The following story appeared in Investment News on 8/7/11.
After avoiding the pitfalls of disastrous Regulation D deals over the past decade, Commonwealth Financial Network and LPL Financial, LLC are contending with potential fallout from a real estate private placement that faces pressure from its creditors.
Financial advisers from both Commonwealth and LPL sold the fund in question, the Laeroc 2005-2006 Income Fund LP, which wants to raise another $12 million to $15 million to pay off — at a steep discount — $49 million of debt.
Laeroc Partners Inc., a real estate investment firm that focuses on property in Los Angeles and other parts of Southern California, in June issued a “cash call” notice to investors who bought the Laeroc 2005-2006 Income Fund.
The fund’s lenders have said that they will foreclose on one of its holdings, the Country Club Plaza shopping center in Sacramento, Calif., by the end of the year if they can’t raise enough money, according to the notice. The Laeroc fund has paid more than $180 million to buy eight properties and owes $105 million in mortgage debt.
It isn’t clear how much of the Laeroc 2005-2006 Income Fund was sold by Commonwealth and LPL brokers. Plaintiff’s attorneys said that they have received a handful of calls from clients who bought the product, but no arbitration complaints have been filed against either Commonwealth or LPL.
Dozens of small to midsize independent broker-dealers became ensnared in the fallout from Reg D private placements after the Securities and Exchange Commission charged two sponsors, Medical Capital Holdings Inc. and Provident Royalties LLC, with fraud in 2009.
For the most part, leading independent firms such as Commonwealth and LPL sidestepped the toxic products, of which brokers sold $2.7 billion. About half of investors’ principal was wiped out in those two deals, and the legal costs of arbitration claims and settlements have pushed dozens of independent broker-dealers to close or be sold.
Industry executives noted that real estate deals of various stripes, including nontraded real estate investment trusts that raised money and bought properties between 2006 and 2009, are struggling.
A cash call on a private real estate offering clearly is not a good sign, said Philip Aidikoff, a plaintiff’s attorney who has taken information from one LPL client who bought $250,000 of the Laeroc 2005-2006 Income Fund.
“When you see a cash call in a private real estate deal like this, the patient is on life support. It’s a very bad piece of information,” Mr. Aidikoff said.
“I can’t recall when a cash call solved the problem. It only delays the inevitable,” Mr. Aidikoff said.
Laeroc Partners Inc. has at least $650 million in assets and has created 14 funds, according to its website. Founded in Manhattan Beach, Calif., in 1986, at first it was a workout specialist for distressed real estate.
In 1993, the company began offering income and equity funds, according to the website.
Kim Benjamin, president of Laeroc Partners, didn’t return messages left last week seeking comment.
John Rooney, managing principal with Commonwealth, declined to comment, except to confirm that the firm’s advisers sold the fund.
Joseph Kuo, a spokesman for LPL, said that the firm’s reps and clients “have successfully avoided the most difficult product-related issues associated with the financial crisis.”
“The challenges currently faced by the Laeroc fund are driven by market forces resulting from the 2008 credit crisis and the stress to the commercial-real-estate markets from the ensuing recession,” he said, adding that LPL will keep a close watch as Laeroc works to address the issue.
The property that has spurred the cash call is Country Club Plaza, a mall in Sacramento, Calif., that is almost half empty. According to the Sacramento Business Journal, Laeroc defaulted on its $49 million loan in November 2009.
Investors had until July 30 to respond to Laeroc’s cash call. It isn’t known whether the attempt to raise more funds was successful.
If Laeroc’s cash call was a winner, it would create a new ownership structure with three levels of investors, according to the notice.
Clients who pony up more money will go to the front of the line for any payment and become “A preferred” investors. If investors vote to approve the changes to the partnership but give no more money, one-third of their investment gains will be given “B priority” status, meaning that they get paid after the “A preferred” investors.
The remaining two-thirds of their money will be reclassified as a “C unit holder.”
That level is for people who don’t vote to change the fund structure or give it more money. They get paid last, if at all, according to the notice.
Such a structure is typical when restructuring a cash call, industry executives and analysts said.
“Laeroc made its reputation in assisting and restructuring troubled limited partnerships,” said Bryan Mick, a due diligence analyst for private investments. “Now they are the restructuree.”
Investors have a number of questions to answer before deciding to invest further in a fund that has issued a cash call, said Gordon Yale, principal of the Yale Group Inc., a forensic accounting firm. He also serves as a special witness in securities disputes.
“You can’t generalize, but it needs to be evaluated in a very serious way,” Mr. Yale said.
“First, investors must ask, “How much equity will I lose if the property is foreclosed upon versus how much additional equity am I required to put at risk?’ Then ask, “Why is the property cash flow negative, and is it likely to change?’” Mr. Yale said.
Other points of information, such as economic and real estate market conditions and whether they are likely to improve, also are important, he said.
Investors also must know when the leases of current tenants expire and whether they are likely to renew, and whether the physical condition of the property has deteriorated because of deferred maintenance, Mr. Yale said.
“The danger of a capital call is an investor throwing good money after bad,” he said. “If the net-operating income of the property, that is, rental income less direct expenses, exclusive of debt service and investor distributions, is not sufficient to cover mortgage payments, then investors must pay attention to the discussed considerations.”