Top Ten Reasons New Sponsors Fail
By: Jan Ryan, JCC Capital Markets
By: Jan Ryan, JCC Capital Markets
The direct participation program industry can be extremely lucrative, but a high percentage of new sponsors fail. Even sponsors with a history of private offerings can fail when entering the independent broker dealer market. Successful sponsors are those who are prepared, bring the right product to market at the right time, presented in the right way, and have the stamina to stay the course. Here are the top ten reasons new sponsors fail.
1. Undercapitalization
This is listed as number one for a reason. This is the most common problem for new sponsors. Even the best products with the best pedigree will fail if they do not have the staying power to get through the first offering. Sponsors need to have the funds available BEFORE entering the market. Sponsors attempting to raise money for the sponsor entity at the same time they are raising money in product offerings have too much distraction just trying to keep the doors open.
2. Unrealistic Expectations
Have reasonable expectations on what you can accomplish in the first three years. Have goals and stretch goals, but make sure your financials still work with more modest targets. A recent product sponsor had an expectation of $200 million for their first-year sales. They hit $100 million, which for most would be a huge success, but for them, it nearly meant the end as they had run out of money.
3. Undifferentiated Product
A new “me too” product will not sell. There must be a compelling reason that YOUR product is needed in the marketplace. Another product means more work for the due diligence professionals and more to learn for their representatives. If all your offering does is cannibalize their existing sales, there is no need to add your product. That will be the base position most firms will have. It will be up to you to clearly articulate why there is nothing else in the marketplace quite like what you have, or if there is, why yours is vastly (not just a little) superior.
4. Lack of Distribution
This is a small industry with players who mostly all know each other. If no one knows you, they are unlikely to want to get to know you. Chicken and the egg? Yes. Many of the independent broker dealers have a firm policy of not signing a firm’s first offering. If you do not know the industry, hire people who do. Go to the industry association meetings and get known. Get the advice of some of the key decision makers and include their suggestions in your offering. They are more likely to sign your product if they had a hand (or think they had a hand) in its design.
5. Lack of Track Record
Even a strong track record may not be enough, but without one, the odds are stacked against you. A long-term track record in your core asset class is essential. A track record without any blemishes is ideal, but a track record that shows you have overcome adversity and kept the interests of the investors as your primary motivation speaks volumes. Moving from 1031s to REITs, or private offerings to publics provides additional challenges relating to scale and compliance that will need to be addressed.
6. Inexperienced Principals
The securities business is complicated. Even if the principals understand their core business, if they do not understand the securities business, or hire people who do, they can run into difficulty. Things as simple as knowing who needs to be registered and with which licenses, the intricacies of escrow, and staying under the 10% guideline seem obvious to those in the business, but all three of these areas have led to significant fines for product sponsors who have been in the industry for years. With new sponsors, getting the basics right and keeping up with the changing compliance landscape is essential. Then there is the business itself. This can be an expensive way to raise capital. Inexperience can lead to poorly constructed pro formas and unrealistic return models.
7. Poorly Structured Product
There is a delicate balance between investor safeguards and sponsor latitude. There are specific items that due diligence officers require and others that are strong sales features important to representatives. Do your homework. Look at the structure of other products. Get the advice of experienced attorneys with expertise in your specific niche. Ask the attorneys what their experience has been with the various states and how long it has taken them to get product through the process. It isn’t just the SEC and FINRA that can hold up your offering. That said, you still need to be able to run your business with enough discretion to allow you to be nimble in changing circumstances. A recent product offering had a $10 million escrow. The feeling of the principals was that it would take no time to raise that kind of money. They were wrong. The deal is no longer on the street. This was an established product sponsor who was entering a new side of the business.
8. Unsupportable Cash Flow/Noncompetitive Cash Flow
Cash flow is critical in most product offerings. Striking the right balance is essential. A high cash flow that must later be cut as unsustainable will brand you as someone who does not keep promises. Don’t do it. On the flip side, having a 3% product in a 5% world is a nonstarter. You do not have to have the highest cash flow, but you need to be in the ballpark. At the very least, you need a distribution that is sustainable on the stabilized portfolio and a demonstrable plan on how you plan to achieve coverage.
9. Weak or Lack of Audited Financials
Small independent broker dealers may not insist on audited financials, but most of the serious players will. If you do not provide them, they will assume you have something to hide. That said, you do not need to be profitable as a company in the beginning. They know that ramp up takes time and capital. They will give you time to mature but they want to know where you stand.
10. 10% Expense Cap
Distribution expenses must fit under a 10% cap for public offerings and no, you cannot just eat the expenses associated with your first program to get it started. You must stay under the cap for wholesaler comp, rep commissions, conference costs, BD overrides, everything. Check out the footnotes in the Use of Proceeds table in the prospectuses of your competitors for guidance. An experienced product sponsor offered their first REIT and pushed some of their conference expenses into offering and organization expenses (not in the 10%). They got caught and got fined by the SEC.
So, what’s the bottom line? In order to enter this business, make sure you have an attractive product, enough capital and the right people to make it happen.
Jan Ryan is the senior vice president, product development, for JCC Capital Markets, a managing broker-dealer working with sponsor clients to bring quality investments to the independent broker-dealer community. She has over 40 years of experience in the financial services industry with expertise in due diligence, product development, analytics, sales, national accounts and marketing.
This article first appeared in the Winter 2022 volume of ADISA’s flagship publication, Alternative Investments Quarterly.
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