E70: Term Sheet Red Flags Every Private Investor Must Know

AIME Episode 70 Transcript

Sarah Florer (00:00.501)
I'm not looking at the Riverside app because I'm looking at the document and it's open in a different browser. So can't minimize it. Yeah, so that's why I didn't pick up that you were trying to talk.

Roland Wiederaenders (00:09.102)
Okay.

Sarah Florer (00:25.505)
Okay, ready? Hi everyone, welcome to Alt Investing Made Easy. Today we have, sorry, I'm gonna start over. Let me just get the right file up. I'm gonna have to just stay over here. Okay. Hi everyone, welcome to Alt Investing Made Easy. Today, Roland and I have the next part in our series on the term sheet teardown, and we want to talk to you about red flags investors should never ignore.

Roland Wiederaenders (00:52.13)
Yeah, just as a reminder, everybody, the term sheet that we're talking about is a term sheet that summarizing the deal terms for financing really could be anything commercial real estate, private equity deal. But we're just trying to give you some some general framework, general framework, some concepts that you can use when you're looking at a summary of a deal that you may be investing in. The first one.

First red flag that we want to identify is whether the deal sponsor, the person that's telling you about the investment opportunity actually has cash invested in the deal themselves beyond their sweat equity. We don't want to minimize anybody's equity, but having cash, your own cash invested in the deal and how much is super relevant. What do you think, Sarah?

Sarah Florer (01:43.467)
I think, you know, if they won't risk their own capital, why should you? So it's a fair question, although sometimes there are reasons for it that make a lot of sense. So it's something that you need to discuss further.

Roland Wiederaenders (01:53.944)
Well, that's right. know, and this is what I wanted to really point out here is that we have this idea about democratization of capital. And for sure, we're going to be dealing with some people that need to raise the investment dollars from outside investors. So, you know, it's commitment and goes beyond merely just the investment of cash, but for sure understanding how invested the deal sponsor is in the deal.

just across the board beyond even what they've got invested in cash.

Sarah Florer (02:23.327)
It's.

Sarah Florer (02:28.445)
Exactly. The second red flag is looking closely at any excessive fees that could eat away at your return. so again, to be mindful here that it is completely normal in these deals to have fees. And it's important because of course the deal sponsors do need to get some kind of compensation, particularly if it's an operational heavy type of investment. need to...

Be earning some money along the way most likely but on the other hand some deals really do look profitable for the investor until you follow the fee waterfall So one thing to look out for is high management fees weather management fees fit Within what a standard is for the industry and we're not going to be specific about what that percentage is because it really does vary by area What standard size of deal can impact that also?

There can be opaque admin or platform fees. You'd always want to understand a little bit more about whether that's a capped amount or what that is. Sometimes there multiple layers of fees upon acquisition disposition related to refinancing. Again, those are standard in some types of private investing, but it's important to make sure that they're benchmarked against what is the current standard in the industry.

And another thing is if performance fees are kicking in too early. So in a waterfall where a deal sponsor or a general partner or the various names for who that party is, if they start to get too much of the carry or anything too close before certain other things happen for an investor, that could be a cause for concern. So what do you think, Roland?

Roland Wiederaenders (04:13.282)
Yeah, for sure. Every time I review an investment opportunity for an investor, one of the first things I do is hit control F to find references to fees. And then what you said, Sarah, is so relevant that in a lot of these industries, there are sort of norms in terms of what these fees should be considering market standards. And there are ranges, of course, but paying attention to those fees is really important.

Number three is, we've got it listed here as circular GP affiliate structures, but I think about these types of transactions, these red flags is related party transactions. This is a required disclosure and under the securities laws, you have an obligation as a deal sponsor to disclose to your investors, any related party transactions that you're gonna be entering into in connection with the deal that you're sponsoring and.

Sarah Florer (04:48.171)
So

Roland Wiederaenders (05:10.818)
Really good example of this would be a development project and I'm the deal sponsor and I'm going to use my brother-in-law's construction company to do all the construction work. That's not necessarily illegal, but if I fail to disclose that to investors, it certainly is material and the failure to disclose would be material. And the biggest thing that people should remember here is that there's nothing untoward necessarily.

with the related party transactions. But what we really want to make sure of is that they are disclosed and that the terms are commercially reasonable. Just because he's my brother-in-law, he should expect to give me the same deal that, or receive the same deal, the payment terms, what I'm going to be paying him, everybody else is. And he should understand that too from the perspective of an investor who expects that. So what do you think, Sarah?

Sarah Florer (05:59.999)
Mm-hmm.

