In the evolving world of passive investment opportunities, Regulation A+ (Reg A+) and Regulation D (Reg D) offerings have become increasingly popular, each presenting distinct characteristics and compliance requirements. As more Reg A+ offerings hit the market, it’s essential to understand the differences between these two types of investment vehicles, especially in terms of scrutiny, accreditation, and investor protection.
The Rise of Reg A+ Offerings
Over the last two years, Reg A+ offerings have gained traction. More companies now see the benefit of raising capital from a larger pool of investors. Reg A+ opened the door to non-accredited investors. Ordinary individuals can now participate in these offerings, which were once reserved for the ultra-wealthy. These offerings are highly scrutinized. The Securities and Exchange Commission (SEC) requires regular disclosures, including audited financials. This information is publicly available for review. This transparency protects investors, especially non-accredited ones with less experience evaluating investments.
The Wild West of Reg D Offerings
In contrast, Reg D offerings, typically restricted to accredited investors, operate with fewer regulations. Reg D allows companies to raise capital without needing to register with the SEC, meaning there are fewer disclosure requirements and less regulatory oversight.
This means that while a sponsor may create a Private Placement Memorandum (PPM) outlining the fund’s investment strategy and rules, it’s not always required. However, many sponsors still use a PPM to protect themselves legally and provide information to investors. The SEC’s viewpoint is that accredited investors are financially savvy enough to bear the risk of loss without extensive regulatory oversight. This means that in the event of losses—such as in the case of multifamily deals that have gone under—investors may have little recourse unless there’s evidence of fraud. The lower regulatory scrutiny in Reg D offerings means that accredited investors must do their own due diligence and assume greater risk.
Defining Accredited vs. Non-Accredited Investors
To understand the regulatory landscape, it’s essential to distinguish between accredited and non-accredited investors. Accredited investors meet certain financial criteria—such as having a net worth of over $1 million (excluding their primary residence) or an annual income exceeding $200,000 individually or $300,000 combined with a spouse. Recently, the accreditation status expanded to include individuals holding certain financial licenses.
Interestingly, these financial thresholds were established in the early 1980s and have remained static ever since. This has led to a growing pool of accredited investors. However, for non-accredited investors, Reg A+ offerings present an opportunity to access investments traditionally reserved for the wealthier.
Evaluating Sponsors: The Key to Passive Investment Success
Whether you’re looking at a Reg A+ or Reg D offering, one of the most critical factors in any passive investment is evaluating the sponsor. After all, when you decide to become a passive investor, you’re entrusting your capital and decision-making power to someone else.
Here are some essential questions to ask when vetting a sponsor:
- Who is the sponsor and their team? Ensure that the sponsor is the one directly managing the investment. With the rise of co-GP (general partner) structures, it’s important to understand if the sponsor is just raising capital or actively involved in the deal.
- What is their track record? Verify the sponsor’s history by reviewing their prior full-cycle funds. Additionally, ask if they have a track record verification report from a third party to validate their prior returns.
- Are they transparent and communicative? Check how often they communicate with investors. Ask for past newsletters or communications to gauge their level of transparency, especially if things go wrong. If you call, will you be able to speak to someone on their team?
- How are they compensated? Fee structures can significantly impact returns. Be cautious of high upfront fees that may disincentivize the sponsor from actively managing the investment long-term. You want a sponsor to be incentivized by profits, not fees.
Red Flags to Watch For When Vetting a Sponsor
When evaluating a sponsor, it’s crucial to look for red flags that could indicate potential issues down the road, such as poor communication, inexperience, or conflicts of interest. For instance, if a sponsor has multiple funds, investigate how they allocate assets across these funds. Similarly, excessive or unclear fees can erode investor returns. Be wary of sponsors who make their money primarily from fees rather than sharing in the success of the investment.
One cautionary tale comes from the world of multifamily investments, where a tech entrepreneur raised over $150 million for deals that later failed. A deeper investigation revealed that their asset management team was composed of virtual assistants with little to no experience in managing multimillion-dollar properties. Make sure the management of the asset(s) is done by someone with experience.
Understanding the Capital Stack
Another important concept is the capital stack, which refers to the hierarchy of who gets paid first in an investment. In a typical real estate deal, debt (from a bank) is at the bottom of the stack, followed by preferred equity and common equity. The higher you go in the stack, the higher the risk, but also the potential for greater returns. However, be aware that higher returns come with significantly more risk—sometimes even the risk of losing your entire investment if the property underperforms.
Conclusion: Asking the Right Questions
Whether you’re exploring a Reg A+ offering as a non-accredited investor or considering a Reg D offering as an accredited one, the key to success in passive investing lies in thorough due diligence. Always ask detailed questions about the sponsor’s track record, fee structure, communication practices, and risk mitigation strategies. By doing so, you’ll be better positioned to make informed decisions that align with your financial goals.
Learn more on this topic by watching our webinar, How to Evaluate Deals & Sponsors.
