The Different Kinds of Private Capital Networks
Historically, private equity real estate investing was arranged through syndications that were only open to friends and family, or people with whom the deal sponsor had some sort of personal relationship. It’s often been referred to as “country club” equity for this reason. There was an underlying assumption that this relationship had been pre-vetted to some degree, and therefore, investors had enough confidence in the sponsor to write a check that would translate into positive returns.
The nature of private equity real estate investing changed dramatically in 2012 with the passing of the JOBS Act, a federal regulation that eased the requirements about who can invest in private equity real estate and under what conditions. Now, there are more efficient mechanisms by which investors can invest – namely, through private capital networks.
What is a Private Capital Network?
A private capital network, or PCN, is a group that is formed with the explicit purpose of aggregating capital to then invest collectively in private real estate deals. PCNs are popular among those who are interested in investing in commercial real estate, but who do not have the bandwidth or interest in identifying and analyzing deals on their own. Members of a PCN would rather entrust this process to a qualified third-party, who may be another member of the PCN or who may be the organizer of the PCN, depending on the nature and structure of that specific PCN.
In this article, we take a look at four different kinds of PCNs, including the pros and cons of each.
Four Types of PCNs
There are four distinct types of private capital networks, as outlined below:
- PCNs comprised of working professionals. These PCNs tend to draw interest from physicians, lawyers, entrepreneurs and other working professionals who have sufficient access to capital that they’re ready to deploy into commercial real estate, but who do not have the experience to feel comfortable investing in deals directly. Members of these PCNs tend not to have direct real estate experience but know enough to understand that they can achieve economies of scale by investing together. This type of PCN is the most akin to a traditional “country club” investors group.
PROS: There are many benefits to investing in this form of PCN. Namely, members of these groups can usually aggregate enough capital amongst themselves to access better, more lucrative opportunities with lower fees. Rather than investing $25,000 a piece individually, they can invest $250,000 into a deal if ten individuals agree to invest at the same time.
CONS: There are a few drawbacks of this approach to consider. The first relates to how these groups identify deals. PCNs comprised of working professionals tend to be dominated by the voices of three or four group leaders who take the reins on identifying and bringing deals to the group. The other 95% of people tend to follow along, given their lack of real estate investing experience. Often, the rest of the group puts blind faith in these group leaders without considering those leaders’ own qualifications or potential motivations (e.g., maybe it’s a friend or family member whose deal they bring to the group). Another pitfall of this format is its structure: funds are generally not aggregated into a single entity; instead, individuals invest funds directly with the sponsor. This means there could easily be 30-40 limited partners in any single deal. Each person is then responsible for their own underwriting, accounting, and related investment decisions.
- “Chat Room” PCNs: Another form of PCN is one that is often referred to as a “chat room” PCN. Chat room PCNs are an advent of the internet age, where like-minded investors have started to come together to share investment strategies and deals with each other. These PCNs are usually led by one person who sets up an online group, and then individuals in that group are free to discuss individual deals behind an online firewall. If there is a deal that seems particularly interesting, the group will then collectively vote on whether to invest or not.
PROS: The primary benefit of chat room PCNs is that it allows the group leader to draw people in from all regions and geographies. It also assumes there is someone in charge—someone who is responsible for identifying opportunities to bring to the rest of the group, thereby taking the pressure off others for acquisition and preliminary underwriting. The rest of the group can then weigh in on those deals accordingly, sharing perspective and information, and then after significant discussion, determine whether the group would like to invest together or not. When not analyzing a specific deal, the group tends to share information and resources with each other, such as their perspectives on what constitutes a “good” cap rate or the top five things to look at when underwriting a deal.
CONS: There are a couple of drawbacks to chat room PCNs. First is the overreliance on the group leader. It is important to understand that person’s real estate investing experience prior to entrusting them with identifying and underwriting the deals they bring to the group. As an individual, someone does not necessarily have the information they need to make an informed decision about a specific deal, which can then lead to the herd mentality discussed above. Investors will want to pay close attention to who’s leading the discussion, their perspectives, and their motivations.
- Crowdfunding platforms. Crowdfunding platforms, such as Crowdstreet and RealtyMogul, really came to the forefront after the 2012 JOBS Act. Some people describe these as real estate platforms, but in reality, they are transaction platforms enabled by the broader fintech movement. That said, what’s particularly novel about these platforms is that they’ve effectively created a marketplace for private real estate, an industry that has historically had significant barriers to entry. Platforms allow individuals, whether accredited investors or not, to invest as little as $100 in private real estate transactions.
