by Jon Baker
There is a growing discussion about liquidity, the ability of EB-5 investors to sell out of their qualifying investment, both inside and outside of the EB-5 market. This discussion is in response to the maturing of the market both in terms of the number of visas issued and, maybe more importantly, in the amount of money raised. With success comes scrutiny and the EB-5 market is no exception as competing capital markets and the securities regulatory bodies such as the U.S. Securities and Exchange Commission (the “SEC”) and the Financial Industry Regulatory Authority (“FINRA”) begin to take notice. Some issues relating to the securities nature of the EB-5 capital stack and others related to the evolution of the EB-5 market as a whole are being addressed through legislation proposed by Senators Grassley and Leahy, as well as Congressmen Polis and Amodei. Internally the various stakeholders in the EB-5 market are addressing these issues through self-regulation. But questions about how retrogression, processing backlogs or even pending changes in interest rates would impact the ability of projects to execute on their exit strategies and how that would affect the return of investor funds are not being discussed.
Liquidity in the EB-5 Context
In a recent discussion about liquidity with David Hirson of David Hirson & Partners, LLP, Mr. Hirson indicated that the “burgeoning EB-5 market” could run into liquidity issues “when a promissory note comes due and the project can not pay,” and that he himself had already witnessed such issues. Each of the participants in the EB-5 process already has a stake in liquidity, although they may not always think in such terms. For regional centers and project sponsors, a well-developed secondary liquidity market would allow them to sell more realistic project timelines without over promising on how a long an investor would expect to have their money locked-up. For investors, access to liquidity would help when life events change how long an investor can wait for a project to go full-cycle. Because the EB-5 marketplace is so young and just beginning to hit its stride, each of the EB-5 market stakeholders, regional centers, project sponsors, immigration lawyers and agents not only has a say in how liquidity plays out with respect to EB-5 offerings, but more importantly, they also have the opportunity to create a liquidity market the right way.
The Need for a Secondary EB-5 Market
Meanwhile, unbeknownst to many in the EB-5 marketplace, EB-5 investors are already seeking liquidity in the secondary markets set up to service other real-estate-based illiquid securities, such as limited partnerships and non-traded real estate investment trust (“REITS”). While these markets can successfully provide liquidity for some investors, they are not familiar with the complex ins-and-outs of EB-5 investments, and have no experience dealing with the cultural issues associated with working with foreign investors. Even so, we certainly can learn from these markets by taking the best practices they have taken years to establish, and using those practices to fold in the more complex requirements of the EB-5 immigration process.
To say that the EB-5 process is complex is an understatement. The process is also often fraught with seemingly competing mandates. On the one hand, the United States Citizenship and Immigration Services requires foreign investor’s money to be at risk with no guarantee of returns on investment. On the other hand, however, the SEC and FINRA are looking at EB-5 offerings and scrutinizing them for compliance with traditional securities issues such as Know Your Customer, anti-money laundering, suitability, and best execution and policies and procedures that are in place to protect investors. So far, the consensus is that these mandates can co-exist while an EB-5 investor is moving through the immigration process. But what happens after an investor receives an I-829 approval, which effectively satisfies the immigration aspect of their investment? Or what happens when an initial five to six year timeline extends into seven or ten years because of changes in the real estate market? After an investor receives an I-829 approval, an investment made to satisfy their needs from an immigration perspective, may no longer be consistent with their investment needs.
The question of aligning an investor’s needs with access to liquidity is a common and often repeated issue in the various markets mentioned above. A common misconception is that sponsor’s and investor’s needs will not change over the life span of the EB-5 program. That is scarcely the case with any investment especially one that is illiquid. EB-5 investors may have different needs after receiving their I-829 approval while, at the same time, project sponsors might have changing needs based on shifting timelines driven by market conditions, like construction delays or for EB-5 specific issues like retrogression.
Other equity markets have experiences these types of delays. For example changes in legislation severely hurt limited partnerships in the early eighties essentially removing the tax incentive that enticed investors in the first place and leaving them with an investment that no longer matched their investment needs. The crash of 2009 added several years to the life span of many REITs because the underlying assets were devalued to such a point that they could no longer be sold to meet liquidity needs. In The Stanger Report, A Guide to DPP, NT-REIT & NT-BDC Investing, a journal published by RA Stanger & Co., Inc. that monitors trading activity for the illiquid alternatives markets, there are limited partnerships that are still trading 20 years into their life cycle. Some non-traded REITs are in their 10th year for offerings that were sold as five to six year holds. Likewise there are EB-5 projects that are into their second one-year optional extension with some equity-based projects well past their original liquidity projections.
A Solution for EB-5 Investors
That being said most investors in limited partnerships, REITs, and other illiquid real estate investments are not seeking liquidity because they are dissatisfied with the investment. They are instead trying to address life events that have made waiting no longer a viable or best option. The majority of these life events fall into what are called the 3Ds: death, disability and divorce. A fourth, disaster, is often added for good measure. Statistics provided by Central Trade & Transfer, LLC , an online liquidity provider for the alternative investments space, suggest that over 90 percent of requests for liquidity fall into one of these four categories. Medical expenses, college funds for children or grandchildren, and foreclosure prevention are also often listed as reasons for selling. Anecdotal evidence suggests that at any given time, six percent of investors in illiquid investments need liquidity for reasons similar to those listed above. It stands to reason that post-I-829 approval EB-5 investors would experience the same needs at some point, too.
