By Debbie A. Klis and Clem G. Turner
Before any investor makes an investment, they should engage in “due diligence” meaning a period of formalized discovery to confirm assumptions, identify risks, and determine whether to move forward with their contemplated investment. It is important for investors to undertake their own reasonable amount of due diligence and outline the due diligence process to be performed before investing in a real estate project or an operating business. Through a bit of pre-investment homework, EB-5 investors can substantially reduce investment risk by gaining valuable insight into the investment opportunity and its sponsors. Whether in connection with an investment in a real estate project or an operating business, investors can avoid undesirable surprises and increase their confidence in the investment.
REAL ESTATE DUE DILIGENCE
Regardless of the property type or location, due diligence is a critical step preceding any arm’s length real estate investment. Fortunately, most investors can benefit from the due diligence undertaken already by the experienced real estate developer sponsoring the project. After selecting the property type and geographic location, the real estate developer will typically ascertain if it has sufficient and accurate information regarding the physical asset, financial performance, and prospects for the property.
DEVELOPER DUE DILIGENCE
Due diligence by seasoned real estate developers and sponsors typically involves two phases the “pre-letter of intent” due diligence and the “post-letter of intent” due diligence. The pre-letter of intent phase includes more high-level inquiries, which means the buyer is relying on public information and seller provided information rather than expending significant time or cost. If this first phase yields favorable results, the buyer or developer will often negotiate a letter of intent with the seller governing the price and material terms before commencing a more extensive due diligence process.
Once the investment is subject to a letter of intent, the due diligence involves more costly inquiries such as ordering third-party studies plus expending greater investments of time to complete a deeper analysis of the property focusing on its history, its present condition and its economic potential. This second phase of due diligence will often lead to the negotiation and execution of a purchase and sale agreement. Throughout both phases, the chief aim is to inspect the property physically, fiscally and legally to mitigate financial uncertainties and ascertain the property’s current and prospective value.
SCOPE OF DEVELOPER DUE DILIGENCE
The due diligence process will generally include a review of the property’s title, geography, topographic study, construction or rehabilitation costs, feasibility of the intended use (whether residential, hospitality, commercial, etc.), environmental studies, tax bills, seller’s financials, and zoning certificate. If the property is improved, due diligence will include a review of the property’s survey, permits, licenses, easements, existing debt and liens, leases, rent rolls, contracts, construction blueprints, engineering plans, and appraisals. The developer is looking for possible red flags with the property itself as well as its title and numerous other considerations.
Below, you will find the key subject areas of a real estate-based due diligence analysis with listed items of information typically culled and reviewed to verify the assumptions of the subject property. The applicability of each of the following subject areas and the scope of the analysis under each of these subject areas will vary substantially based on the underlying property’s particular circumstances:
Physical Inspection. The physical inspection of the property should include, as applicable:
- Area surrounding the location
- General Condition of the property
- Deferred maintenance
- Structural condition of buildings
- Condition of buildings systems (plumbing, electrical, HVAC, elevators)
- Land conditions
- Access and flood plains
- Compliance with building codes
- Compliance with fire codes
- Insurance rating issues
Leases. The analysis of leases on the property should confirm that there are no undisclosed, extraordinary obligations or unexpected liabilities by reviewing the respective property’s:
- Rent roll
- Leases and amendments and side letters
- Financial terms
- Lease terms, renewal and expansion options
- Basic rent, additional rent and escalations
- Tax and expense pass-through
- Insurance requirements
- Cancellation and recapture rights
- Subordination and non-disturbance
- Estoppel obligation
- Landlord’s unperformed obligations
- Maintenance and repair obligations
- Options to renew, expand, purchase
- Rights to sublet, assign and/or to assume
- Indemnity obligations expiration
- Environmental protections, obligations
- Disposition of security deposits
- Pending disputes
Existing Debt. Analyze existing debt to determine limitations on debt payoff including to review:
- Loan agreement, promissory note
- Deed of trust/mortgage
- Assignment of leases, rents and income
- Security agreements and guaranties
- Financing statements
- Loan commitment letter
- Review financial terms
- Unpaid principal amount
- Interest rate, interest accrued
- Amortization rate/balloon payment
- Term and payments
- Tax escrow and Insurance escrow
Easements, Permits, Licenses & Utilities. Due diligence should include review of permits, licenses, easements and access to utilities:
- Appurtenant easements
- Permits for buildings and building system
- Building permits and access permits
- Environmental permits
- Special activity permits
- Business licenses
- Water and Sewer and storm drainage
- Natural gas
- Telephone and telecommunications
Environmental Issues and Liabilities. Violation of environmental laws can lead to significant liability for cleanup, thus must review:
- Environmental permits and compliance
- Compliance with federal, state, local laws
- Pending or threatened enforcement actions
- Property’s compliance history
- State, federal or local inspections available
- Potential for toxic tort litigation
- Contamination from neighboring properties
Building and Zoning and Other Miscellaneous Regulations. Confirm that the current and intended uses of the property are lawful by confirming compliance with the following:
- Building and fire codes
- Americans with Disabilities Act (ADA)
- Review certificate of occupancy
- Compliance with master plan
- Zoning compliance
- Local master plan
- Planned Unit Development (P.U.D.)