PROS: Real estate crowdfunding platforms have created unprecedented access to private real estate. For example, few individuals can afford to purchase a downtown office building. Most wouldn’t even know where to identify such opportunities. Crowdfunding creates a marketplace wherein several individuals can invest smaller dollar amounts whereby, collectively, they can then invest in something like an office building together. This allows investors to diversify their portfolios by investing in many different kinds of deals using platforms such as these. From a sponsor’s perspective, it also broadens the pool of potential investors. They can attract capital from people anywhere in the country—or anyone across the globe, for that matter. Crowdfunding platforms allow them to get their deals in front of tens of thousands of investors at once.
CONS: Crowdfunding platforms are certainly not without their critics, and for good reason. One of the main issues with this improved access is that now, sponsors of all kinds, those with experience and those with none alike, can pitch deals to unsuspecting investors. Any group who wants to raise money can use this as a tool for doing so. This has flooded the marketplace with deals, making it more difficult for individual investors to sort through them, given the sheer volume of deals available. It is also more difficult to ascertain who is behind a specific deal. What’s their experience? How do they make money? Sometimes it can be tough to tell.
Real estate crowdfunding platforms are primarily backed by venture capital dollars. As a result, their investors (the venture capitalists) require them to adopt a ‘grow at all costs’ mentality, meaning crowdfunders are incentivized to close as many deals as possible with the goal of raising as much investor capital as they can. If they don’t, they’re faced with the very real risk of having to shut down as they will be unable to raise their next round of venture capital. This is important to understand because real estate deals are marketed based on forward looking projections and these platforms know investors will be more interested in deals with higher return profiles – you can see the inherent conflict of interest that exists and the need to be extra diligent as you evaluate any investment opportunity.
- Exclusive PCNs. Exclusive PCNs, such as those operated by groups like Alpha Investing, are open only to those who have been invited by the firm or referred by an existing investor. These groups tend to have a much smaller group of investors compared to the other PCNs described here today. Exclusive PCNs will usually thoroughly vet each prospective investor. This pre-vetting process is designed to ensure that the prospective investors fully understand the PCN’s operating model and investment thesis, but also to ensure the investors’ goals are adequately aligned. For example, Alpha Investing tends to invest in acquisitions with strong in-place cash flow. Thus, investors looking for deals focused on appreciation will soon realize that this exclusive PCN is not the best model for their needs.
PROS: Exclusive PCNs place a great emphasis on up-front information sharing and transparency. Because the investment group works with fewer investors, they have more time and resources to spend with individuals—there’s better information flow, sharing of diligence folders, etc. Prospective investors are asked, encouraged even, to come back to the principles with questions prior to investing. This helps to ensure that interests are aligned prior to a deal moving forward.
CONS: The primary drawback to exclusive PCNs is their limited nature. Someone who’s eager to invest, but who has no investment experience to date, may not be eligible to invest with an exclusive PCN right out the gate. Instead, the exclusive PCN might require that investor to brush up on private equity real estate. They’ll likely share education materials and other resources to help the individual become more confident with their investment decisions before agreeing to accept their capital in a private equity real estate transaction. As their name would imply, exclusive PCNs are inherently more exclusive than the other PCNs discussed above.
Investing in a PCN vs. a Fund
Most PCNs invest on a deal-by-deal basis. This is because the average investors like to know exactly what they’re investing in: the product type, asset class, geography, and more. These materials provide some level of comfort with any given transaction. This is fundamentally different than investing in a fund, whereby you’re entrusting the sponsor to invest your money across a portfolio of deals that may vary in product type, asset class, geography and the like.
To be sure, some PCNs also offer funds. Alpha Investing is one such example. This allows someone with $100,000 to invest, for example, to invest $20,000 into five different deals. Investing in a fund, via a PCN or otherwise, helps limit concentration risk. Rather than investing in an individual property, the investor is opting to invest smaller dollar amounts across an array of properties, thereby maximizing yield while minimizing risk.
Which PCN is right for me?
Despite knowing the pros and cons of each PCN type, many investors will still struggle to decide which PCN is best for them. Frankly, there’s no right or wrong answer. The key is understanding alignment of interests.
Before investing in any type of private real estate transaction, be sure to understand how the deal is structured. Specifically, look at how much capital the sponsors are putting into the deal. Look for sponsors to have at least 5% to 20% equity to ensure alignment of interests. Then consider the fee structure. How a deal’s waterfall and promotes are structured is critically important to PCNs. Look not only at total fees, but when the fees are incurred. Ideally, you’ll want to see the sponsor (or in some cases, the PCN itself if acting as a third-party intermediary) backloaded. Of course, there will be some fees up front—after all, the sponsor and/or PCN needs to collect some income for running the operation—but most fees should be structured as promotes to ensure the group you’re investing with is incentivized to perform. As an investor, be sure to consider what your preferred rate of return is and over what time horizon, and then what the sponsor is taking as a promote above and beyond that (and when).