How to Invest Wisely: Navigating LP Due Diligence & Fund Decisions
How to approach due diligence on a new operator as a limited partner? How should investors decide if they should invest in a fund or not? How should you fundraise for deals that have not been determined what they are yet? And when to say no to a potential investor? Dr. Joseph Ryan Smolarz, founder of Storpartners, shares his insights.
Tell us a little bit about you.
Most of the time I live in the Virgin Islands and St. Thomas. During the day, I'm working on ear, nose, and throat problems and doing some investing here and there. We have several projects going on, one of which is self-storage. Since 2017, we've been acquiring facilities and learning the ropes and now we moved over into the realm of raising capital. We have a series LLC fund for acquiring self-storage facilities and our target audience is doctors, which would make a lot of sense. A big premise of what we're trying to do is teach doctors how to be a good limited partner, how to do due diligence on the project, and understand what's going on because if you don't understand, especially investing when things aren't going as well as you would like, it's going to be hard not to get frustrated. And if you understand why it's happening and what is happening, in our opinion, you just tried to figure out how to ride the ship and keep going.
I always tell people that our investors have full-time jobs and they don't live and breathe real estate, we need to keep that in mind when talking about our deals. What are some of the main topics that you typically want to pass to these investors and how should they do some due diligence?
The basis of the whole interaction is trust, you're trying to build rapport with your investors from a sponsor's point of view. From an investor's point of view, you want to make sure that you're a good fit. You have ways of thinking about things and your risk tolerance needs to fit into the asset class and the investment strategy that you're trying to do because if you're in a very aggressive fund, and you have a low-risk tolerance, regardless of what happens, you're not going to be happy. Those are the questions that I would start with.
When you're starting the due diligence in a sponsor, the number one goal is to make sure you're not in a Ponzi scheme or some sort of fraudulent group. There are a lot of good questions to ask to drill down on that and if you're not comfortable at the beginning, you're probably not going to be comfortable at the middle or the end as well. Having a system is key, especially when you're first starting out. Investing is very anxiety-provoking, and you may forget some of the steps. It's exciting, but it's also scary, so if you have this systematized approach to it, then you shouldn't skip any steps as you go through that process.
During an up market, how would you recommend doctors doing their best to find out if a sponsor is not legitimate?
Having made several pretty bad mistakes as a limited partner, this is a topic that's near and dear to my heart. When I approach a deal as a limited partner, what I'm trying to do is understand that sponsor in such a way that we can build a 30, 40-year relationship. It's not about the first deal in its entirety, because I'm willing to put in the time, effort, and cost to get to a comfortable place knowing that when these guys or girls have a deal, and they send it to me, that I'm never going to have to go through this first step of due diligence again. I'm comfortable that they're not trying to push one past me, or whatever the case may be. And that's a gigantic step. I would personally say, and I know this is going to be shocking to your audience, but a lot of times, what I'll do is, I will hire a PI to go through and make sure that some of their previous deals have not been fraudulent. It's not to uncover skeletons in the closet, I don't care if they've been divorced, or whatever the case may be, what I want to know is if their heart is in the right place. And if I can get there, if I have to spend some money to get there, and I never have to do it again, that makes me happy and comfortable.
Any time that you ask for a referral and there's hesitation, that's bad. In our world, as Scott Myers always says, it's a full-contact sport. Deals are not always going to go perfectly, it's not all sunshine and rainbows. And I think that as investors, we get it but what we don't get is a lack of transparency and lack of communication. If a deal is going south, and there's no more communication, there's less, than that is horrible because what the mind can't see is always going to go to a dark place, it's going to be the worst-case scenario. If you don't hear from your sponsor, and maybe there's a capital call or something like that, that is not going to be good for anyone. You want to know up front that the communication is going to happen.
When things start to go bad, you better start communicating even more so that if there is a need for a cash call, it is not going to be a surprise for the investors. For funds, do you call in all of that money right away to be in the operator’s bank account?
Most of the time, that capital sitting on the sidelines. As a rule, funds don't like holding your capital if they're not investing it because there's liability there. Most of the time, it sits in your bank account, there may be various reasons to call that capital early, maybe there's a cash deal where you're trying to go up against another group and it has to close in two days after the agreement has been made, so you would hold that capital, and if you lost on the deal you would send the capital back. But the point is the operating agreement is the Bible and there's not much legal that says you can or can't do something in an operating agreement because you are accepting those terms. The terms should be upfront, you should make time when you can go through the terms with the attorneys and review all the SEC items. In the SEC’s mind and all the regulatory board viewpoint is, if it's in there and you agree to it, then that's what the deal is.
If I had a fund, and I knew that the economy was about to take a turn, for example, in 2024, we all know that it'll be even better for finding deals. However, there is a lot of fear that normal human beings think that that specific time will never end and it'll be doom and gloom for a very long time so they end up not putting the money. From a fund perspective, I would personally prefer to have that cash available right now in case people get cold feet, how would one go about that, in your experience?
There are lots of sponsors out there that will do that, they'll get the capital, and hold on to it. It does add liability to to the fund. If you're going to do that, you would probably want to know how much E&O insurance they have, errors and omissions, and all the things to safeguard. Is there the ability for one person to be able to extract all of the cash and run, or is there a safety mechanism where it takes two people to sign off on it? There are lots of checks and balances, and systems out there that can be put in place for a reasonable cost if the sponsor hasn't thought about that, and what happens in those scenarios, and they very well should. But it's just personal preference.
Lots of people are triple raising right now, which means they're raising triple the amount of money that they need because they do know that this is a scary environment and when push comes to shove, there will be probably about two-thirds of the people who are going to say, "Hey, you know what, I'm not going to put my capital in, I'm willing to take the penalty for whatever it is for not placing the capital." It's a problem.
A new investor wanting to invest 50k in one of our opportunities, which is not a huge amount, was asking about 10 questions at first, which I gladly answered and then there were 10 more questions including wanting to meet with everybody on the team and wanting to see the contracts from our subcontractors. That person was asking for actual documentation. From an operator's perspective, I had to say, "I'm so sorry, I understand what you're asking, however, for the amount of the investment, we can't do it. If we were to do that for everybody, we wouldn't be focusing on the opportunity." We had to decline that request, but it's not because we didn't want to provide it. What would you do in that situation?
That is another point for the operating agreement that should be there. It should be very clear what's available and what's not. You can review the operating agreement, the PPM, the subscription agreement, and maybe the pro forma, all the things that you need to review for the facility itself for your due diligence. But the subcontractor agreements are private and held within whatever documents that are not investor-facing because as a limited partner, there's no point in knowing all the secret sauce. It's more about declaring that in the beginning, so there are no questions about it and that may make some people not be uncomfortable with that particular fund or syndication, and that's okay. You're not making decisions just for this one person, it's for everyone. It's much easier to do upfront while you're preparing the docs, so that everybody is being treated equally and that's important.
Is there anything else that you haven't covered that you think would be important for our audience to know?
Your due diligence on the operator and opportunity is going to make you or break you in your investment journey as a passive investor, take it very seriously. Always go to the site, always meet the people in person, and make sure that there's nothing nefarious going on.