The Importance Of Due Diligence In EB5 Investments
The following is an edited excerpt from the book EB5 2.0 | The Institutionalization of EB5: Changes in Legislation, China, and the Role of the Broker-Dealer by Kevin Wright and Michael Fitzpatrick.
Broker-dealers are required by their very nature to perform due diligence on an investment product before offering it to prospective investors. Under previously proposed EB-5 renewal bills (and expected integrity measures), regional centers would also be held accountable for performing due diligence. Thorough due diligence is a best practice to protect investors and regional centers from engaging in projects that might be subject to fraud or weak financial or operational fundamentals that could give rise to legal liability and reputational damage.
Each investment is unique, and diligence needs to be customized to fit the specifics of each case. However, due diligence can be broken down into several broad components, which bear similarity to many of the enhanced marketability features listed in Chapter 3, including the following:
- The structure and offering documents
- The development team
- Financial feasibility
- Real estate matters
- Job creation
Structure And Offering Documents
The structure of an EB-5 investment sometimes resembles a web of entities, and every entity has to be verified on a granular level. An organizational chart creates a visual flow chart to simplify the relationship and role of each entity involved in the transaction.
Dissecting the structure requires one to understand how funds flow from one entity to the next and the conditions required to transfer those funds. During this process, risks that might prevent the flow of funds can be identified, and conflicts of interest will become apparent based on the party or parties authorized to move funds through the structure.
Typically, EB-5 funds are structured as a loan to the project. Careful attention needs to be given to the note, loan agreement, intercreditor agreement with the senior lender, and any collateral documents to ensure the terms are accurately described in the offering materials and are commercially reasonable to protect the interests of the investors as a lender. A popular technique used by EB-5 developers has been to have the New Commercial Enterprise make a “secured” loan to an intermediary entity that uses the loan proceeds to make a preferred equity investment in the Job Creating Entity, pledging the preferred equity as collateral to the New Commercial Enterprise to secure the loan.
Immigration agents liberally marketed such investments as “secured,” but in reality, after cutting through the semantics of the structure, they are typically unsecured preferred equity investments. If the project has a bridge loan, those terms should be reviewed for full and accurate disclosure, especially if there are any conversion rights or punitive terms if the bridge loan is not fully taken out at maturity. Once the structure, risks, and conflicts of interest are fully understood, a final step is to review the offering documents to ensure full and transparent disclosure.
A broker-dealer or regional center may find certain conflicts of interest too risky to accept, such as having the manager of the New Commercial Enterprise related to or affiliated with the Job Creating Entity. However, it is important to remember, as mentioned earlier, that conflicts of interest are not prohibited, provided they are fully disclosed. While full disclosure may protect from a claim of securities fraud, disclosure does not relieve the New Commercial Enterprise manager from their fiduciary duty to look out for the best interests of the investors. However, the existence of the conflict introduces risk that the related party manager may not act as aggressively as an independent manager.
A broker-dealer will also pay particular attention to the use of an escrow agent and the conditions for releasing the investor’s funds to the project. Due to long processing times by USCIS, the market has evolved to use a holdback or I-526 denial guaranty structure, but given the low denial rate of I-526 petitions (the fourth quarter of the 2017 fiscal year saw an I-526 approval rate of 93 percent),48 a holdback of 10 to 20 percent of investor funds will generally create a pool of liquid funds to return capital to any investor who is denied after all appeals are exhausted. Under the denial guaranty structure, a responsible party guarantees the investor a return of their capital in the event of a denial. Good due diligence includes verification that the guarantor has sufficient net worth and liquidity to honor the guaranty. Finally, a comprehensive review of the offering documents, including exhibits, should ensure that there are no material misstatements or omissions that would give rise to a claim of securities fraud.
The private placement memorandum describes the plan to market the offering, which must comply with US securities laws. Every offering of securities in the US must be registered with the SEC, unless it qualifies for an exemption from registration. The two exemptions from registration available to EB-5 offerings are under Regulations D and S.
