“Loan Model” vs. “Equity Model” EB-5 Regional Center Investments
The basic framework of the EB-5 regulations requires that an investor make an “equity” investment into a qualifying EB-5 program. A loan to a project with a guarantee of repayment does not suffice. This has not always been the case, however. When the program was first implemented, it was common for investors to invest with a cash down and a portion in the form of “promissory notes”. The USCIS did away with that and has since made it clear that a loan is not an investment.
But many Regional Center investment projects are structured as a loan these days and clients who have read a lot of information on the internet about EB-5s come to me a bit confused with the following question: “If an EB-5 investment cannot be in the form of a loan, then how are the Regional Centers saying that their project will give them a 1% interest rate with the “loan” repaid in 5 years?”
This is because the investor is not making a loan to the project, but rather an equity investment in a limited partnership created by the Regional Center, which then in turn makes a loan to the EB-5 project. At this juncture, a diagram would be helpful.
A simple way to explain what is going on is that the EB-5 investor is taking an equity position in a debt fund. The EB-5 “loan” is then structured with the Regional Center Company in the picture (the lender) and the Project (the borrower) within the parameters of the EB-5 regulations. This usually results in a 5-year secured term loan. The security that is provided would be whatever the borrower can give to cover the EB-5 loan. It can be related to the project itself, such as the land or business that is being developed or the expected cash flow from the project. Or it can be unrelated to the project itself such as a guarantee by the owner of the project, a parent company or even cross-guarantees. Some projects have even tried to introduce a third party insurance that covers the principal of the EB-5 loans. (There is still a bit of controversy surrounding this arrangement which I won’t go into here, but this article provides a good analysis.)
An “Equity Model” investment has a completely different structure. There, the individual investor takes an equity position in the project itself. This is what an individual investor who makes an EB-5 investment into his or her own project in a so-called “direct EB-5” or “stand-alone EB-5” (which basically means no Regional Center is involved) will be doing.
What are the pros and cons to each model? Theoretically, one can’t say one is better than the other, although the majority of Regional Center projects out there today employ the “loan-model” in their projects. The reasons for this are rather simple: the investor knows with relative certainty the mode and timing of the exit (i.e. repayment of the loan by the borrower at the end of the term of the loan). In an equity-model, after the investor successfully obtains a permanent greencard, the exit will depend on market conditions – if the market for whatever the equity interest is good, you should sell, if not good, you should hold. As a result, I know of people who invested in equity model EB-5s a long time ago who forgot about it and then were rewarded with a sizable profit after many years, almost doubling their principal. Some people didn’t or couldn’t wait for the market to improve so they sold early and as a result couldn’t recover all of their principal.
Conversely, loan-model investors can expect regular interest payments (generally starting at about 1%; but once the Regional Center management fees are deducted, it isn’t that much) and a specific period at which their principal will be returned. Of course, both the loan-model and equity-model carry the same kind of business risk. Think of it this way: you have $500K, a friend is opening a business. She needs some money and is offering you the option of 1) loaning her the money with a promise to pay you back in 5 years with some interest or 2) investing in her company with a promise to give you back your investment plus any additional profits she can share when her company is successful. In either scenario, the possibility of her business failing and her not being able to return the loan or your investment exists. There are also other possible scenarios. You have $500K. Your friend Jim is opening a shoe store and he wants you to lend him the money at interest. Your friend Sally is opening a deli and she wants you to invest the money. Jim is a smart guy but he has no experience in the retail industry. Sally, on the other hand, has successfully opened and operated five delis in the past. So here, obviously, going with Sally is the better answer. (Or is it? What if Jim already has a successful consulting business and is willing to secure his loan with proceeds from his existing business; while Sally just liquidated all her assets and gave it all away to Autism Speaks and is now starting on a fresh slate?) And on and on. I can flip it around and give it you different variations on this ad nauseum. In short, the lawyer’s answer to which is better, the loan-model or the equity-model, is “It depends.”