Vetting Private Investment Sponsors

A History of Regulation

Prior to the Securities Acts Amendments of 1975, all commissions on stock trades were fixed.  Without being able to compete on price, brokers competed on service and advice.  Deregulation spawned discount brokerages such as Charles Schwab that charged individual investors less but without the advice from the legacy “full service” firms.  In 2019, major brokerages removed trading fees entirely for most stocks, mutual funds, and ETFs.  This removed a barrier to market participation and directly enabled the later rise of Robinhood and the “meme stock” rally of 2021.

In the private markets, there has been a similar democratization of investment opportunities.  The JOBS Act introduced SEC Rule 506(c) in July 2013 and enabled sponsors to advertise and generally solicit for capital in private investments.  This led to the rise of new real estate syndication groups and a visible increase in pitches at seminars and on social media platforms.

Why does this matter?

During 2021, fortunes were made and lost by speculating on volatile stocks (or cryptocurrencies) alongside anonymous voices pitching various ideas and views.  With the removal of trade barriers and an increase in online financial discussions, bad actors were able to take advantage of unsophisticated investors.

The same was true in 2020 and 2021 as sponsors promised incredible returns to limited partners only to pause distributions, issue unplanned capital calls, or default entirely in 2023 alongside higher interest rates.  Once again, clever marketing led to losses for investors who failed to fully vet the opportunity.

How do you vet a sponsor?

Reputations can take years to establish, but there are ways to identify a promising new sponsor from a questionable one.  Typically, if you notice one ethical issue, there are many other invisible ones.  Think of it like a roach infestation.  If you notice one roach, there are likely hundreds hiding in the walls.  If a sponsor is willing to cut corners in one dimension, they are probably doing so in others too.

What should you be looking for?

1. The sponsor guarantees a return or claims it is impossible to lose the principal.  This is the single largest red flag.  It is impossible for this to be true and the SEC explicitly warns against investments that make this claim.
2. The sponsor deviates from standard regulatory compliance.  Asking for wired funds before having signed a private placement memorandum or proposing Limited Partnership Agreements without constraints on the general partner is not standard practice.
3. The sponsor employs “plants” that pretend to be fellow investors.  Strong sponsors can raise capital without misleading investors with paid fake reviews or paying commissions to others who do not disclose their financial incentives with the sponsor.
4. The sponsor has been convicted of crimes or been sanctioned by a regulatory agency.  This would also include those currently under investigation.  Those who have committed fraud in the past are likely to do so again and may be legally prohibited from raising investor capital.
5. The sponsor refuses to provide critical information for making an informed assessment about the investment.  Some information is confidential, but most is not.  If the sponsor refuses to reveal a pro-forma income statement or explain basic underwriting assumptions, it is likely those values are not justifiable.
6. The sponsor markets with false information.  If the sponsor makes factually incorrect claims (about population growth, economic activity, current events, etc) and refuses to make corrections after being confronted, they will likely provide incorrect information to you in the future as well.
7. The sponsor pays out distributions that exceed the returns of the underlying investments.  While possible for brief periods of time, this can indicate new investor money is being used to pay existing investors.  In other words, it is a Ponzi scheme.

There are of course other indications that you may be investing with an unethical or inexperienced operator, but this list provides a starting point for your research.  With the proliferation of investment options in 2024, ensure you are protecting your capital by performing thorough due diligence on any new groups with promising marketing.