Regulation D is the exemption traditionally associated with the private placement of securities in the US. Under Rule 506(b) of Regulation D, privately placed securities may be offered and sold in a nonpublic manner to accredited investors, and up to thirty-five nonaccredited investors. An accredited investor is a person with a net worth (excluding home equity) of $1 million or more, or a person with an annual income of $200,000 or more in each of the last two years with the reasonable expectation of maintaining that level of income ($300,000 if measured jointly with a spouse). Rule 506(b) also permits the issuer to self-certify their accredited status.
Rule 506(c) permits the public solicitation of the unregistered security, provided it is sold only to accredited investors, and the issuer is obligated to collect documentation from the investor to reasonably verify that the investor is accredited. Whether sold under rule 506(b) or ©, because Regulation D sales occur within the US, transaction-based compensation may only be paid to a licensed securities broker-dealer.
Regulation S is the most commonly used exemption for EB-5 investments. Under Regulation S, the offer and sale of US securities may be conducted offshore to foreign persons using general solicitation, such as seminars and advertising, and without regard to the accredited status of the investor. Under Regulation S, fees may be paid to finders who are non-US persons.
Another exemption that often creates confusion is the “issuer’s exemption.” The issuer’s exemption is not an exemption from registration, but it does exempt employees and officers of the issuer from the requirement to register as brokers in order to participate in the solicitation and sale of a private placement. While exempt from registering as a broker, an officer or employee of the issuer may not receive transaction-based compensation, such as commissions, whether sold under Regulation D or S.
Conducting due diligence on the management team requires more than a Google search. Best practices start with a visit to the project site and sponsor’s office to ensure everything exists as it has been presented. The project site should be owned, under option, or under lease by the developer. Entitlements, zoning, and municipal approvals should be in hand or well underway.
Next, the project management team’s experience and background must be checked. Use of a professional background agency ensures that sponsors do not have a criminal history, bad credit check, undisclosed prior bankruptcy, or undisclosed project failures in their history. Open and concluded lawsuits should be reviewed as well to assess the reasons for the suits and to assess the character of management.
Third parties key to the success of the project need to be assessed. Does the general contractor have a track record of building projects of a similar scope and scale? Are they bonded? If there is a third-party manager/operator, do they have the experience and current capacity to take on this project? If there is a leasing or sales agent, do they have the expertise to successfully market the space? Which law firms have been engaged as security and immigration counsel? What is their experience and track record?
Is anyone else providing money to the project? If, for example, the brochure states that 20 percent of the money comes from tax credits, are those New Markets Tax Credits? Even if someone wrote a letter of intent to give money through a certain funding source, that letter of intent is nonbinding. When was the letter written? Five years ago? Yesterday? Has anyone contacted the company that wrote the letter to make sure it’s real?
Are there equity investors in the project who aren’t involved in development? If so, they might be purely financially driven. Where is the cash equity coming from? Is every source legal? In the Chicago convention center case, no one contacted the franchise companies to verify an agreement was in place, and one of the franchises turned out to be a fake agreement.
Ultimately, it should be verified that competent professionals structured the project.
Regional Center Diligence
Ownership and management of regional centers generally fall into four categories. First, some are captive to developers that plan to develop extensively within the geographic region for an extended period of time. Rather than pay a third-party regional center, they have chosen to invest in creating their own source of investors and manage compliance risk. Generally, developer-controlled regional centers stick to funding their own projects rather than taking a risk that a third-party project might cause reputational harm to their regional center. However, developer-controlled regional centers tend to lack any third-party oversight and are most vulnerable to fraud.
A second category of regional centers operate as financing companies, with the source of capital funded by foreign investors instead of shareholders and depositors. These regional centers tend to operate professionally and treat investors with a high degree of care, as their reputation and business model are dependent upon investor satisfaction. These regional centers perform due diligence, structure the transaction, issue a term sheet, raise the funds, and perform asset management and loan servicing during the life of the EB-5 loan.