- Annexation agreements and plat notes
- Stormwater Discharge
- Wildlife/Endangered Species/Wetlands
- Water and sewer service
Title Review, Public Record Searches, Taxes and Assessments. Due diligence efforts should include a search of a myriad of public records and obtain title commitments or abstracts to review:
- Legal description
- Compliance with survey
- Tax assessor’s map
- Title vesting
- Requirements to convey can be met
- Adverse possession, prescriptive easements
- Indemnity for mechanics liens
- Easements benefiting/burdening the land
- Covenants, conditions and restrictions
- Liens, deeds, mortgages, UCC filings
- Mechanics liens, judgement liens,
- Environmental liens
- Association dues
- Assessments title insurance
- UCC and county real property records
- Litigation and bankruptcy records
- Judgment lien records
- Clerk and recorder of county records
- Central Filing Office records
- Tax assessment records
- Sales tax payable on personal property
The foregoing in-depth review of the real estate due diligence process has a singular purpose: to show investors that by the time that a developer, sponsor or fund seeks investors, these parties should have completed a significant amount of due diligence, which investors can request copies of without cost or time expended on their part. Here are some suggestions how to proceed:
PIGGY-BACK ON COMPLETED DUE DILIGENCE
To commence the investment process, the investor receives private offering materials including a private placement memorandum (PPM); a subscription agreement (with an investor questionnaire); a partnership agreement (for limited partnerships) or operating agreement (for LLCs); and other supporting documents to disclose the offering terms and the merits of the project. These offering materials and exhibits should be reviewed carefully, and all questions should be addressed. The excitement to participate in a real estate deal should be balanced with the due diligence necessary to invest wisely.
After reviewing the offering materials for one or more projects and selecting an investment, before executing the subscription agreement and wiring funds, it is recommended to request due diligence documents from among the categories above such as:
Experience of the Developer. The experience of the developer is one of the most important factors that determine the success of a real estate project. Before investing, the investor must explore and verify the developer’s track record by asking how many deals the developer has completed in the past and does the developer have experience with the current asset class. Always search the name of the developer and members of its team on the Internet looking for experience and track record as well as past litigation, bankruptcies, liens and judgements or pending litigation for breach of contract or securities law violations.
Ownership, Financing and Title Documents. Investors should request and the developer should send title documents to prove that the property has been acquired. If not yet acquired, the developer should provide the letter of intent and land acquisition contract to show efforts to acquire the property as well as to provide the timeline to close on the purchase. Further to this effort, requesting the senior loan agreement to demonstrate that senior financing is in hand or in process provides proof of legitimacy of the project and that it will be properly funded.
Third-Party Reports and Studies. Third-party reports procured for the project by the Developer or its senior lender provide the most unbiased analysis of the property’s strengths and weaknesses. Potential reports include property valuations, appraisals, environmental site assessments, surveys, engineering studies, property condition report, feasibility studies, title reports, property condition reports and so forth, which show many things. First, the availability of these reports substantiates the legitimacy of the project (i.e., that it is an actual project). Second, these reports provide evidence of the developer’s capacity to manage a project properly because it has the funds and experience to complete a due diligence analysis properly. Last, the contents of these reports discuss the project’s viability which should be considered before investing despite the claims in the PPM and marketing materials.
Miscellaneous Additional Due Diligence. Lastly, investors should consider asking for any other of the documents set forth above under “Scope of Developer Due Diligence” that are applicable to the current project.
