The Long Arithmetic: Issue 4

The first private placement memorandum I read, I read like a contract. Front to back, every page, pen in hand. It took an afternoon, and it left me knowing less than when I started. It reminded me of War and Peace, which I had to read cover to cover in school, back before Cliffs Notes existed.

Most of those pages were risk factors, written by the sponsor's lawyers to make sure that if the deal went badly, no investor could claim they were not warned. They were thorough. They were also beside the point. The pages that actually decided what I was agreeing to were maybe five of the ninety, and I had given them the same attention as everything else.

This is what I see now, after reading a lot of these from both sides of the table. A private placement memorandum is a defensive document. Its first job is to protect the sponsor who wrote it, so that if the deal goes badly, every risk was disclosed somewhere in those ninety pages. Reading all of it, evenly, is the wrong instinct. The skill is knowing which few sections carry the real terms, and what question to put to each one.

One caveat before any of this is useful. A PPM cannot tell you whether a deal is good. A clean document can sit on top of a deal that loses money, and an ugly one can sit on top of a deal that pays. What the document can tell you is what you are actually agreeing to, which is a smaller and more answerable question. Skipping the parts that matter does not make the deal worse. It means you are outsourcing a decision you believe you are making yourself.

You probably know the moment. An 80-to-120-page PDF lands in your inbox a few days after a good conversation, maybe a warm introduction from someone you trust. You open it. The first pages are defined terms, then a wall of risk factors in language you are not really meant to read. You read the executive summary, glance at the projected returns table, and you make one of two moves. You sign it, because the deck was convincing and the person seemed credible. Or you put it away. Sometimes putting it away is a clean no, the deal is not for you, or the money is not there, and that is a fine place to land. Sometimes you put it away meaning to come back, and never quite do. That second version is the one worth noticing. (A few people forward it to an advisor and wait to be told it is fine, though most of the ones I know make this kind of call themselves.) Either way, the ninety pages went mostly unread, which was the point of writing them that way.

The question in your head when that PDF arrives is usually some version of do I trust these people and is the return worth it. Both are reasonable. The document is not built to answer either one.

What it is built to do is describe, in binding language, four things: what you are buying, what the sponsor can do with your money, what the sponsor gets paid, and what happens when something goes wrong. The pitch deck is the advertisement for those terms. The PPM is the terms. When the two disagree, and they sometimes do, the document is the one you are signing, so the document wins.

The executive summary is the deck. The same people wrote it, for the same purpose. It is accurate, for the most part. It is also curated. The work is to go find the four places where the curation matters.

These are the pages I read first, before the summary, before the risk factors. The order is mine, not a rule, and the section names vary by document. The questions do not.

1. The fee and promote waterfall. This is what the sponsor gets paid, and the order in which money flows back. The question to ask: before I see a dollar of profit, who gets paid first, and how much? You are looking for acquisition fees, asset management fees, the preferred return (the hurdle investors get before the sponsor shares in profit), and the promote (the sponsor's slice of the upside above that hurdle, in a lot of cases 20 to 30 percent). The returns in the deck are sometimes shown after all of this and sometimes before. Knowing which one you are looking at can move the real number by a lot.

2. Sponsor discretion and conflicts of interest. This is how much the sponsor can do without asking you. The question to ask: what can they decide alone, and where do their interests stop matching mine? The conflicts section is often the most honest part of the whole document, because the lawyers wrote it to be complete rather than persuasive. Look for related-party deals, an affiliated property manager or broker collecting its own fees, and the sponsor's right to change the business plan after you have wired the money.

3. What a capital call actually obligates. This is whether you can be asked for more money later, and what happens if you decline. The question to ask: if the deal needs more capital, what am I on the hook for, and what is the penalty if I say no? Some structures simply dilute you. Others treat a missed call as a default, with real teeth. This is the line that surprises people most, usually at the worst possible time.

4. GP removal and no-fault provisions. This is whether investors can replace a sponsor who is doing a poor job but nothing illegal. The question to ask: if they underperform without crossing a legal line, can we remove them, and what would it take? The bar is usually high, often a supermajority of investors who have never met each other. A high bar is common, and on its own it is mostly a measure of how much control you are handing over, worth knowing before you do.

A few ways careful people still get this wrong.

They spend their attention on the risk factors, because that section looks the most serious. It is the most visible part and the least useful for a decision. Everything is listed as a risk, which means nothing is ranked, which means the section tells you the sponsor's lawyers were thorough and not much else.

They trust the returns table without checking whether it is net of the promote and the fees from the first section. A 2x shown gross of the promote is not the 2x you receive.

They read the word “we” in the governance sections and assume it includes them in some meaningful way. Usually, it does not.

And they read the whole thing once, alone, late at night, and confuse having opened the document with having understood it. I have done that. It does not work.

Here is what reading the four sections gets you, and what it does not. It does not tell you the deal is good. It cannot. What it gives you is the ability to say yes to the real terms instead of to the feeling the deck created. The question at this stage is narrower than whether the deal will work. It is whether you should even be in the room, on these terms, with these people, holding this little control. That decision you can make now. The future you cannot.

So, before you sign the next one, consider not starting on page one. Start with four questions and go find where the document answers them. Who gets paid before I do. What can they decide without me. Can they ask me for more money. Can we remove them if they fail. If those four answers are hard to find, that difficulty is itself an answer.

 I keep a short version of how I read these, the order I go in and the exact questions. If it would help, it lives here. It is the first thing I send people who join this letter, because most people were never shown that the document was the point.

Disclaimer: This is not financial advice. Consult your CPA or licensed advisor before acting on anything specific to your situation.

Until Monday.

Alina