Structuring
Real Estate Funds
A real
estate investor’s projects increase in size and volume as the investor evolves.
With the growth, an investor might need more capital for down payments and
development costs. The investor might already have exhausted all available debt
financing, however. The investor might then decide to organize a real estate
fund to accommodate passive investors who will bring in the extra needed
capital. The investor will be looking for equity financing now.
In this presentation, I hope to give you
a bird’s eye view of some of the bigger issues in structuring a real estate
fund. I will address two basic parts of organizing a fund: first, structuring
the fund itself, and second, complying with securities laws when bringing in
investors.
Real estate funds are very complex.
This is not something to learn as you go. Organizing a fund is a big step up in
complexity. You’ll need the help of accounting, tax and legal counsel who are
experienced in the area. In particular, securities law compliance is not a game
for the uninitiated.
One last word to the wise: With a fund,
you are responsible for other people’s money. That’s a heavy burden. The
burden is heavier if your investors are friends and family, which usually is the
case with new fund managers. Many would-be fund managers give up after their
first fund because of the added responsibility and stress. In any case, without
further ado, let me discuss structuring the fund and complying with securities
laws when bringing in investors.
1. Structuring
the Fund. There are countless legal issues involved in structuring
your fund. All of the issues are potentially crucial. That said, I will
introduce three issues that are always important: the term of the fund (put
otherwise, your deadline for returning your investors’ money); keeping control
over your fund; and getting paid for managing the fund.
1.1.
Term of the Fund; Mandatory Return of Capital. Here is the
problem: your fund is not a mutual fund and you lack the liquidity to return an
investor’s capital at will. Nearly all of your investors’ capital will be tied
up in investments. This means you must liquidate investments to return an
investor’s money – which may be impossible or disastrous. From an investor’s
perspective, however, they won’t trust you with their money for an indefinite
term.
Solution: To solve this dilemma, you might
write into your fund charter a deadline for the return of the investors’ money.
For example, you might provide that the fund will liquidate all investments and
wind down by some date certain, e.g. two years after formation. Now of course
you must restrict your investments to deals from which you can exit within two
years. I usually write in provisions that let the managers extend the term for
a few months to effect an orderly liquidation of assets.
1.2.
Control. Your investors are passive, which means they should not
have operational control. Instead the fund’s managers control the fund. The
investors retain overall control only through their ability to replace the
managers, and perhaps through certain specified veto rights.
A veto right is a right held by the investors to block
certain specified actions, for example, amendments to the charter documents;
affiliate transactions; dissolution; etc. The investors as a group exercise a
veto right by the votes of a certain percentage of ownership (for example, 51%
or 75% of the membership interests).
1.3.
Manager Compensation. Manager compensation is where the
negotiation gets difficult. I have seen many variations on how managers are
compensated, but as a general matter, managers usually receive a combination of
management fees + “carry” + reimbursement of expenses.
1.3.1.
Management Fees. For small real estate
funds, I frequently set management fees at some annualized percentage of the
fair market value of assets. The fund pays fees monthly or quarterly. An
annualized management fee of up to 3% of FMV is not unheard of.
1.3.2.
Carry. A carry is essentially the managers’
share in fund profits. A carry kicks in when the fund distributes money to
investors. A common formulation is for the fund to distribute all money to the
investors until they have received 100% of their contributions plus a 10%
preferred return. After that, the investors and the managers divide all excess
profits based on some agreed split, for example, investors 70 / managers 30.
1.3.3.
Expenses. Sophisticated investors are wary
of how the fund pays expenses. The issue is the allocation of fund expenses
either: (i) to the fund (that is, to be paid by the investors out of their
profits), or (ii) to the managers (that is, to be paid by the managers out of
their fees). This issue frequently stays hidden, but it is very important.
2. Securities
Laws. When your fund offers or sells ownership interests to
investors, the fund likely is conducting a securities offering. A securities
offering is a highly regulated and complex undertaking. For every offering, the
fund must comply with federal securities laws and the laws of each state
where an investor resides. This can add up to a lot of law. Further, you do
not have the choice to opt out of these laws – securities laws will apply to
your fund whether you want them to or not. Pretending the laws don’t exist
won’t save you.
2.1.
Exemptions. When complying with securities laws, small funds
usually work within various exemptions, for example, state and federal private
placement exemptions. Most of the law applicable to your fund’s offering will
be contained in the relevant private placement exemptions.
Exemptions are the key to any private offering of securities, but
unfortunately they are far too complex and intricate for me to discuss at any
length here. I will only introduce some topics that in my practice I have found
to be troublesome for organizers of real estate funds.
2.2.
Manner of the Offering. You may not sell interests in your fund
to just any person by any means. When selling interests in your fund, you may
not advertise or otherwise solicit the public. This applies to the fund and
anyone acting on its behalf (usually managers and brokers). Hence you may not
use any advertisement, article, notice or other communication in any newspaper,
TV or similar media. You may not use seminars whose attendees have been invited
by any general solicitation or advertising. In brief, you may only sell to
investors with whom you have a pre-existing, substantive relationship.
2.3.
Brokers. Not only must you sell interests in the fund in the
manner described above, you also must be very careful about the people who help
you sell the interests in your fund. Extensive broker regulations apply to you
and all other people who sell interests in your fund. In brief, no one involved
in the offering may be regularly engaged in selling securities unless that
person is licensed as a securities broker. Many professionals in the field
forget about broker regulations (instead they concentrate exclusively on the
exemptions). This can be a fatal mistake if the investors bring litigation.
2.4.
Liability. Securities violations usually
come in two flavors: a technical defect in compliance with your applicable
exemption, and/or securities fraud. Securities fraud occurs when you misstate
some material fact or fail to disclose some material fact.
As a final matter, I will quickly summarize the consequences of
violating your applicable securities laws. In brief, purchasers of securities
may bring an action against the fund and even you personally. Generally,
investors seek the return of the money they invested. A technical defect in
your exemption compliance can be the most frustrating for you, because an
investor can leverage it into forcing you to return the investor’s money – you
become an unwilling guarantor of the investment.
Lastly, if you remember nothing else, remember this: securities laws
favor the investors, not you, and you can become
personally liable for your fund’s violation of securities laws.
This presentation only gives a brief
outline of some issues involved in structuring a real estate fund. I have only
scratched the surface. I strongly urge you to get competent legal, accounting
and tax counsel when you set up a fund. Competent counsel is a necessary part
of the organization process.
Call
me to schedule a legal consultation:
510-796-9144
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