The good news is that none of the above steps creates any out-of-pocket cost to the investor. The only expense is time, which should be minor with endless benefit resulting. The refusal to supply requested due diligence materials to an investor should be a red flag of the fact that:
- the project is still in its infancy thus too early in the due diligence process to invest wisely;
- the developer, sponsor, or fund principals may lack sufficient experience to conduct proper due diligence thus it would be imprudent to invest; or
- the developer, sponsor, or fund is not promoting a legitimate project thus maybe it will never be a good time to invest.
Remember to always be willing to walk away from an investment if necessary.
OPERATING COMPANY DUE DILIGENCE
Due to the changes to the EB-5 program that went into effect on Nov. 21, 2019, a number of non-real estate financings have entered the EB-5 marketplace for operating businesses seeking capital to expand their companies’ operations. These businesses typically are seeking less than five EB-5 investors; however, it is important to keep in mind that just because the raise may be small, that does not mean that the risk involved with these potential investments is also small. It is important to validate the company’s claims regarding the nature of the company seeking the capital and its business model.
Business due diligence is a comprehensive investigation of a company’s business, financial position, and prospects, and the identification of the major risks associated with its business. It is largely an exercise in gathering all of the relevant information about, and confirming the accuracy and adequacy of, the disclosure included or incorporated by reference in the company’s Comprehensive Matter of Ho Business Plan and private placement memorandum.
The appropriate scope of business due diligence review varies from deal to deal depending on a number of factors, including the nature of the specific company’s business, the level of risk involved in the offering, the type of securities being offered, and the jurisdictions in which the securities are being sold. It is important that investors keep in mind that this chapter is not a definitive guide to conducting due diligence. There are no hard and fast rules. It is not possible to establish a uniform set of due diligence procedures for all transactions. The determination of how much diligence is necessary or appropriate or what constitutes a “reasonable investigation” varies depending on the specific facts and circumstances of each offering and each company.
What follows is a summary of key items that should be covered as part of an EB-5 Investor’s due diligence process, in connection with a private offering for investment in an operating business. In practice, due diligence investigations can be categorized into:
- Business diligence;
- Legal diligence; and
- Financial and accounting
BUSINESS DUE DILIGENCE
Business due diligence is undertaken to gain an in-depth knowledge (business and financial) of the company (whether in case of a direct investment or an investment through a regional center) and to assess its financial condition, liabilities, material contracts, executive staff, material risks, and the feasibility of the market in which it operates. Business diligence considers broad issues, including:
- The market in which the business operates.
- Competitors and barriers to entry.
- The business’ strengths and weaknesses.
- The business’ production, sales and marketing.
- Research and development.
- The business’ forecasts and budget.
- Future growth potential and strategy.
- Relationship with major stockholders.
- Use of proceeds from investment.
- Whether the business is pre- or post-revenue.
Business due diligence is conducted by using some or all the following investigations:
- A thorough review of the Matter of Ho compliant business plan.
- Request a meeting with senior management to ask specific questions relating to the company’s background, products and services, competitive market, research and development, sales and marketing and any other questions they have that are not covered by or supported in the business plan.
- Request a site tour of the business’ main facilities or retail locations.
- Review the business’s historical and projected financial information, preferably financial books and records prepared by an accountant or better yet, audited financials.
- Review third-party reports and studies requested from third party consultants such as feasibility studies or risk assessments related to their business that are helpful in evaluating the propositions set forth in the private placement memorandum. Potential investors should request if any such studies or reports are available.
Legal Due Diligence. The principal areas of review covered in the legal due diligence include an analysis of:
- Organization documents including capital structure, charter, and by-laws, and the rights the EB-5 Investors will have in comparison to the rights of management and other shareholders.
- Intellectual property and technology ownership, licenses, and proper filings to protect the company’s due diligence.
- Material agreements, meaning agreements that are material to the business and that pose material business or liability risks to the business. A review of the material contracts can raise various issues for consideration, including:
- Does a credit agreement or other debt instrument need to be amended before the offering can proceed?
- Will a major supply contract, for example, terminate in the near future?
- Does the business have a few specific major contracts or clients that are essential to its viability?
- Tax issues that might impact the health of the company.
- Management and employees, including compensation and benefits arrangements.
