What happens if we enter into a recession?

 

We entered into what’s known as the COVID-19 recession in early 2020. It was one of the deepest recessions in U.S. history, with 14.7% peak unemployment and a 19.2% drop in GDP. By comparison, the Great Recession resulted in only 10% and 5.1% respectively. (Source)

 

For about two months, buying activity slowed down and some borrowers didn’t make their mortgage payments due to some misinformation that had spread. These issues were quickly resolved, and we went on to sell over $10M worth of ranchettes that year. This bodes well for this business’s ability to thrive during all market cycles.

 

In addition, selling on owner financing and collecting on those payments is traditionally seen as a recession strategy. Doug and his colleagues saw this work extremely well during and after the Great Recession when selling houses conventionally proved difficult in many cases.

 

Should we experience a prolonged recession with large job losses, some or many of our borrowers will be affected. That will likely increase the default rate to some extent. Although Hawthorne Interests (HI) is to make monthly payments to the fund each month, regardless of the income it collects, a steady stream of income into HI does help in that regard.

 

It would be difficult for HI’s income to drop below what it pays to the fund. If that happened, we suspect it would only be temporary until HI was able to foreclose on its non-performing loans and originate new ones, many of which would be at larger amounts. During that temporary period, additional cash could be funneled into HI from Doug’s other business and personal checking accounts.

 

Extremely high default rates during a recession seem unlikely, as they didn’t occur during the COVID-19 recession. Moreover, borrowers are incentivized to keep a property that they have put a substantial amount of money into via mortgage payments and improvements and that they have seen increase in value over time.

 

This is not needed or even desired to get the fund or our business through a recession, but we have seen an extreme willingness by the U.S. government to pump large amounts of capital into the economy to prop it up. This tends to prevent massive waves of foreclosures in all areas of real estate, including rural land.

 

How might inflation affect the business or fund?

 

Inflation is impacting individuals, businesses and governments in various ways, both positive and negative. Below are some of the ways it can impact the business and/or fund:

 

Real estate values tend to rise with inflation. That includes rural land. This means that we now must pay more for land when we buy. It also means that we sell for more, so it’s not necessarily a positive or negative in this regard.

 

Over time, inflation leads to higher wages and higher profits in nominal dollars. Hawthorne Interests (HI) collects monthly payments from those who bought ranchettes on owner financing. These payment amounts don’t change, thus making them more affordable in comparison with our borrowers’ higher wages and/or profits over time. This helps HI keep its default rate down, which provides HI with a more reliable steam of income. That stream of income is used to pay loans from the fund and its investors by extension.

 

On occasion, HI must foreclose on a borrower, take possession of the underlying land and resell it. A desirable outcome is reselling the land for more than it was first sold for and generating an even larger note with a larger monthly payment coming in. This is much more likely when land values have gone up. Inflation is helping that to happen.

 

Some other types of investments rise with inflation. That could make them more appealing to some of our current or prospective investors, thus making it more difficult for us to attract or retain investor capital. This has not happened thus far. One reason could be that many of those types of investments appear to be overvalued and/or high-risk.

 

Can the fund manager be removed if necessary?

 

The fund is managed by Hawthorne Income Fund Manager, LLC, which is owed by Doug Smith. The manager can be removed and replaced by a two-thirds vote of investors (by number) and investor interests (by investment amount). This is a lower threshold than is typically seen with private equity funds and is therefore pro-investor. This removal and replacement process is outlined in Section 7.03 of the Company Agreement.

 

How have some people lost money in private equity investments?

 

People are making money in the vast majority of private equity investments that we have seen. There is an occasional fund or investment that that ends badly, and these are the ones that are widely discussed and/or covered in the news.

 

It is very rare, but a fund manager could have a business model that makes no or minimal profits, instead providing investors with “returns” by falsifying statements and/or distributing “returns” from the capital provided by other investors. This is difficult or impossible to do with third-party administration and audited financials, which are in place with this fund. This fund also makes a substantial profit each month in the form of interest income.

 

Equity funds that borrow against their assets, and therefore place that debt ahead of their investors in the capital stack, expose their investors to some risk. If the asset values drop or do not increase as planned, the debt can get paid back first, leaving investors with little or nothing. In contrast, this is a debt fund that does not owe any debt but instead owns it.

 

Many people have lost most or all of their investment simply by investing in something that was high risk. An example would be investing in startups.

 

Could funds be mismanaged or squandered?

