Sep 27, 2023
To our mind, there are five basic functions of a private lending mortgage pool fund manager (or really any 506 Reg D fund manager). We believe that in order to be an effective and well-rounded manager, you really need to possess strong competencies in all five areas: 1) Origination, 2) Underwriting, 3) Asset Management, 4) Fund Administration, and 5) Capital Raising.
They are all very different skills and they are all important. The fact that they are very different skills is what makes it so hard to find all of them in one fund manager. That manager has to be not only a good “loan person” but also a good business operator who understands how to think strategically, hires well, is disciplined in approach and execution, employs long-term thinking, and is honest enough with themself to admit what they don’t do well and figure out effective ways to supplement those shortcomings.
In our experience, we have come across a broad cross-section of private lenders who are generally good at number 1 (origination) and, to varying degrees, numbers 2 (underwriting) and 3 (asset management). Most of them know very little about number 4 (fund administration) at the outset of launching their fund. Number 5 (capital raising), in our opinion, is the most difficult of all to master. Let’s take a brief look at each of these functions and at least scratch the surface of the challenges that could lay before a potential fund manager.
By and large, this is the function that in our experience most private lenders know and do the best. One common difficulty can be for the fund manager to accurately understand the implications of their overall origination strategy on the structure of the fund, especially in trying to balance these considerations with investor-related considerations. One frequent mistake we see is misalignment between the economic structure of the fund, the interests of the investors, and the company’s compensation program relative to its origination strategy. This is not an easy balance to get right, and it is misaligned more often than not. It is important for the economics behind a fund to be aligned with investor interests and comport with your origination (and other) compensation structures (e.g. how you pay your loan officers).
We believe this is the most important element of being a good fund manager. Through our observations, we noticed that one of the largest challenges for new fund managers is that once they are managing a fund rather than selling loans off individually, they alone are responsible for the lending decision on behalf of the fund and there is no backstop of someone else saying “yes or no”. The decision now is purely theirs to make and it can be very hard not to let other factors (fear, greed, monetary pressure, competition, etc.) unduly affect their decisions. As the market heats up and other lenders start stretching guidelines, they often feel compelled to stretch theirs in order to “compete”, if not to simply make money. The chickens can take a long time to come home to roost if underwriting is poor. The market may be able to cover up mistakes for as long as it is moving in the right direction. Poor underwriting in a fund in the long run can cause a bad situation; therefore, we think it is the single most important function. Unfortunately, we have seen many managers, especially less experienced ones, have a hard time maintaining underwriting discipline when the market is frothy.
Asset management includes, but is not limited to servicing, collection, workouts, foreclosures, bankruptcies, forbearance, and managing real estate owned “REO” (e.g. rehabs, leasing, selling, dealing with municipalities, etc.). Doing this effectively can make a big difference in the recovery of troubled assets and therefore in the ultimate performance of a fund. We find this capacity varies wildly with fund managers (or would-be fund managers) depending on how long they have been in the business, how much direct experience they have in this area, and what part of the cycle the market is in. Unless you have really had to manage a portfolio of loans and REO through difficult times, you may not be as adept as you think. This function will be very important if you ever find yourself managing a fund through a difficult cycle and will likely play a big part in your ultimate fund performance. Having a lot of asset management experience usually helps to make a better underwriter.
For new fund managers, often times their fund has been structured unknowingly in a way that is difficult, cumbersome and time consuming to administer. If they do the fund creation right, they have considered how it is to be administered before they completed their offering documents and can then easily outsource this function at a very reasonable cost (usually for far less than the manager can replicate the services internally). We have witnessed that many times, they do not consider the implications of structure on administration (not to mention capital raising) until after the offering documents have been completed (and the heavy cost has been incurred) and then the administration is likely more difficult.
In our eyes, this is the most difficult function for a fund manager to understand and master. The challenge is that their current or past experience is with whole (or fractional) loans rather than a pooled format, and everything about your fund affects this function: the quality and appearance of the offering documents, the very structure of the fund’s economics, the governance, the investor returns, the manager-investor alignment, the asset model, the risk profile, the local market environment for investors, your personal network, your strategy to raise capital, the tactics you deploy to procure investors, the consistency of your efforts, your underwriting capabilities, the manager’s track record and ability to document that track record, the manner and quality of fund administration, and on and on. These all combine to impact your capital raising outcome. Raising money from investors in a blind pool as opposed to one-deal-at-a-time is a completely different animal and a leap that fund managers can struggle to make. If you do not grasp the factors, it is hard to know what to do to make it better.
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.