One of the first investors to try and sell their EB-5 qualifying investment by accessing liquidity options that were normally reserved for the REIT secondary market indicated that they were “ecstatic” at having received their permanent green cards but were now in a position that they could no longer wait for the project to go full-cycle. The brokered transaction between them and a qualified buyer allowed them to receive cash for their investment and to respond to life events that were dictating a change in their plans, part of which was using the proceeds to buy a house and thus bring closure to their immigration journey. This family’s experience is a prime example of how an EB-5 investment after doing what it was intended to do, secure green cards, became a burden that became heaver the longer the liquidity expectations went unmet.
A Secondary Market Signals the Maturation of the Industry
As life events put pressure on investors, investors put pressure on the sponsors. When sponsors are unable to provide liquidity through their own channels, secondary liquidity options provide an important pressure-release valve. Although not all investors who need liquidity are “needy”, the ones who are can be a drain on sponsor resources and, if not taken care of, can affect other investors. Allowing a needy investor to gracefully exit restores balance and harmony to the long-term goals of the project and keeps the frustrations of one investor from bleeding over to others. Allowing an EB-5 investor to exit the project on their own terms can provide similar benefits to EB-5 project sponsors.
A disgruntled investor is oftentimes not the biggest challenge facing an illiquid real estate market. The amount of money raised in the EB-5 market over the last couple years has brought it to the attention of what are known as mini tender firms, colloquially referred to as “sharks” or “vultures.” These firms prey on individual investors by directly soliciting their shares, through mini tender offers, tender offers that are small enough that they do not need to be registered with the SEC, oftentimes at pennies on the dollar. Mini tender firms may also use language and arguments that undermine the sponsor such as suggesting that the project is under-performing or that project sponsors may arbitrarily extend the life of the project. Sponsors, in turn, spend valuable time, energy and effort responding to unsolicited tender offers – resources that could be better spent in other areas. For 2014, it is estimated that some non-traded REIT investors lost an additional 50 percent of their equity by accepting a mini-tender offers instead of selling at fair market prices established through the secondary liquidity market. Although there is no indication that there have been tender offers directly soliciting EB-5 projects yet, it is only a matter of time, as both the amount of money being raised in the market and the time to liquidity increase.
Challenges for the EB-5 Secondary Market
Liquidity can be a touchy subject, especially for regional centers and project sponsors, but it does not have to be. As established above, an effective liquidity market does not only benefit investors. It is a substantial benefit to sponsors, too. And it is not just equity-based EB-5 sponsors who may need access to a secondary liquidity market. In the same discussion about liquidity with Mr. Hirson mentioned above he suggested that even loan-based regional centers could find it difficult to provide liquidity if the job creating entities (“JCEs”) ran into issues that delayed repayment of loans to the new commercial enterprises and that there were several JCEs who have exercised their options to add additional years to their loans and, subsequently, liquidity to their investors. Recently, there have been several success stories of loan-based projects, like CMB, returning money to investors, but this still remains a small portion of the total money raised to date.
Because sponsors’ need to continue raising money they must walk a fine line between servicing their current investors while at the same time funding subsequent offerings. The fear being that low secondary market prices may deter future investors from investing in the sponsor’s future projects. In the EB-5 space this is even more critical because investors tend to invest in regional centers that have a reputation for not only successfully guiding investors through the immigration process, but also for returning money. A well-established liquidity market allows sponsors to sell a more realistic timeline while at the same time letting investors confronted with unexpected life events get the liquidity they need.
The best liquidity markets are the ones that are allowed to arrive at “fair market” pricing without the undue influence of any of the individual stakeholders, while at the same time working closely with them. This independence allows all the parties in an EB-5 transaction: agents, lawyers, regional centers, project sponsors, investors and buyers to participate in the market without creating conflicts of interest that could damage reputations. One of the biggest conflicts is pricing, and how it was reached. Transactions that cannot clearly explain how they arrived at pricing will not withstand scrutiny going forward. The more investors list their investments the more buyers will participate and the more buyers participate the better the pricing. But getting investors and buyers to buy into the market requires all the stakeholders to participate.
In order for an EB-5 secondary market to succeed and to arrive at “fair market” pricing it needs the active participation of all stakeholders. It needs to be a place where savvy EB-5 investors can list their investments for sale on an open and transparent platform, where they can see pricing histories and they can monitor the progress of their sale. It needs to be a place where buyers can compete for investments knowing that they are actually competing for investments, and thus are willing to raise their prices. It needs to be a place that sponsors can claim, at arms length, that they have no influence over pricing, while at the same time asserting that the pricing does not reflect the reality of how their projects are doing. It needs to be a place where agents and immigration lawyers can show investors that are just starting the process that after receiving their I-829 approval there are viable alternatives when life events get in the way of waiting for their EB-5 projects to go full-cycle. It needs to be a market that becomes and integral part of the EB-5 success story, and when it does it will be an open and transparent “fair market” liquidity option where all parties benefit.