- Environmental issues.
- Whether the business is involved in any significant disputes or litigation.
- Adequate insurance coverage.
- Investigation of title to any major property and premises.
- Regulatory framework, including compliance with laws and regulations material to the business’ business.
- Issuer’s strategy, plans, and projections.
- Industry outlook and any issues specific to the business’ industry sector.
Potential investors (or their attorneys) also obtain information about a business from a variety of other sources. While a company’s website is a good starting point, investors should also scour the Internet for news items and other information on the business, its management, and its industry. Some of the more traditional sources for information about intangible assets are still likely to be important, however. For example:
- Existence of any patents and registered trademarks, including any applications that have been filed, can be found at the US Patent and Trademark Office.
- Information about real property can be found at the local land registry department.
In addition, company counsel may consider in certain instances ordering searches for the following items pertaining to a company’s debt and insolvency:
- Bankruptcy filings.
- UCC filings.
- Federal tax, state tax, and judgment liens by or against the business and its subsidiaries.
These searches can be ordered through a corporate service company, which coordinates and conducts searches of the public records of each applicable state and city or other locality for evidence of any bankruptcy filings or creditor or tax liens. For example, lien searches should be ordered for the state of incorporation of the business and its subsidiaries. Other public sources of information about a business include:
- Any public regulatory filings by the business.
- Press releases by the business and its subsidiaries and other affiliates.
- Analyst and rating-agency reports on the business or its industry sector.
- Other third-party media coverage of the business or its industry sector.
However, a substantial amount of the information that must be reviewed can only be obtained from the business itself. Interviews with the business’ management can provide valuable information. Much of the important information about a business and its business may be poorly documented or not documented at all. Management time is a valuable resource, so questions should be prepared in advance and should be limited to information that is not available elsewhere. In addition, consider a site visit to observe the business’ facilities firsthand, depending on the specific business. Are the buildings and equipment well maintained? Is there any evidence of environmental problems? Are their customers?
Financial and Accounting Due Diligence. Financial and accounting due diligence is typically led by accountants and is conducted with members of the business’ accounting, treasury, and finance departments as well as its outside auditors. Financial due diligence typically includes reviewing the following items:
- Historical and pro forma financial statements including any material changes from the previous year’s reporting period and significant items in the financial statements (such as restatements, impairments, unusual transactions, acquisitions, derivatives and hedging, reserves, off-balance sheet arrangements, or under-recorded liabilities).
- The business’ projections, budgets, and any long-term plans.
- Outstanding debt securities, existing credit facilities, and any other financing arrangements, and a determination of whether the offering violates any of the business’ existing financial covenants.
- Issuer’s current financial condition and conditions in its industry.
- Research reports by other analysts.
- Historical trends in the industry.
- The business’ prospects. This involves comparison of expectations against future trends based on factors such as the budget and cash flow projections.
- The industry condition and competition. Who are the business’ major customers and what are the major contracts?
- The use of proceeds. How exactly will they be used?
- Capital expenditure estimates.
Red Flags in Financial Statements. Potential investors should be conscious of any “red flags” in the financial statements that may indicate that the financial statements should not be relied on. Some examples of red flags include:
- Changes in internal credit risk assessments.
- Goodwill/asset impairments.
- Boosting income with unusual or one-time gains.
- Shifting current expenses to a later period or shifting future revenues to the current period.
- A pattern of indebtedness to the business’ executives by members of the underwriting syndicate.
- Off-balance sheet entities.
- Many backlog orders from customers.
- Management claims that information key to a material transaction is unavailable.
- Backdating of a sales contract to permit timely revenue recognition.
- A financial press article questioning a business’ aggressive accounting.
- The booking of significant consignment sales at the end of a quarter.
- Guaranteed sales practices allowing customers to exchange or return non-defective merchandise.
- Complex organizational structures without any apparent business purpose.
- Lagging systems and controls procedures during a period of rapid growth.
- Significant accounts or operations in tax haven jurisdictions.
Again, the refusal to supply requested due diligence materials to an investor should be a red flag not to proceed.
