By: Ray Davis, Chief Business Development Officer of Red Oak Capital
In 2018, Red Oak Capital was preparing to launch a second offering and solicited the opinions of an array of broker-dealer and registered investment advisor firms to determine the issues they were facing, both with investors and with investment products being offered in the marketplace.
The questions posed were straightforward: What were they looking for in an exempt investment product? What problems were they trying to solve for their clients?
The answers that came back were instructive: BDs wanted investment products that were secure and stable, that delivered strong income, had a specified, non-negotiable exit date, and carried a minimum potential for liability to themselves. The fund sponsor should be locked in with an alignment of interests with investors and should take full responsibility for the fund’s performance.
Red Oak recognized that responding to what they were hearing from financial advisors required a very specific approach: a bond offering with high- quality underlying assets, institutional-quality underwriting, oversight by an indenture trustee, and an increased level of transparency that met the BDs’ expectations — “radical transparency.” Red Oak knew that with a comprehensive set of investor protections, such a product would also be suitable for non-accredited investors, giving advisors a product, they could present across their client roster.
Reg A+ presented the structure they needed but educating the selling community on how to use it would require a significant investment of time, effort, and attention.
Reg A+ was identified as the structure for this purpose. But no one in the BD/RIA community was accustomed to using Reg A+ this way. Red Oak knew that Reg A+ presented the structure they needed but educating the selling community on how to use it would require a significant investment of time, effort, and attention.
The key objectives Red Oak established at the outset addressed the number one issue BDs had indicated, mitigating legal challenges. Next, Red Oak committed itself to serving as a professional operator of real assets (rather than conducting business as a professional sponsor) while working to preserve investment capital and providing a defined exit date.
Red Oak spent nine months updating its company policies, procedures, and offering documents as well as working through a host of legal considerations and SEC requirements. Red Oak also made structural changes to the way it operated, positioning the company to operate in alignment with the offering structure. In the name of radical transparency, any due diligence officer was welcome to examine Red Oak’s records at any time, without notice. The involvement of an indenture trustee would ensure real accountability. Red Oak agreed to be immediately removed from management in the event of a single missed or even delayed investor distribution. The indenture trustee would take over operations.
A contingent interest kicker incorporated in Red Oak’s unique structure was a critical component. Upside participation as part of the equation would serve to ensure interests were aligned between fund sponsor and investors.
This structure would allow a bondholder to benefit as the company succeeded. It would also serve as a risk mitigator of sorts as Red Oak would be restricted from profiting until all interest and return of principal payments had been made to investors.
This approach, though it will be easy to copy, took Red Oak many months of working with auditors. Many details had to be ironed out within IRS guidelines before the structure and the offering could work.
Another consideration was the problem of the marketing expenses involved in a $50 million offering. Red Oak determined that the best course of action was not to hire a team of wholesalers, but to engage a managing broker-dealer (MBD) who could leverage industry relationships to establish selling agreements and facilitate the education of BDs and RIAs on the benefits of the Reg A+ offering structure.
Of the five MBDs Red Oak interviewed, Nick Duren at Crescent Securities was by far the most focused on investor protections and the most willing to do the hands-on hard work required.
Only by systematically educating the selling community could Red Oak get this offering off the ground.
Only by systematically educating the selling community could Red Oak get this offering off the ground. After months of consultation with BDs, RIAs, due diligence firms, FINRA, and others, Crescent Securities established 26 selling agreements for Red Oak Capital Fund II.
As a Reg A+ offering, Fund II would be available to non-accredited investors. Red Oak and Crescent believed that, structured as it was as a corporate bond offering, it should be eligible to be sold through the Depository Trust Corporation (DTC).
In recent years, DTC had approved alternative real estate investments that were structured as preferred share offerings in management companies backed by real estate. Cottonwood Residential and GK Development had already achieved some success in this space.
Red Oak anticipated that a real estate-backed bond offering would find the same eligibility. If so, Red Oak Capital Fund II would have the same easy accessibility for financial advisors as preferred share offerings, an alternative investment product that by this time was well known to the BD/RIA community as available through DTC.
DTC did find Red Oak Capital Fund II eligible. At last, an investment product designed specifically to answer the concerns of BDs and RIAs would be easily accessible via electronic subscription for both accredited and non-accredited investors.
… raised over $200 million in four Reg A+ offerings, largely from non-accredited investors.
Red Oak investment positions would appear on their investors’ brokerage statements along with all their traditional investment holdings. Investment funds would be drawn directly from the investor’s brokerage account so the investor would not even need to write a check.
The formation and marketing costs of a Reg D offering are typically in the neighborhood of $2 million. The total all-in cost of Red Oak Capital Fund II from offering formation to fully sold, including salaries, was under a quarter of that amount, well under 1% of the $50 million offering. Since 2018, Red Oak has raised over $200 million in four Reg A+ offerings, largely from non- accredited investors.
Each of Red Oak’s Reg A+ funds is established as a distinct corporation. The Reg A+ provision limiting capital raises to $75 million per 12- month period applies only to individual corporate entities and therefore, only to each corporation as issuer. For sponsors launching a series of entity-specific Reg A+ funds with distinct portfolios, the fundraising cap is not a limiting factor.
As long as each portfolio is distinct and there is no co-investment among the funds, there are no issues of integration.
Red Oak’s approach to the market was unique, but the fundamentals of investing remained at its foundation while addressing the specific stated needs of the selling community. A corporate bond offering with the security of seniority and a specified maturity date that delivers strong regular income backed by high-quality underlying assets and is overseen by an indenture trustee represents an attractive investment for both accredited and non-accredited investors.
There was an element of good timing, too. GWG Holdings, which had sold preferred share offerings for some time through DTC, had recently paused selling in 2018, creating a temporary void in the market. Also, by 2017- 18, BDs and RIAs had an appetite for an alternative to non-traded REIT investments for their non-accredited investors.
Ultimately, in the words of Nick Duren, the real drivers behind Red Oak’s accomplishment were “disciplined investing, a well-structured product, industry relationships, and a lot of hard work.”
Still, if Reg A+ was a Formula One race car, Red Oak Capital and Crescent Securities had not only learned how to drive it, they had essentially built the track.
Naturally, several investment sponsors, impressed with the success of this model, are now seeking to replicate Red Oak’s approach.
Red Oak Capital’s Reg A+ Comes of Age: Industry Insights on Regulation A, a white paper that examines the long anticipated emergence of the Regulation A+ fund structure after nine years of development following its creation in the 2012 JOBS Act. The white paper analyzes the trajectory of the two-tiered offering vehicle over recent years, profiles the sponsors and managing broker-dealers involved in its utilization and offers perspectives from key industry participants on its prospects for the future.
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The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.