By Catherine DeBono Holmes
Marketing agents can protect themselves and their investors by conducting due diligence on every EB-5 offering in which they participate. Marketing agents should perform the same types of due diligence as a lender or securities broker-dealer in the United States would conduct for an offering being sold in the United States. A due diligence review is intended to provide verification of the statements made in the EB-5 offering private placement memorandum, and to provide essential information regarding the background of the project sponsors, the quality of the project being financed, and the estimated times for the project to be completed and to commence making distributions to the investors.
Due diligence of every EB-5 project should take into consideration the type of industry being financed. The quality of a project will, in part, depend upon the characteristics of the business being financed and the market to be served by that business. In order to judge the quality of a hotel project being financed with EB-5 funds, a marketing agent should seek information regarding the local hotel market, the background of the hotel developer and information regarding the hotel brand and hotel manager intended to operate the hotel. If EB-5 financing is being raised through an EB-5 Regional Center that is independent of the project owner, the marketing agent can ask to see copies of the due diligence report prepared by the EB-5 Regional Center. If the regional center’s report includes an analysis by an independent third party of the quality of the project, the marketing agent may not need to engage its own expert to do such an analysis. The marketing agent should always conduct its own due diligence review of all of the project related documents, to confirm that all agreements referred to in the PPM have been executed and are accurately described in the offering documents. If the EB-5 Regional Center is affiliated with the project owner, the lead EB-5 marketing agent should require that a third party hotel expert conduct an independent due diligence review of the project, and prepare a due diligence report regarding the project and the project owners. The cost of such an independent review and report should be included in the costs charged to the hotel project developer. The EB-5 marketing agent or independent EB-5 Regional Center should hire the independent expert directly, rather than have the independent expert engaged by the project owner, in order to ensure that the expert is primarily concerned for the interests of the regional center, EB-5 marketing agent and the investors.
Due diligence for a hotel development project should include the following:
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A feasibility study for the development of the hotel. In the United States, a hotel developer will usually obtain a feasibility study that analyzes the local hotel market supply and demand to determine if a new hotel is needed for that market, and if so, the best brands and quality/price level for that hotel. Hotel feasibility studies are often conducted by an independent hotel consultant, or by a regional hotel consultant. The study will include occupancy rates and average daily rates for all of the existing hotels in the local market, using data provided by Smith Travel Research (also known as “STAR Reports”) and an analysis of the number, size and type of other new hotels planned to be built in that market. The study will also include projections of the occupancy rates, average daily rates, gross revenues, expenses and net profits of the proposed hotel. Sometimes a hotel owner will obtain a feasibility study directly from the hotel brand, and that study will include the same types of information as an independent study. The feasibility study will show whether the proposed hotel has a good chance of operating successfully after it is built.
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A written agreement with the hotel brand. If the hotel will be operated under the name of one of the major hotel brands, such as Hilton, Hyatt, IHG, Marriott, Starwood or Wyndham, the hotel owner will be required to enter into a hotel franchise agreement or a hotel management agreement with the hotel brand. It is common for the hotel brand to first sign a Term Sheet or a Memorandum of Understanding (“MOU”) or Letter of Intent (“LOI”) with the hotel developer, before preparing a final agreement. The Term Sheet, MOU or Letter is usually not binding on either the hotel brand or the hotel owner, and it usually expires after a specified period of time if a binding agreement is not signed before the expiration date. The due diligence reviewer should ask to see a copy of the signed hotel franchise agreement or hotel management agreement, or the Term Sheet, MOU or LOI. The reviewer could also ask for a contact person at the hotel brand to confirm that the hotel brand expects to have the hotel operating under the hotel brand disclosed in the private placement memorandum (“PPM“) for the EB-5 offering.
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A written agreement with the hotel operator. Many hotels in the United States, especially larger hotels, are operated either by the hotel brand, or by an independent third party hotel operator. The due diligence reviewer should ask who the hotel operator will be, and ask to see the Term Sheet, MOU, LOI or written agreement between the hotel owner and the hotel operator. A hotel owner may not have an agreement with a hotel operator in the early stages of hotel development, but the reviewer should ask what operator the hotel owner intends to use, and seek confirmation that the hotel operator is in discussions with the hotel owner. The reviewer should ask for background information regarding the hotel operator, including what other hotels it operates, how long it has been in the business and the background of its owners.
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A deed or purchase agreement showing that the hotel owner owns the property or has a legal right to acquire the property, and confirmation that the property is zoned for hotel use. As with any other real estate development project, the due diligence reviewer should require verification that the hotel owner actually owns the property or has a right to acquire the property. If the hotel owner does not yet own the property, the due diligence review should include information regarding the conditions required for the hotel owner to acquire the property. The reviewer should also request confirmation that the local area is zoned for hotel use and that the size of the building conforms to the local building requirements.
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Evidence of sufficient financing to build the hotel and finance pre-opening expenses and working capital. The hotel owner should provide a detailed description of the sources of capital required to build the hotel, and a detailed capital budget for construction of the hotel, pre-opening expenses and working capital. If a portion of the capital is to be provided by a senior construction loan, the owner should provide a copy of the loan agreement or Term Sheet with the senior lender.
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If the hotel will be financed with a senior construction loan and EB-5 financing, evidence that the senior lender will permit the EB-5 financing to be secured by the collateral described in the PPM. Senior lenders almost always impose restrictions on the terms of the loan or preferred equity investment that may be made with EB-5 financing, and it is critical that the marketing agent be certain that the proposed terms of the EB-5 financing described in the PPM will be permitted by the senior lender. For example, most senior construction lenders will not permit an EB-5 loan to be secured by a subordinated mortgage on the hotel property. If the PPM states that an EB-5 loan will be secured by a subordinated mortgage, and it is later discovered that the senior lender will not allow such a mortgage, the EB-5 issuer will need to disclose a material change in the terms offered to the investors, and will be required to obtain the investors’ consent to the change. This could cause the marketing agent to lose investors and damage the reputation of the marketing agent.
Marketing agents should have a due diligence report that identifies the documents reviewed and interviews conducted. If the regional center or a third party conducts the due diligence review, the marketing agent should ask to see a copy of the due diligence report and the material documents identified in the report. If the marketing agent conducts its own due diligence, it should prepare its own report with the same information. If a hotel owner is unable to provide evidence of any important facts stated in the PPM or relevant to a determination of the quality of the hotel project, the marketing agent should consider this a red flag and not proceed until the required information is provided. By requiring hotel owners to provide verification of the material information necessary to evaluate a hotel project, marketing agents will protect themselves and their investors, and will improve the quality of the entire EB-5 market.
Catherine DeBono Holmes
Catherine DeBono Holmes is the chair of the investment capital law group at Jeffer Mangels Butler & Mitchell LLP in Los Angeles, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S.
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