IMMIGRATION RELATED DUE DILIGENCE
Because the investor is making an investment decision with an immigration motive, potential EB-5 investors should evaluate the likelihood that the investment will accomplish their immigration goals. Potential EB-5 investors may rely on their immigration counsel for this analysis that should generally include the following:
Targeted Employment Area
In order to confirm that investors are investing the appropriate amount, they must know whether the business receiving the investment is in a Targeted Employment Area (TEA). If the investment is in a TEA, the minimum investment is $800,000 and if not, the minimum investment is $1,050,000.
The business should provide all EB-5 investors with a letter from an EB-5 expert that the census tract in which the business is located is a TEA, or adjacent to a TEA and the weighted average of the unemployment rates in both the TEA and adjacent census tracts is greater than 150% of the national unemployment average. Alternatively, the business could be deploying the EB-5 investor’s capital in a rural area which also requires the lower $800,000 minimum investment amount. EB-5 investors should not consider making a $800,000 investment without evidence that the funds will be deployed in a TEA.
Each EB-5 investor’s capital contribution must be deployed to create ten jobs in a three- to five-year period. Investors should conduct business due diligence, as described above to satisfy themselves that the investment is reasonably likely to generate this required number of jobs. Investors should seek to invest in projects that expect to result in more than the required 10 jobs per investor, and, investors should not consider a project that claims to produce fewer than 12 jobs per investor.
Projects conducted through a regional center must provide a job creation analysis, prepared by a qualified EB-5 economist. In the event a job creation analysis has been provided, it should be reviewed by qualified securities or immigration attorneys with experience in EB-5 and the assumptions and calculation set forth in the analysis should be verified by the investor. Investments into operating businesses and other smaller investments may not rely on a job creation analysis. In these instances, it is imperative that the business’ job creation strategy be clear and reasonable. Business due diligence should be conducted to verify, to the extent possible, the business’ job creation claims.
Regional Center Due Diligence
If the EB-5 investment occurs through a USCIS-approved regional center, the investor’s fate is in the regional center’s hands as well as those of the developer. Therefore, investors should visit the approved regional center page of USCIS website to confirm the regional center’s designation and review the regional center’s website regarding its experience and background, and be on look-out for any red flags about prior deals and regulatory inquiries.
The EB-5 program rules require that an EB-5 investors capital must remain “at risk” for the duration of the investor’s period of conditional residency. The conditional residency period is the approximately two-year period that commences when the investor enters the United States and ends upon the filing of the investor’s I-829 Petition. Initially, investors want to confirm through their regular due diligence review, that the project into which their capital is deployed is a stable one, that will survive and thrive beyond their conditional residency. However, in both real estate and operating businesses, exit strategies are in place and an eventual liquidation of the investor’s investment is contemplated. Investors must be confident that a redeployment solution or strategy exists, so that their investment can be redeployed into another “at-risk” project if their conditional residency period has not ended.
However, not all redeployment solutions or strategies are created equally. In assessing a business’ redeployment strategy, investors should consider:
- Will their investment be redeployed into a vehicle that will result in a favorable immigration result?
- Will their investment be redeployed into a project comparable to the business?
- Will the investment be redeployed into a project controlled by the business, or by an unfamiliar management team?
- Will their investment be redeployed into a risky project?
- What input, if any, will investors have in reinvestment such as an opt-out right or approval right?
- Can the investors consent to the entity that will receive their redeployed funds? (Investors should understand that a right to consent is not typically provided.)
- Will they be able to achieve a refund of their capital shortly after their conditional residency ends, or is their capital illiquid and locked into the redeployed project?
- What is the anticipated liquidity date of the redeployed project?
- Does the redeployed investment carry the same return or profits share, or will the investors enjoy a larger return in exchange for their capital being redeployed?
- Do they have enough information to evaluate a business’ redeployment strategy?
The foregoing factors apply equally in the regional center context and regarding direct investments and the performance of which would reduce immigration risk substantially.
Due diligence requires time and attention to detail that will save investors from costly mistakes. Comprehensive due diligence before investing is a risk management strategy that should be undertaken by all serious investors. While nothing is entirely certain in investing, due diligence can provide a much higher level of assurance. The practice of due diligence before committing to an investment mostly derives from common sense and, in some cases, a legal obligation. Nevertheless, there are studies indicating a positive correlation between the extent of the investor’s due diligence and the investment’s subsequent performance. The correlation appears to span different types of investment scenarios, and it strongly supports the case for due diligence.
Read about the next step in the EB-5 process: Which EB-5 Service Providers Can Help Me Prepare?