Sarah Florer (06:07.273)
I think that's important. mean, clean structures can really actually build up to where it looks like there's a lot of cash flowing out of the business before investors get their returns. And just to emphasize here, you know, especially in some kinds of private investing, it's very common to have related parties involved and there's nothing inherently wrong with that. What matters is that there's a mark to market in terms of compensation and also expectations for what that compensation is for.

And then I think the second part of it is just disclosure. You as an investor want to know. If it's hidden, that just tends to sit wrong. moving on to point red flag number four, and we've talked about this before, is this idea of perfection dependent underwriting. So making unrealistic assumptions about how a deal is going to go. So for example,

Roland Wiederaenders (06:46.926)
That's right.

Sarah Florer (07:04.009)
It's the rosy glasses assumption where the deal is going to be successful and you're going to make the profits that you think you're going to make from it only if everything goes right. Nothing goes wrong. So interest rates don't change, occupancy doesn't change, economic growth is as expected, etc. But that's not planning. for example, if you see a deal proposed to you with projections that have no downside case,

Rent growth is above historical averages. Exit cap rates are tighter than entry cap rates. That would be in commercial real estate. Borrowers or tenants are assumed to perform flawlessly. So if you have a private credit deal presented to you, what's going on? What's the profile of the potential borrower? It's one thing to say that it's secured, but does that actually mean that it's infallible? So I do think that

In this case, there's a lot of very specific assumptions depending on the industry and the type of deal. And a smart sponsor is one who will map out and do some testing on variables for these different risk areas and then you can see combinations of those. And that is a good sign that risk is actually being managed. What do you think, Roland?

Roland Wiederaenders (08:27.33)
Yeah, for sure, sir. And I like this, what we've gotten the outline here that the statement about good allocators ask, what does this deal look like when things go wrong? So I think that's a great question to ask when you're evaluating an investment opportunity is make those assumptions and make sure that the deal sponsor are making those assumptions themselves. It kind of giving you a worst case scenario, the conservative, the middle of the road, and then the optimistic. But if they're not

know, realistic about that conservative estimate, you know, targets, then, you know, just, it should be a red flag.

Sarah Florer (09:04.529)
Exactly. Yeah, no, exactly.

Roland Wiederaenders (09:07.169)
OK, so I guess we're on number five now. No independent auditor. You know, this is good for us to bring up. A lot of times you will invest in a deal and their financial statements won't be audited by a third party auditor. And that that auditing function does give investors a lot of confidence, can give investors a lot of confidence. But the thing that I would note is that it.

creates an expense for the deal. And when you get into a big enough deal, for sure the deal is going to engage an auditor. But you may be investing in a smaller deal that's not, the books aren't audited. so just be aware what that implies just in terms of the financial information that you're receiving from the company. And one,

takeaway or one thing, one hint or tip that I would give people is this becomes particularly relevant in a one man team. You know, if you're investing in a deal that's sponsored by one person, there's no redundancy and it's a lot easier to conceal things when you don't have someone to, that you have to share information with. So if you've got a two man team, it's harder for them to, you know,

Sarah Florer (10:28.714)
Yeah.

Roland Wiederaenders (10:30.904)
Be dishonest, I guess, just because of the sheer numbers. So what do you think, Sarah?

Sarah Florer (10:34.267)
Right, Yeah, you need a buddy to keep you on the straight and narrow. Yeah, because the sponsor who resists audits is a sponsor who doesn't want their work scrutinized. And if it's a small deal and the cost of an auditor is not really merited, at least having another person there, you know, typically would lead to just another set of eyes, even if it's just mistakes that are being made, you know, not even intentional misrepresentation or anything.

Roland Wiederaenders (11:01.454)
That's right.

Sarah Florer (11:04.289)
Number six, the red flag is limited reporting transparency. And this also is related to the point five. As an investor, what do you get until you get your money? You get information and your information rights are limited, but you have them also. so transparency is not optional. At the beginning of the deal, transparency is...

mandated by law and regulation, first of all, there's certain disclosure that's required. But it's also such an important attitude or mindset to embrace for sponsors and investors should expect that from their sponsors. that is that quarterly reporting is consistent. It has financial statements with it. You see...

asset level KPIs potentially, depending on what kind of investment it is. Management or investor calls on a regular basis, I think a lot of times these can be quarterly, but for sure there needs to be some kind of generic communication process between management and the investors. And then of course the big one, which is when things get tough, did that deal sponsor stop talking because probably they're worried and they don't want to deal with conflict. Well, that's...

Roland Wiederaenders (12:20.844)
Mm-hmm. That's a great point.