 

Any fund manager could mismanage or squander funds. Fortunately, this is fairly rare because most managers are seasoned professionals who wish to 1) maintain a solid reputation, 2) avoid legal problems, and 3) secure repeat investors and referrals so that they can do more deals.

 

Mismanagement of this fund is largely prevented by this fund’s structure and strict lending criteria. The only thing that could feasibly be stolen is liquid capital, which typically represents a very small percentage of fund assets. In addition, most of the fund’s cash is only accessible to Doug and two key employees.

 

Fund capital is highly accounted for via our partnership with Cobalt Fund Services, which is an accounting firm that handles bookkeeping and reporting. Another accounting firm, Whitley Penn, conducts an annual audit and provides a report of its findings to our investors.

 

In addition, we provide regular emails and reports that show the properties and notes that the fund is lending against.

 

Finally, all fund investors are welcome to stop by our offices anytime during normal business hours to view the checking accounts, loan paperwork, QuickBooks reports and more.

 

What happens if demand for rural land dries up?

 

We’re seeing extremely strong demand for the ranchettes that we sell. This was also the case during the pandemic and resulting recession and even long before that period. It’s reassuring that demand for our product has far exceeded our ability to meet it across these very different market cycles.

 

If we ever see demand dropping off, we could certainly curtail buying activity. In the unlikely scenario where we needed to stop buying, we would finish out current projects and provide investors with preferred returns and a return of their capital over time.

 

What happens if you go out of business?

 

The fund does not make unsecured loans to a business but instead makes secured loans against real assets. Therefore, the pertinent question would really be, “What happens if you go out of business and quit paying on your loans?… even though the fund structure means you have significant cash flow to pay those loans.”

 

As was mentioned in the prior FAQ, in a far-fetched worst-case scenario, the fund has mechanisms in place for fund management or fund investors to foreclose on assets that the fund has loaned against. It could either hold or sell them at that point.

 

“Going out of business” has involved a bankruptcy for some companies. This has happened when their liabilities were greater than their assets. We do not see how this would be feasible with the fund structure, seeing that strict lending criteria is in place to keep loan balances within reason.

 

It is implausible but technically possible that Doug’s entities could take on additional unsecured debt that ultimately led the company to bankruptcy. In this case, the courts would oversee the process of selling assets, paying off the fund’s loans (which are all secured by first liens) and returning capital to investors.

 

What happens if the fund’s loans go bad?

 

The fund lends to Doug Smith’s entities, which are primarily Hawthorne Land and Hawthorne Interests.

 

In the “flow of funds” FAQ, you can see that the structure of the fund provides for ample liquid capital for Hawthorne Land each time it sells a ranchette. This capital, along with capital already available in Hawthorne Land and Doug’s other personal and business checking accounts, provides substantially more resources than are needed to service the loans made to Hawthorne Land.

 

Hawthorne Interests should not have an issue covering loan payments either, as it receives more income each month from its borrowers on each note than it must pay to the fund each month for the associated fund loan.

 

In an unlikely and unforeseeable worst-case scenario, the fund has mechanisms in place for fund management or fund investors to foreclose on assets that the fund has loaned against. It could either hold or sell them at that point.

 

What happens if the fund, its borrowers, or Doug Smith get sued?

 

The fund is a lender. Lenders are unlikely to get sued unless they are violating lending laws, which the fund does takes great care not to do.

 

In any case, the borrower would generally need to sue the lender, and Doug’s entities are the borrower. Doug has no reason to sue the fund that he and his team created to serve as a “friendly lender.” In addition, any suit would almost certainly get tossed out because his entity is managing the fund.

 

As with anyone or any company involved in a business undertaking, Hawthorne Land, Hawthorne Interests or Doug Smith could get sued. Innocence and/or insurance would protect us in most cases. Access to our own capital reserves would resolve the issue in other cases.

 

Regardless, the fund has first liens on our assets and would therefore be in a first position to get paid should assets need to be sold to resolve legal issues.

 

What if Doug passes away?

 

Doug is in excellent health, but the fund and business have structures, systems and processes in place that should remain in place if Doug passes away. Current team members are capable of rising up to fill his shoes, and a new but seasoned executive could even be hired.

 

If the team does well, the business will grow at the same pace or faster. If they fall short, business will slow down. In either case, existing fund loans, all of which are secured by real assets, will stay in place, and fund returns can continue being paid out.

 

In addition, the fund can continue lending against assets that meet its strict lending criteria.

 

If any investor wishes to withdraw his or her capital before or after Doug’s passing, he or she is welcome to request that as outlined in the “return of capital” section. The fund’s management is required to carry out those requests or face negative consequences.

 


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