Which is the Best Lending Model for You?

In our industry, there’s two main lending models that I see frequently: One is called the Direct Placement model. It also has a couple other names such as “trust deed investment”, “co-lending” or “fractionalized notes”. There is also the Fund model.

Often times, lenders have a hard time knowing which is the best lending model for them. Not to get confused, and for the purpose of this article, we’ll just refer to them as “Direct Placement” vs. “Fund”. If you go by a different term or you call it something else, realize that that’s what I’m referring to.

Pros and Cons of the Direct Placement Model

First and foremost, let’s go over the Direct Placement model and explain the pros and cons. This is the model that I see most frequently used. That’s not necessarily a good or a bad thing. In most cases, it’s the first natural model and place that lenders start when they’re first getting started. I have noticed that this is the natural progression of lenders – to start with this method.

With direct placement, many people don’t realize what they’re doing could be classified as illegal. I don’t say that to scare you or to try and convince you to pick one way or another but I see a lot of people who use the Direct Placement model and they’re just fine. They’ve been doing it for 20 years and it hasn’t been an issue.

While I was starting my lending company, I talked to four or five different attorneys. A lot of people carve up their notes and include three or four investors on a single loan. What a lot of people don’t realize is this may be breaking the law. You’re technically making a security and that security falls under securities laws, which typically means that you’re not doing things legally.

Do I think you’re going to run into any issues?

No, I don’t.

I think the SEC is trying to crack down on people who are fraudulent.

By definition, a security is when passive investors are making returns based off of your efforts. When I say yours, I mean the person putting the deal together, the general partner, or however you want to refer to it. If they’re making returns off of your efforts, that is classified as a security.

As far as the direct placement model goes, I do see some pros with it and mainly from the investor side of things. For example, let’s say we have a deal that we’re going to fund. It is $100,000 and you have three different investors. Let’s say you invest in it too and you divide it four ways. Each person brings $25,000 to the table. One of the pros that I see is it requires a lot of face-to-face interaction with your investors.

Investor relations is a HUGE part of this business. If you have a deal on the table and you have to call up your investors, that’s actually a really good thing.

Investors want to be informed. They want to be in the know and they want to know what’s going on. With the direct placement model, it requires a lot of face time. Speaking with your investors is crucial. You can tell them about upcoming deals and if they want to invest or not. You can also tell them that their deal is completely paying off and their funds should be returning to them shortly. It’s really great.

Investors want to be informed. They want to be in the know and they want to know what’s going on.

As you’re starting to build capital, that’s one way to do it. Having your investors trust you. That is massive in this business and I don’t think that it’s talked about enough.

Aside from that, every other aspect of the direct placement model seems kind of like a pain in the ass to me.

I’ve had numerous cases where I get to the funding table and I haven’t received a wire from the investor yet. That makes me as a lender look bad because now the borrower can’t close because I don’t have the funds from the investors. Obviously there’s ways to mitigate this.

For example, you can take the funds and give the investors a deadline. This way, you can make sure that you have the funds. Worst case scenario, you can table fund it and you can fund it with your own funds. Then, you can reimburse yourself once you get the funds from the investor. There’s ways around it.

Personally, I don’t like that model. I don’t like being dependent on other people. I want to know if I can fund this loan. Yes or no. I want to mitigate all the moving pieces in the background that could potentially jeopardize the deal.

Pros and Cons of the Fund Model

Fast forward to what we are currently doing. We have a fund for our business. It is the best lending model for what we need.

If you are a little intimidated by setting up a fund, or if you think it’s too expensive, it’s actually not. It’s very simple. I would encourage you to go and check out the blog post we posted two weeks ago. It talked about how you can set up a fund yourself. It’s really quite easy.

The benefits of the fund model that I see are like I mentioned before. It is where you’re doing everything by the book. You’re doing everything according to securities laws; you have a private placement memorandum, your subscription agreement, operating agreements, investor questionnaires, etc. I notice many direct placement lenders that have some of these elements, but not all of them. I like this model because, like I said before, you’re doing things by the book. It’s legal and it’s not as difficult or expensive as you might think.

I like this model because, like I said before, you’re doing things by the book. It’s legal and it’s not as difficult or expensive as you might think.

Another benefit to having a fund is you retain the capital from the investors. Right off the bat, you can know for a fact if you have the funds or not to fund a deal. I love that.

Not having to be dependent on an investor sending me funds or wiring me funds back and forth is amazing. I can look at the account, see how much money we can lend out, and know whether or not to help borrowers fund their deals.

There’s not going to be any hiccups. There’s not going to be issues at the closing table. I know I can perform for the borrower, which obviously helps me look better because I’m not the one who didn’t pull through at the last minute. In those unfortunate instances, even though it’s an investor that has messed it up for you, YOU are the one who’s going to take the heat.

At that moment, unfortunately, it’s your company’s reputation that’s on the line.

One of the downsides of the fund model is the investor relations are not as strong. It is definitely more difficult to keep your investors informed solely because you’re less incentivized to update them regularly. That’s not to say you can’t. In fact, I think you absolutely should.

I have noticed that in the past when investors send me funds, sometimes I forget to give them updates. The funds are there working, doing what they do, and it’s easy to forget. I’m not calling up my investors regularly for capital calls and updates. That’s something I’ve actively had to work on and set calendar reminders for myself. Simple reminders that tell me to shoot an investor an email, give them a call, or send them a report.

Again, this practice of regularly updating investors is not difficult or hard. It’s something you should be doing in your business anyway. It is just one small aspect of the fund model that I don’t particularly love.

Regardless, I do love the fund model. It’s significantly better and I sleep better at night knowing that I’m doing everything according to the book and the laws. There aren’t going to be issues with the SEC or with me potentially doing something that’s not 100% accurate. I also love the convenience of having the capital on hand to deploy as I see fit.

In the debate of direct placement versus the fund model, I highly recommend the fund model. I started using the direct placement model at first, but I quickly came across flaws in that model. Ultimately, we moved to the fund model and it’s been significantly better for us.

Again, if you’re intimidated with setting up a fund, go check out the blog we uploaded 2 weeks ago, I highly recommend it. It’s really simple.

If you have any questions on which is the best lending model for you, feel free to reach out to me directly. I’d be happy to go over anything in further detail with you! Drop us a note if you have any questions!