Kurt: When it comes to financial projections and exit strategy, how do you vet the numbers?
Rupy Cheema: A financial review starts with a review of the market feasibility report (if available). Most large deals have an extensive, say 200-page, market feasibility report prepared to help the developer assess the viability of the project. When we review a third-party report from an industry expert, what we're really looking into are the assumptions they're using and the competitive analysis, or the demand generators being used. We're looking for reasonableness and that income projections do not seem to be overstated and that expenses do not appear to be understated.
With small projects we might get a 5-page report prepared from a marketing firm or we may only receive internally prepared financial projections. In those cases we really have to do some independent research. We'll look for publicly available information or research reports, depending on the industry and the project. The bottom line is that if we don’t have a good market feasibility report to work with we tend to have to do a lot more digging.
The market feasibility and appraisal will go into calculating the sale price of the project upon stabilization. We review the inputs being used such as capitalization rates to project the sales price and compare these to industry averages for similar projects. The projected sale price of a project allows us to calculate the expected return for the equity holders.
Most private equity holders expect to receive a 20% to 25% return on their investment. If the numbers show that after all debt is paid off, the equity holders will earn an IRR of say 5%, this would be of concern because if the NCE is a preferred equity investor or an unsecured lender, there is a possibility that the developer does not have enough cushion to pay back the unsecured investors.
Dawn Lurie: Rupy, have you reviewed any preferred equity deals, especially when they are true preferred equity and we're looking at operations and other things for the exit. Many of the preferred equity deals are really loans that are almost masked as part equity, but some of them are true equity deals.
Rupy Cheema: I think they're becoming more common now. About one-third of the projects we review are structured as preferred equity rather than a mezzanine loan.
In that case we need to review the operating agreement of the project company, because that's where the NCE, (the EB-5 investors), are investing in as an equity holder of a ‘preferred class’. We want to understand the rights and remedies assigned to that class of units or shares. We want to review the priority of distributions stated in the operating agreements and how the preferred equity ownership is ultimately liquidated and whether there are any options for the common equity holders to buy out the preferred equity holders.
Dawn Lurie: Share agreements are also another thing I believe are important to look at. Especially for immigration lawyers who are doing any sort of immigration related due diligence, it’s critical that those agreements are appropriately reviewed. I can’t tell you how many times investors dismiss those agreements and focus only on the NCE, which is a big mistake.
Rupy Cheema: Right. They're used to seeing the loan deals and the related loan documents, and I think they may not be used to reviewing the operating agreements of the project company.
Dawn Lurie: That's right, and that's another great thing to point out. Going back to due diligence, in the past we have always asked to see the loan agreement. But in quite a few cases, we would get a lot of pushback; there were some regional centers or issuers that refused to give that to us.
We passed on those deals.