Sarah Florer (12:23.561)
That's exactly when you need to, and we advise about this and we also help clients with how to do this, but it's very important to share the bad news. Like with anything in life, if you hear the bad news from somebody else instead of the person who should have told you, that breaks down trust and it can lead to thinking things are worse, which then leads to all kinds of spiraling out of control problems. So really, you as an investor,

would want to expect or maybe also if you wanted to approach the sponsor with grace just say, hey, I'm expecting bad news. know interest rates have gone up. Talk to me about it. Talk to us about it. So this is something that's really important for not just entering into an investment, but also keeping along. And also it's part of the job of being an investor is to keep up with all that information as it's shared and keep up with the fact that it needs to be shared.

Roland Wiederaenders (13:23.758)
Yeah, for sure. And remember everyone, you're investing in private securities and so you don't have the luxury of being able to log into EDGAR, the SEC's database and look at a company's 10Q, 10K, or the 8K that are required to be these, these are all forms that are required to be filed whenever you're subject to the Exchange Act reporting requirements and these private securities deals, they aren't, they're obligated to disclose

all the material information about your investment, but a lot of that disclosure, the continuing actually obligation, it's defined in the term sheet. it's an important thing to, and the definitive deal documents as well. So it's an important thing to ask about, know, and you'll get the sense at the outset of the deal sponsor, how communicative are they going to be? You want somebody that is not afraid to communicate with you.

Sarah Florer (14:20.627)
Exactly.

Roland Wiederaenders (14:21.888)
All right, well, we've got number seven illiquid structure with short term promises. So we always talk with people about part of the disclosures. What's the potential holding period for the investment? As an investor, how long am I going to have my money at risk? And in so many of these commercial real estate deals, we typically disclose kind of a standard disclosures. We're going to hold it for three to five years, particularly

in the past where we're doing some kind of rehab or capital improvement and expecting to increase rates and then increase value and then sell after some time period. understand that if we have a deal sponsor coming in and telling us that they want to invest in this type of strategy, but they want to allow their investors to withdraw their cash after a year.

Well, we really challenge them as attorneys and say, listen, are you going to have the cash? Because if you're telling people that, if you're offering that liquidity option to them, it's a great deal, but you've got to be able to follow through. And if you can't, then potentially people will be mad at you for not being able to meet your promises. And as we know, angry people can sue. And that's the last thing that we want to.

invite a deal sponsor to offer terms that they're just not going to be able to honor. So liquidity is a really important consideration and making sure that the deal sponsor is being realistic and not blown smoke in terms of expectations about liquidity that they're creating with their investors.

Sarah Florer (16:07.745)
Well, and basically, you know, wanting to kick that can down the road. So, because liquidity just doesn't magically appear. And in the private market, it's just like you said, Roland, it has to be engineered. And that's part of why private investing is actually a way that it can be very good, and especially in some parts of it, it can be a very good tool for wealth building actually, is because the...

the parties that do all of this really well respect that issue about liquidity and you get into it for the long term because you're locked in. Moving on to red flag number eight, Patchwork Track Record or coming up with a new strategy. So, deal sponsors typically need to, well, they're required to disclose their work history and the relevant work history, but it's also...

The history of a deal sponsor is very, important to an investor. And it needs to be real, but the tricky bit is that some deal sponsors might claim experience in a new field when they actually have experience in an old field. Say a real estate team claiming venture experience or a credit sponsor suddenly trying to get into a private equity proposal. in principle, I don't think that this is

necessarily wrong, but it's a red flag because you need to make sure you really understand how much of the skills from previous deals are transferable into the new environment and the new investment proposal. And some people are able to do that well and other people aren't. So a good golden rule is that you only count the track record that matches the strategy you're investing in. And that's fair. And that's, you know, that's one approach to take.

And then if you are considering deals that look like people have a different patchwork, how they present that is probably also what's important. Admitting, for example, or saying that their experience is in a different area and they think these specific skills are transferable into this new area, to me, strikes me as something that's transparent. And you can make a choice about whether you're comfortable with that or not as an investor. But this is something to just be a generic private

Sarah Florer (18:28.417)
Sponsor of private securities deals is probably a little too generic and you'd want to dig down into the specific industry and related experience in that industry for the deal you're looking at.

Roland Wiederaenders (18:42.914)
And you know, whenever we talk about track records, Sarah, I always think about how it's materially misrepresenting, know, it's misleading for me to cherry pick my past performance, only tell you about the good things that happened and never about the deals that didn't go so well. So that's one thing that I think about with track records. It's not directly related, but we'll call that 8.5. Okay, how about number nine, what's that?

Sarah Florer (18:50.934)
Hmm.

Sarah Florer (18:59.861)
Mm-hmm.

Sarah Florer (19:06.965)
I think it's important too, isn't it? 8.5.

