These failures led to litigation and SEC investigations.
4. Deviating from the Offering Documents
Many fund managers are unaware of the terms, the scope of authority, or business restrictions in their fund’s offering documents. This creates significant risk because continued deviation from the offering documents could amount to an argument that the fund manager violated Rule 10B-5 or committed securities fraud.
This becomes extra problematic when the terms are so broad that the fund manager operates inconsistently. For example, if a fund has a “best efforts basis” redemption provision with no additional guidelines, the fund manager must utilize and stick to a firm policy on redemptions for investors. Deviation from this policy is too easy because the documents have no strict guidelines. Repeated and inconsistent divergence from an unwritten redemption policy will create arguments that one investor was treated preferentially over another, thereby supporting an argument for breach of fiduciary duty.
Deviating from the Stated Business Plan
Another problematic example is the fund manager deviating from the stated business plan in the offering documents. If your fund documents do not permit you to make certain types of loans or exceed certain loan to values, it would be improper to do so without revising and disclosing these changes to the investors and giving them an opportunity to exit the fund. It is so common for funds to suddenly add new asset classes to their business model without verifying their capability to do this.
Fund managers must consult with securities counsel consistently to ensure they are fully aware of their authorities as the fund manager and to make decisions that will not create additional liability in the long term. Further, it is important to ensure you evaluate your offering documents to determine whether any revisions, additional disclosures, or updates may be required.
5. Insufficient Legal Protections in Offering Documents
The last pitfall is very specific. Many funds’ limited partnership agreements or operating agreements fail to grant sufficient authority and protection to the fund manager. Certain key powers include discretionary authority to suspend withdrawals and distributions, halt operations, raise additional capital, secure tenure as manager or general partner, and expand or contract the business model. Further, many offering documents fail to include sufficient indemnification and arbitration provisions to ensure the fund manager is not buried in legal bills for doing nothing wrong. Finally, fund documents often fail to have up-to-date risk factors and disclosures.
Evaluate Your Offering Documents
We strongly recommend fund managers have their offering documents evaluated to ensure they are following best practices. The true challenges in fund management come during economic crises. It is imperative that fund managers consult with their experts and their advisors and execute using best practices and sound business judgment. Utilizing best practices, avoiding the dangers mentioned above, and operating with integrity will reduce risk, unnecessary legal bills, and protect the investors’ capital long term.