The Craze That's Sweeping Real Estate—and Why It's Riskier Than You Think
It's a story I've seen play out too many times. A new investor, brimming with excitement and motivation when they return from a flashy conference held by a big name real estate guru where they're told that starting a fund is the golden ticket to financial freedom. The pitch is irresistible: "Set up an LLC, raise private capital, and watch the money roll in."But here's the truth no one tells you: starting a fund isn't just about raising money. It's about navigating the legal structure, managing that money safely, legally, and responsibly. And without the right preparation, the consequences can be devastating—not just for you, but for the people who trust you with their hard-earned capital.I've been in the trenches of private lending, and I've seen firsthand what happens when due diligence is treated as an afterthought. It's not just about losing money—it's about losing trust, reputation, and the opportunity to build something sustainable.
The Allure of Funds
Private debt funds have exploded in popularity, especially in the real estate world. They offer a way to pool capital from multiple investors to fund projects, often with the promise of high returns. Pooling funds is often selling a security which means one should consult with a securities attorney before getting any bright ideas. Fund of Funds, Debt Funds, Friends and Family, Limited Partnerships, the list of structures goes on. For real estate investors, they can seem like the perfect solution: a way to streamline funding for deals without the hassle of securing traditional financing.
But here’s the catch: managing a private debt fund is far more complex than it looks. It’s not just about finding deals and collecting interest payments. It’s about navigating a labyrinth of legal, financial, and operational challenges—any one of which can sink your fund if you’re not prepared.
The Risks No One Talks About
Let’s break down some of the most common risks associated with private debt funds:
Legal and Regulatory Pitfalls
Many aspiring fund managers don’t realize that private debt funds operate in a highly regulated environment. From securities laws to investor disclosures, the legal requirements are extensive—and failing to comply can lead to hefty fines or even criminal charges. It’s not enough to have an attorney draft your documents; you need someone who will guide you through the entire process and ensure you’re operating within the law.Credit Risk
Every loan you make carries the risk that the borrower won’t repay. Unfortunately, most asset-based lenders do not seriously assess creditworthiness. If a borrower struggles to pay their credit card bills on time, what makes you think they will prioritize your loan? Without a rigorous process for assessing creditworthiness, you’re essentially gambling with your investors’ money. And when a borrower defaults, it’s not just your fund’s bottom line that takes a hit—it’s your reputation.Cash Drag
Holding cash reserves can lead to performance drag, where uninvested capital negatively impacts returns. Managing cash drag effectively requires clear communication with investors about the reasons for holding cash and the strategies in place to deploy it efficiently. Keeping investors informed and engaged during periods when funds aren’t deployed is crucial for maintaining their confidence and satisfaction.Frozen Funds
Another risk to consider is the potential for frozen funds, particularly if the SEC intervenes. If your fund is under investigation or faces regulatory scrutiny, access to capital can be restricted, leaving you unable to meet obligations or make new investments. This situation happens to the greenest of fund managers as well as big names, like Bigger Pockets Brandon Turner… Frozen funds can lead to significant reputational damage and financial loss, making it essential to have contingency plans in place.Operational Challenges
Managing a fund isn’t just about making loans. It’s about tracking payments, managing cash flow, and ensuring that every dollar is accounted for. Without strong operational systems in place, even a profitable fund can quickly spiral into chaos.Reputational Damage
This is the risk that keeps me up at night. When you manage other people’s money, you’re not just responsible for financial returns—you’re responsible for their trust. One misstep, and that trust can be shattered, taking years to rebuild.
Why Due Diligence is Non-Negotiable
If there’s one thing I’ve learned in my career, it’s this: prevention is always cheaper than the cure. Due diligence isn’t just a step in the process—it’s the foundation of everything you do. Here’s what it looks like in practice:
Thoroughly Vetting Borrowers: This means digging into their financial history, understanding their business model, and assessing their ability to repay the loan. It’s not enough to take their word for it—you need hard data to back up their claims.
Evaluating Deals, Not Just People: It’s easy to get swept up in a borrower’s charisma or track record, but the numbers don’t lie. Every deal needs to stand on its own merits, with a clear plan for how the loan will be repaid.
Understanding the Legal Landscape: This is where many fund managers stumble. Securities laws are complex, and the penalties for non-compliance are severe. A good attorney isn’t just a cost—it’s an investment in your fund’s future.
Building Strong Operational Systems: From tracking payments to managing investor communications, every aspect of your fund’s operations needs to be airtight. This isn’t just about efficiency—it’s about protecting your investors and your reputation.
A Cautionary Tale
Let me share a real-world example that illustrates the importance of due diligence. ThinkStrategy Capital Management LLC, a hedge fund manager, was found liable for failing to conduct adequate due diligence on the sub-hedge funds in which it invested. Their due diligence process was described as cursory and lacking independent verification of the claims made by the funds they invested in. This negligence led to investments in fraudulent sub-funds, resulting in significant financial losses for their investors. Ultimately, the court awarded the plaintiffs $3,068,483 in damages, representing the total amount of their investment, net of redemptions.This case is a stark reminder of what can happen when fund managers cut corners on due diligence. It’s not just about losing money—it’s about losing trust, credibility, and the ability to recover from reputational damage.
Final Thoughts
Starting a private debt fund can be a powerful way to build wealth and create opportunities—but only if you do it the right way at the right time. Many are trying to do it too early before they even get reps in as a private lender or know what a well-managed fund looks like from the investor side. There's a Seneca quote: "Without a ruler to do it against, you can't set crooked straight." If investors don't know how a reputable fund should be managed in the first place, how are they going to go and start their own fund? Due diligence isn’t just a step in the process—it’s the foundation of everything you do. By taking the time to vet your borrowers, understand the legal landscape, and build strong operational systems, you can protect your investors, your reputation, and your future.Don’t let the allure of quick profits blind you to the risks. Take the time to do it right, and you’ll build something that lasts and boosts your experience, reputation, and most importantly, profit!
Register to Join the Conversation
If you’re considering starting a private debt fund—or if you’re already managing one and want to avoid these pitfalls—I invite you to join a call I’ll be on hosted by Beth Johnson, Lend to Live Author and Fund Manager. She’s invited Kevin Kim, a securities attorney and Partner at Geraci LLP, for a no-nonsense session titled "Taking the Fun Out of Funds."
