Investing as a Key Principal (Securing Loans for Others)
Key Principals (KPs) can help syndicators and fund managers to qualify for loans in exchange for an equity interest in an investment. They do this by “contributing” their strong financial record and experience, and in some case also acting in a consultative capacity.
What is a Key Principal?
Key Principals are responsible parties who act on behalf of a company. In the case of a real estate loan, a key principal is generally a high net worth individual who helps to secure a loan.
Generally, the sponsor, syndicator, or fund manager of a deal is inherently considered a key principal because of the managerial role they play. However, when it comes to qualifying for a loan, the sponsor may not always meet all of the lender’s requirements. In such a situation, a sponsor may elect to bring in an outside party and add them as a key principal on the deal.
When is a KP Needed?
When applying for a loan, particularly a non-recourse agency loan, the lender will have certain requirements of the responsible party. These typically relate to three issues: net worth, liquidity, and experience.
Although requirements will vary, it’s common for lenders to require a net worth equal to or exceeding the loan amount and liquid assets equal or exceeding 10% of the loan. In addition, a good key principal should also have a high credit score, not have a history of any bankruptcies or foreclosures, have no pending lawsuits, and have experience owning and operating the applicable asset class (e.g. multifamily, office, retail, etc).
Most key principals, like most borrowers, would prefer to avoid recourse loans. However, in some instances they may sign on to a full or partial recourse loan.
Qualifying as a KP
While a lender may require evidence of one’s net worth, verification of their liquidity is more common. This is in part because a person’s liquid assets are easy to verify. It’s easy to provide a copy of a bank or brokerage account statement for instance.
On the other hand, valuing assets and liabilities as they relate to one’s net worth is a more subjective task. Assets such as property, businesses, and collectibles would require an appraisal. The value of these assets is also more prone to volatility.
Piecing the Arrangement Together
As an example, if a sponsor is applying for a $10 million loan, then using the rule of thumb described above, the KP would need to have a net worth of $10 million and liquid assets exceeding $1 million. Naturally, the higher one’s net worth and the more liquidity they have the more desirable they would be as a potential KP.
However, it’s also possible to use more than one external key principal. While individual lender requirements will vary, many will allow for the combining of assets to meet the needed qualifications. For example, if the liquidity requirement was $1 million, instead of using a single KP, a sponsor may bring on two or three key principals whose cumulative liquid assets meet the $1 million requirement. Often the sponsors themselves will be able to contribute something towards that necessary threshold, and outside key principals will be brought on to cover the deficit.
People interested in offering their services as a key principal typically find opportunities through networking, such as by participating at live events, speaking on podcasts, and connecting with others online. It’s not common to find a KP actively advertising through more traditional channels.
Many times, a key principal will start out in another role such as a private lender. Perhaps they provide gap funding, bridge loans, or even acquisition loans. This experience can help a future KP learn the ropes and understand the funding process, gain experience, make connections, and develop the skills needed to conduct a proper due diligence.
The due diligence process generally involves financial underwriting such as reviewing a sponsor/borrower’s credit report and examining certain specific metrics such as the required debt service coverage ratio.
Other non-financial factors to consider include the experience and personality of the sponsor. A key principal wants to make sure that they can trust and work comfortably with the sponsor. They may be interested in things such as the sponsor’s communication style, work habits, and ethics. With the goal of reducing risk, a prospective KP wants to make sure that if and when things get difficult that the sponsor has what it takes to see a project through.
It’s preferred to bring a key principal on early on in the process and more fully include them as part of the team. However, there will always be situations where a sponsor’s initial KP falls through for one reason or another and a new key principal is needed.
A key principal will frequently want to have some degree of managerial involvement such as voting rights and the ability to listen in on conference calls and other executive meetings. The degree of this involvement is negotiable and will relate to the experience level of the fund sponsor.
Like many financial arrangements, the compensation of a key principal is open to negotiation. A KP will likely look at things such as the financial strength and experience of the sponsor in determining what they determine to be suitable compensation. The chosen asset class, the risk level of the investments, market conditions, and the size of the deal will also impact compensation. For example, if a sponsor is less experienced and the KP anticipates having to do more coaching and consulting, they may ask for a higher rate or charge a separate consulting fee.
The compensation itself generally comes in the form of an equity interest in the general partnership of the fund. When a syndicator raises capital, they generally set up a legal entity where they act as the general partner with managerial control and they bring on equity investors as limited partners. The limited partners lack managerial say and financial liability in excess of their investment.
Remember that the KP is not providing a loan, but rather their reputation, which allows the sponsor to acquire a loan elsewhere. If the limited partners are able to contribute 30% of the needed capital, the sponsor may then seek a loan for the remaining 70%. In exchange for their investment capital, limited partners earn an equity interest in the company that owns the investment property. Likewise, the general partner (the sponsor) also earns an equity interest in the profits in exchange for their efforts managing the investment.
The KP will generally be compensated by taking a portion of the general partner’s portion of the equity. This could be anywhere from 5-25%, though 10-20% seems to be the general range. As mentioned, especially when greater consultative services are provided there may also be an additional fee, similar to points being charged on a loan.
All investments naturally have risk and acting as a key principal is no different. One of the primary risks is default risk. If for whatever reason a deal does not perform as expected, the sponsor may not be able to make loan payments. In this case, if the KP signed on as a guarantor to the loan, they could be held financially responsible. That said, depending on the specifics such as the presence of an acceleration clause and the degree of recourse, the KP would not necessarily be responsible for the entire outstanding balance.
The other main risk is bad actor carve out provisions. Even a non-recourse loan (meaning one with no personal liability) has provisions in place where if certain events take place, the principals can be held personally liable. These bad actor carve outs generally occur in cases where there is gross negligence, fraud, filing for bankruptcy protection, or not maintaining adequate and proper insurance on the securitized asset. The actions of the sponsor could mean that the KP is held liable, which again is reason for a KP to get to know the sponsor before signing on as a partner.
Clearly, acting as a key principal is not for beginners. It entails a certain degree of experience, financial stability, and risk tolerance. Still, it can be a great way for some people to earn a profit without having to take too active a role. This allows skilled KPs to scale up and leverage their time. They can also provide a valuable service to fund managers who either do not qualify financially for a needed loan and/or who have limited operational experience.