Third, municipalities form regional centers as an economic development incentive to give developers low-cost access to the benefits of associating with a regional center without having to form one or associate with a for-profit regional center. While inexpensive to use, these regional centers tend to be characterized by a lack of due diligence or provision of other services — fundraising in particular — to projects. The projects have to determine their own structure, create their own offering documents, and source investors. Similar to developer-controlled regional center projects, there is usually no third-party oversight afforded to protect investors.
Fourth, a number of regional centers are formed to generate fee income from developers who need quick access to an existing regional center or in instances where it does not make economic sense to form a dedicated regional center. These regional centers create the most risk for developers and investors since they generally lack “skin in the game.” They might be incented to take lower quality projects, while skimping on diligence and disbursement procedures. If the regional center folds due to problems, it can taint an otherwise good project and may impair pending I-526 applications for investors.
When selecting a regional center, project sponsors should not only conduct diligence on the owners and management, but the other projects already associated with the regional center. Even if all existing projects are progressing with no problems, a troubled or failed project during the marketing period will damage the marketability of a new project, even if it is independent of the troubled project. A final step is verification of the regional center’s good standing with USCIS.
Financial analysis covers the life cycle of the project, including the construction budget, operational assumptions (or history, if applicable), and exit strategy to return investors’ capital. Generally, EB-5 investments fund new construction, and the budget needs to be reviewed. Diligence should assess if the budget sufficiently covers construction for the proposed project. After getting comfortable that the project can be built with the proposed budget, other sources of funds (equity, debt, and any incentives) should be verified as committed and not contingent.
Typically, land may be purchased from a related party or contributed as equity by the developer. The most conservative approach credits the value at the lower end of cost or current market value, but in all cases the value should be supported by a recent appraisal from a qualified independent appraiser. Finally, best practices include a completion guaranty from the developer, and the ability of the developer to fund change orders and cost overruns.
If the project is to be built with a guaranteed maximum price (GMP) contract, diligence needs to extend to the financial capacity of the general contractor and an assessment of the construction documents. Investors can get a false sense of confidence when they hear the developer has a GMP contract. GMP contracts stipulate that the price is based on the level of detail in the construction documents, with allowances for costs not yet fully known. The developer can adjust the price of the GMP contract upon finalizing those costs.
After completion of construction-phase financial diligence, projections must be assessed. Are revenue assumptions supported by an independent market study from a credible expert? Is there any preleasing? If so, do the assumptions for space to be leased seem reasonable in light of the terms in the executed lease? Are there any presales? If so, what are the terms? Can buyers easily walk away from the presales, or do they have a substantial, nonrefundable deposit? Are hotel occupancy and rate assumptions consistent with their competitive set? Has the operational manager reviewed and approved the projections? Similarly, expense assumptions should be put through considerable rigor to assess if the project can reasonably achieve the expectations outlined in the projections.
For an operating business or expansion project with historical financial statements, three years of audited financial history should be reviewed to ensure that the forward-looking projections are reasonable for both revenue and expenses.
If projections appear reasonable, then the cash flow must be checked to ensure the project provides a likely exit potential for investors and that the timing reasonably coincides with the expected completion of the immigration process (filing of the I-829 form).
Exit strategies typically fall into two categories:
- Sale of the asset (e.g., condos)
Third-party market studies will provide insightful information about the supply of competing products, trends in the velocity of sales, likely selling prices, and concessions. Projects relying on a refinance (e.g., hotel, office, retail, or residential rentals) need to achieve an appraised value and demonstrate sufficient cash flow to cover the proposed level of debt needed to refinance the EB-5 investors.
A typical analysis estimates the value of the project using the projected cash flow at the time of the refinance with a capitalization rate specific to the property type and market. Depending on the type of property, banks typically loan 60 to 80 percent of the appraised value, provided the cash flow can support a debt service coverage ratio of 1.2 times or greater.
Highly specialized financial due diligence is required based on the type of property being financed, including third-party reports to assess if the projections can reasonably be realized. A developer can make any project look good with an Excel spreadsheet, but a skilled diligence expert will sift through the assumptions to separate institutional-quality projects from weak projects.
