Dec 29, 2023
There are many unknowns and challenges when making the leap from the one-deal-at-a-time model to the pooled investment fund model. Getting the fund structure right and architecting it properly given any particular asset model, origination strategy, and operation capabilities can be very difficult to do but a valuable starting point. Even if one does this well, new fund managers are still likely to face significant challenges in the critical area of raising capital for their new discretionary fund (also referred to as a “blind pool”). Chief among these challenges is that the type of investor who is likely to be attracted to a pooled investment vehicle is very different than the type a manager has become accustomed to dealing with in the one-deal-at-a-time model. The “active” and “passive” investor are rarely the same people, and this dynamic causes great angst for many new fund managers as they try to make the transition to doing deals in their discretionary fund.
In our experience, most SBRE and private lending originators start off by funding each deal with a specific investor (or several specific investors) one deal at a time. This is the easiest way to start. In our opinion, it is easier because the particular deal has been identified and the originator is communicating the details and characteristics of that particular deal to their investors when they are “selling” them on it. This process lends itself to “active” investors who want to be involved in the decision making process of the deal itself and who are, in our experience, easier to find. Many originators therefore end up gravitating early towards this type of investor who is interested in investing in real estate in some fashion and who wants some control over what that investment is. The “active” investors often have some level of knowledge, understanding, and experience in real estate which gives them the capacity to make their own judgment about the merits and shortcomings of that particular investment. In other words, they get to pick and choose which specific deals they want to invest in and which to say no to. This type of investor then naturally tends to be the one that many or most originators fill their stable with as it suits the manner in which they are running their business – that is matching investor(s) with deal(s) one at a time.
As they do more deals and this process starts to become unwieldy and burdensome, often the originator wants to set up a discretionary fund, or blind pool, over which they have full authority and autonomy to make investment decisions. Now the investors are being asked to place their money into that pool and abdicate their ability to make decisions about specifically which assets they are going to invest in. Rather than obtain a first trust deed (or undivided percentage thereof) or an ownership interest in an LLC that owns a particular piece of property, they are buying shares of an entity which is going to acquire unspecified assets on an ongoing basis as determined solely by the manager rather than allowing the investor any say in which assets they invest in. This fact requires a different and higher level of confidence and comfort from investors in the manager. They no longer can gain that confidence and comfort by knowing they are involved in one specific deal with an identified property that secures their investment. The bottom line is that these are fundamentally different investments from the investor point of view even though the manager is originating or acquiring the same basic assets. It logically follows that it requires a fundamentally different type of investor who prefers the dynamics of a pooled vehicle over those of the individual deal. This is the core challenge when it comes to the difference in raising capital in a blind pool vs. one-deal-at-a-time. It is the difference between an “active” and a “passive” investor.
The challenge for the originator is that they are (most often) used to dealing with active investors and these are the majority of the investors they know. When they make the leap to the blind pool and start to raise capital, they can find that many of the people who appeared to trust them so deeply in the one-deal-at-a-time model are not willing to make the leap to the discretionary fund model and they run out of people to call very quickly with only a few willing to make the leap along with them. The more appropriate target audience of investors for them now is really the “passive” investor, but the fund manager doesn’t know who these people are, where to find them, or how really to market to them with his new investment (debt to or shares of an entity that owns pool of assets). This is a major problem for new fund managers and one that they must try to anticipate and understand going into the transition. If understood properly, a manager can develop good strategies and plans that factor in this dynamic and have a better chance of avoiding quickly getting stuck in their capital raising efforts. It will also be highly likely that the manager will need to continue to fund deals using the one-deal-at-a-time model for some period of time in the early days of his discretionary fund while gradually building up a base of “passive” investors as well as confidence in marketing a different product to this new group of people.
Once the one-deal-at-a-time originator becomes a fund manager, everything is different. The type of person to whom they are marketing is different, and they have different needs, fears, and desires than the “active” investors. It is important to learn and understand what these are. Among other issues, many investors in this category simply do not understand how to effectively evaluate the merits and risks of any given pooled investment offering (which is exacerbated by the fact that many managers do not know how to do this either). Whatever they have done to produce the wealth which they are looking to invest rarely qualifies them to perform due diligence that is relevant to what should really be their decision making criteria for funds of this nature. This simultaneously creates difficulties and obstacles for the fund manager as well as opportunities to differentiate themselves from others by effectively speaking to what is important to their target investor. Unfortunately, we have seen that many do not understand the nuanced differences between fund and individual asset investors, and continue to focus on the ways and means by which they sold to investors in their one-deal-at-a-time model. All of this leads to confusion on the part of the investor and you know what they say about a confused mind – it tends to say “no”.
The main message here is that it is vitally important for a new manager to understand that there is a fundamental difference between the ideal profile of the one-deal-at-a-time investor and the blind-pool investor. By and large, these are two different people with two different mindsets and two different decision making criteria. This fact requires the originator to take a different approach and to develop a new toolkit and an updated set of skills when making the leap from the one-deal-at-a-time model to the other if success in raising capital is to be achieved. Everything from who you target to how you find them to understanding what is important to them and how to message it properly must be reconsidered and updated. Alongside getting the structure correct in the first place, this can be one of the most challenging pieces to early progress in a new discretionary fund. When considered thoughtfully and addressed carefully at the outset of a launch, the manager may be way ahead of the game.
Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions.