Crowdfunding Sites -- Are They Platforms or Fund Managers?
Crowdfunding is the future. Or at least an important part of the future. According to Statista, the overall crowdfunding market in the United States during 2019 was $17.2 billion. And in 2020, global real estate finance completed through crowdfunding is expected to reach $8.3 billion, with the majority of that funding located in the United States or Europe. As the saying goes, a billion here, a billion there, and pretty soon you’re talking real money.
At the same time, crowdfunding in real estate (I’m just going to say crowdfunding from here), is still working on defining itself and different approaches and business models abound. There have been some notable early successes, and some equally notable failures. In addition, the model is now in the process of facing its first real challenge – what happens when the market stops going up and to the right? It’s an interesting moment to be sure.
All that said, I think the most important challenge facing the crowdfunding market today is not the state of financial markets, but more a question of identity. Are these companies platforms or fund managers? What are the implications of making either of those choices? Is there a ‘right’ answer, or is it up to each company to choose what fits it best? And based on those choices, what will the crowdfunding marketplace look like in five years?
I’ll start with a story. Back when crowdfunding was still in its relative infancy, I was tasked by my employer at the time (an LP focused on real estate investments) with exploring the crowdfunding market. The concept was – could we take deals that we were sourcing and negotiating with our operating partners, raise crowdfunding around them, and end up with a lower cost of capital? I had calls with several crowdfunding companies, and one conversation sticks out in my mind as emblematic of the approach to the business at that time. It was the second or third call with the sales director of that company, and I had sent him a set of deals to review. These ranged from ones we were actively pursuing and excited about to ones we thought were very problematic and had no intention of pursuing. The response we got an all of them – “let’s put it on the platform and see what happens!” I’ll ascribe some of this response to salesmanship and bravado, but it also gets to the core of the question. What is the role of the crowdfunding company in the marketplace? Is it simply a platform where deals exist and investors decide what they think is good or bad, or do they have responsibility for the performance of transactions funded through their platforms?
I would say that at least in the past few years crowdfunding platforms would have said that they are just bringing deals to the marketplace and nothing more, while their investors would have had the expectation that they are carefully vetting those deals. A very meaningful disconnect. And again, it raises the question: are these companies platforms or fund managers?
Let’s start on the platform side by comparing crowdfunding to the most bronzed and well-known finance platform out there – the New York Stock Exchange (NYSE). The NYSE is without question large and successful, and importantly it has succeeded in being viewed by every market participant solely as a platform. What I mean by that is this – while it’s true that there are a set of minimum standards for a company to be listed on the NYSE and maybe that’s somewhat of a tacit endorsement of the company, nobody considers the NYSE to be making a financial recommendation to investors by virtue of listing a company.
If you buy a stock on the NYSE, and it goes down, and you lose money, you don’t start sending angry letters to the NYSE about the company they chose to list. It is well-understood by everyone that the NYSE is enabling your investment but it is not recommending for or against it. It is buyer-beware, and you are responsible for your own due diligence. The NYSE in a sense makes money being a facilitator of investments, not an investor in and of itself. It is purely a platform.
If you’re a crowdfunding CEO, you now have permission to salivate. This is the dream, and when that sales director said to me, “let’s put it on the platform and see what happens,” this is what he was getting at. The role of their company was not to decide whether the investments were good (beyond some minimum standard), but to let investors learn about and have access to a set of investments and to draw their own conclusions. The advantage of this approach is the serious volume you can drive with it. And if you are charging based on volume, well, you get the idea.
Let’s examine the platform approach further by founding a theoretical crowdfunding company, crowdmoney.madeup (welcome to the board)! We are trying to decide how to structure the company and the transactions it facilitates and the following idea comes to us. Let’s set a basic bar for investments that can be listed on the platform. We will provide information about the transactions to investors, and take care of settlement, but beyond that it is up to the investors to pick their investments, and the results are their responsibility. Sound familiar? This is basically the NYSE model. The advantage to this approach is that because our bar is low, we can onboard many deals in the marketplace. In other words, we can drive a high volume of transactions. Because we have such a high volume of transactions, investors will be attracted to our platform. After all, where can you see a greater variety of opportunities to invest than on crowdmoney.madeup? This is a virtuous cycle, and more deals leads to more investors, which makes it more likely the next operator puts his deal on our platform rather than another one, and so forth. Even better, the company takes no real investment risk (that is not the role of a platform after all, which is a passive intermediary), but gets to charge fees as transactions are completed. This sounds great!
But is this workable for crowdfunding of real estate transactions?
The NYSE works in part because of an ecosystem of established institutions, precedents, and investor expectations that support its business. For example, in terms of institutions, you have the SEC that has stringent reporting and disclosure requirements for companies that would like to list publicly, investment banks that police (if imperfectly) new companies to be listed, analysts whose professional role is to review and question the information companies are providing and to make recommendations to investors about which investments do or don't make sense, and institutional investors that are able to lead and demand change at companies they have invested in.
Beyond this, there is a legal system that has had hundreds of years to establish precedents for what is and isn’t fair dealing for a public company as it goes through its lifecycle, and investors have at least some understanding of how misbehavior by a public company might be dealt with by the courts. How are you going to re-establish this ecosystem for transactions that may be as small as a four-plex value-add deal in Paducha? Or a mid-rise office building investment in Pittsburgh? It’s a challenging question.
There is another important difference between investments in public companies, and investments in crowdfunded real estate – that of management and decision-making. Again, its an imperfect system, but public companies for the most part have large, professional, full-time management teams, and an active board of directors minding the store. Investors in these companies can rely on (or at least hope that) these parties are looking after their interests, challenging corporate decision-making when appropriate, and driving the best results for shareholders. This does not really exist for a small real-estate transaction. Often there is only one party (or at most a small partnership) making decisions for the business. They have wide latitude to exercise judgment and may or may not make decisions that best serve investors. The private investment market has traditionally solved this problem in one of two ways - 1) requiring a tough set of decision-making rights and controls to invest (when a single, professional LP makes the investment for example), or 2) having a close, pre-existing relationship of trust between investors and operators (for a syndicated transaction where the operator has more control).
Neither of these are really present in crowdfunding when the platform approach is taken, as on the one hand the crowdfunding company doesn’t have a stake in the investment itself, and so has limited incentive to enforce its rights or even to ask to have them, and on the other hand doesn’t really have a deep, trust-based relationship with the operator (that’s kind of the whole idea of crowdfunding as platform). So, while good management may happen on crowdfunded investments under this approach, it’s really more of luck and circumstance, rather than something that is built in by design. You can elect to ignore these problems for a time, and maybe build out the platform to a degree. But eventually if transactions don't work out, and your investors view is that you are responsible then you will both lose investors quickly, and potentially end up on the business end of some painful investor litigation. Not great for business.
OK, the list of potential issues with the platform approach enumerated, let’s turn to the other option for crowdmoney.madeup – formulating itself as a manager of funds (in some sense of the word). Under this model the crowdfunding company takes a position on the investments it makes. It is rewarded or punished, at some level, based on the success of its investments. Given that the goal of the company now is to make great investments, it has an incentive to hire top-flight fund managers, to pick only a limited set of investments that it views as best-in-class, and to manage them carefully. This resolves nearly all of the issues of crowdfunding as a platform raised above. It also has plenty of precedent – this is how real estate funds have approached things since time immemorial.
So, there is a lot to commend this approach. But there is a critical flaw. After all, the whole point of crowdfunding is to democratize the real estate finance markets, to connect investors with opportunities directly, and to fundamentally change the game of financial markets for private investments (VCs slowly reach for your checkbooks). None of that is really being accomplished here at all. In essence what has been created is a traditional real estate fund that uses a website to raise money. Which is somewhat of an innovation maybe, but not really a world-changing one (VCs slowly put your checkbooks back in the desk).
The approach also struggles a bit to really differentiate itself. When the platform approach is chosen, that is something that hasn’t really existed previously. It is unique and new, and that has some power. But when you run a fund, the game is a different one and the killer app is not running a website effectively but rather making better than average investments. It’s not clear at all that website-based fundraising will accomplish that investment performance better than traditional funds, and there is plenty of reason to believe it won’t. After all, those traditional funds have skilled managers, lengthy track records, experience, relationships and processes that are hard to re-create quickly. The crowdfunding approach taken under this model becomes more of a gimmick rather than an exciting innovation. Maybe that gimmick allows a few emerging fund managers to establish themselves in a business they would otherwise have been locked out of, but that seems a far cry from the world-changing innovation crowdfunding has promised.
So, where does that leave us? How do we roll out crowdmoney.madeup? It seems like it’s damned if you do and damned if you don’t. But perhaps it’s more of a question not of which choice is better, but rather of how you manage the challenges associated with the primary choice you’ve made – crowdfunding as a platform or as a fund manager.
If you’ve chosen to be platform, it’s all about informing investors well about the options available to them, setting the right expectations in terms of their responsibility to make judgments about the investments they are making, and aligning incentives and structures so that those investors can count on good management once investments are made.
If you’ve chosen to be a fund manager, then it’s about getting up the fund management learning curve as quickly as possible, and then thinking about how you can differentiate yourself and find a niche where the fact that you are raising money through crowdfunding becomes an advantage and differentiator, rather than some downstream choice that is ultimately irrelevant to the business of making great investments.
Challenging problems both, but with a $17.2 billion market and growing, the squeeze may be worth the juice. Original Article by: Martin Kemeny
Image by: Scott Graham