Real Estate Diligence
Real estate diligence starts with verifying the legal existence and good standing of the entities involved in the transaction, ensuring that the land is held by the Job Creating Entity or under contract to be purchased at closing. Environmental diligence follows, and a Phase I report will indicate if conditions exist that warrant soil testing. The file should conclude with documentation to support no contamination, completed remediation, or an approved plan if remediation is within the scope of the project.
An independent appraisal should be obtained from a qualified appraiser that reports three values: “as is,” “as completed,” and “as stabilized.” The “as is” value should support the value of contributed equity if shown as an SOF. Additionally, a report of title should be obtained to ensure all taxes are paid, with no undisclosed liens against the real estate. Finally, evidence of insurance and all approvals, permits, and zoning should be reviewed and verified to ensure that the project is “shovel ready.”
Last, critical contracts should be reviewed for commercially reasonable terms and disclosure of any related party matters. Major contracts include those with the architect, general contractor, franchisor, and property manager.
Job Creation Analysis
Achievement of the immigration benefit, the green card, depends upon providing evidence that ten US jobs were created per investor. However, when it comes to assessing the risk associated with job creation, all jobs are not equal.
In addition to counting model-driven direct jobs, projects associated with a regional center are allowed to calculate and count indirect and induced jobs. Projects not using a regional center may only count full-time employees. Direct jobs are those that can be observed and counted on a payroll report. The downside to direct jobs is that they are subject to a good economy and successful operation of the project. One of the first costs cut after disappointing results are direct jobs. Operational performance and general economic conditions can have a negative impact on the number of direct jobs created for purposes of achieving a green card.
Indirect jobs provide goods and services to the project but aren’t directly employed by the project. Construction jobs create both direct and indirect jobs, but you can only count the direct construction jobs when the project goes past the two-year mark. Prior to that, they are counted as indirect jobs, and in some instances, they are considered induced jobs.
Construction jobs are calculated by an economist using a computer model (e.g., IMPLAN or RIMS II) that utilizes inputs such as the cost of construction, location, time to build the project, and the percentage of hard-cost materials and furniture, fixtures, and equipment used that are produced within the US. On average, construction usually costs more than budgeted and takes longer than expected, so there is usually very little risk associated with the creation of construction jobs. The main risk associated with the creation of construction jobs is ensuring that the project is fully funded and that the project is actually built. The risk of funds and completion can be mitigated with the use of a bridge loan and completion guaranty.
Induced jobs are created by direct or indirect employees of the project as they spend their paychecks in the local community. Induced jobs are calculated by an economist using a computer model that utilizes economic inputs. Like direct jobs, if the project does not meet projections, the inputs that drive the econometric model will project a lower level of job creation.
Diligence procedures for job creation include reviewing the report and credentials of the independent economist, such as their track record of USCIS approval on prior economic analysis reports comparing the methodology used with those accepted by USCIS and a review of the assumptions used in the econometric model to ensure they are transparent and supported by third-party data. Additional comfort can be gained by hiring another economist to prepare a report to compare results for reasonableness. Generally, a broker-dealer will size an EB-5 offering to ensure a cushion of at least 30 percent excess jobs over the minimum requirement.
Targeted Employment Area
Since EB-5 investments have historically not offered an opportunity for commensurate financial returns, investors prefer to invest the lower amount of capital enabled through a TEA. Under the current law, TEAs are certified through a state agency. Also, while marketing the investment, investors must invest with a TEA designation that is less than one year old. Therefore, capital raises that extend twelve months beyond the date of the initial TEA certification need to have the TEA renewed. Investors who submit their I-526 with a current TEA are protected from a future change in the designation.
Given the recent proposals to change TEA designations, project sponsors would be wise to show cautiousness in going to market with a complex TEA that may lose its status should the law change in a manner consistent with prior draft legislation.
EB5 2.0 | The Institutionalization of EB5: Changes in Legislation, China, and the Role of the Broker-Dealer by Kevin Wright and Michael Fitzpatrick is available now.