Roland Wiederaenders (19:12.908)
yeah, no, we're just going through the list. But number nine, vague use of proceeds. Again, this is a required section, required disclosure for sure material. How is the company, how's the deal sponsor going to be using the money, the investment dollars that it's raising for the deal? And if they're not specific about it, you want to see.

Sarah Florer (19:14.164)
Yeah, go ahead.

Roland Wiederaenders (19:37.738)
They should be specific. They should be very clear use of proceeds. It's required disclosure. I don't know how much more there is really to say about that, but feel free when you get that use of proceeds to drill down, ask them specific questions. And it's maybe easier with the commercial real estate, but there can be hidden things there as well. So I don't really have anything else there.

Sarah Florer (20:03.125)
No, I think that this is hopefully something that's intuitive for most investors, which is, what are you using my money for? And a good deal sponsor, this is like non-negotiable really, I would say with some of our clients, Well, they absolutely want their investors to know exactly what their plan is for where these things are going to go, where the proceeds are going.

So the last one on our list of 10 red flags are conflicted roles and this one is also really important sometimes you can see that one entity or one set of people are performing multiple roles and and sometimes it become it's it creates efficiency and sometimes it translate that that kind of converts over into a minefield of conflict. So sometimes you see the the general partner as the lender

Maybe they'll be the broker, they could be an asset manager or property manager. GP is a lender and an equity partner or it's brokering its own deals, collecting fees at all these different levels, through affiliated companies, we touched on that earlier. The GP serving as the property manager, asset manager and development arm. And again, these types of conflicts are not...

deal breakers necessarily, you could get lot of efficiencies through that. And actually, if it's very trusted sponsor, you're getting their trusted services and all these other areas. But if it's undisclosed or unmitigated, and then that's where the red flag comes in because you want to actually know where your party, your GP is.

what they're actually doing, right? So if they're not telling you that they're actually doing all of these other things, then that to me speaks to a trust, a transparency and a trust issue. So I don't know, Roland, do you wanna move on? These are our 10 red flags. And if you use this list when you evaluate a deal, the idea is that this helps you.

Sarah Florer (22:14.109)
at least have a checklist. I think Roland's going to tell us a little bit about how you could actually get this term sheet teardown that includes this checklist and others to help you analyze term sheets and deals that you might be interested in investing in.

Roland Wiederaenders (22:28.684)
Yeah, that's right, Sarah. We've generated this ebook that it's not going to be available on Kindle, but it's going to it's through a PDF that we can email to you. But we want to get some involvement, use this as a resource for our audience members that will send to you for free. We really think that this will allow you to turn your investments into more profitable investments just by

going through and using this as a checklist. If you're serious about private investing, investing in private securities deals, you shouldn't be guessing. Shouldn't be relying on the glossy pitch deck, just the emotional response, all the beautiful pictures and the good feelings that you get when you talk to the deal sponsor. We want you to make substantive objective decisions. And that's why we're making this

Term Sheet Tear Down available free to all our listeners and viewers who subscribe to our channel. So here's the deal. What we'd like you to do is subscribe to the podcast, subscribe to the YouTube channel, and take a screenshot showing your subscription, and then email that to info at altinvestingmadeeasy.com with the subject line Term Sheet Tear Down Access. We'll put all this in the show notes as well.

But once we verify, once we got that image, we'll send you a free copy of the term sheet teardown PDF. And it's really providing you with the same framework that professional asset allocators use to make their investment decisions. Well, let's see, sir. Did I miss anything there?

Sarah Florer (24:14.313)
No, I think that's great. So just remember, when you get our guide, we're presenting this guide in pieces in our series, so it's more than just what we've discussed here. So it's definitely worth your while. There's the complete term sheet tear down framework, 60 second term sheet checklist, red flag and green flag checklists. We haven't gone through green flags yet. Deal comparison metrics and all of these things help focus the mind. And Roland and I were laughing before about how

We're going to use our own term sheet tear down when we evaluate our own investment opportunities that we are also involved in. So we highly recommend it to you. That's why we prepared it. And we intend for our listeners, viewers, and subscribers to have a tool that can help them be successful. So I think that about wraps it up, Roland. Shall I close it out? Yeah.

Roland Wiederaenders (25:05.836)
Yeah, I think so, sir.

Sarah Florer (25:08.903)
Okay, well, thanks everyone for joining us today on Alt Investing Made Easy. We hope you enjoyed this episode. And as I said, please like and subscribe. Go through the process Roland just described where you take a screenshot and email info at Alt Investing Made Easy so that you can get your free copy of the term sheet teardown.

Roland Wiederaenders (25:27.778)
And remember everyone, take aim with your alternative investing strategies.

Sarah Florer (25:32.811)
See you next time.