Private Real Estate Investment Funds
Article #2 – Legal Structure of the Fund
In this 6-part series, I explain
private real estate investment funds. You have a real estate
fund when you accept money from passive investors to do
transactions in real estate. A real estate fund is a hedge
fund and it is subject to most laws that apply to hedge
funds, including securities laws and ERISA. Real estate
funds usually are LLCs or limited partnerships, and they
have complex terms for investor rights, manager compensation
These are the 6 articles in the
In this Article #2, I talk
about the basic documents and terms that make up a fund.
Specifically, I discuss: (1) your choice of entity; (2) the
basic fund documents; (3) the term of the fund, that is,
your deadline for returning your investors’ money; and (4)
keeping control over your fund. I discuss manager
LLC or LP
Most funds are either limited
liability companies or limited partnerships. Both LLCs and
LPs give limited liability protection to the investors, and
both are tax pass-through entities. The trend is toward
LLCs but LPs work just fine.
The primary fund documents
1. The LLC Agreement (aka
Operating Agreement) or LP Agreement. This document
controls the relationship among the fund and its investors.
It contains the basic terms of the fund, including duration,
control, management, manager compensation, distribution
preferences, exits, etc.
2. The Private Placement
Memorandum (PPM). This document discloses material
information about the fund to investors. The PPM is a
disclosure document required under securities law.
3. Various subscription
documents, including the Investor Questionnaire.
4. Side letters; see
Term of the Fund;
Return of the Investors’ 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 LLC Agreement 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 for a flip fund. Now of course you
must restrict your investments to deals from which you can
exit within two years. For a buy-and-hold fund, you'll need
a longer term (perhaps with provisions for refinance at the
end). I usually write in provisions that let the
managers extend the term for a few months to effect an
orderly liquidation of assets.
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
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
I discuss the most
interesting term in the fund documents, manager
Article #3 next.
Get a Lawyer
estate funds, like all hedge funds, are very complex. This
is not something to learn as you go. You need the help of
accounting, tax and legal counsel who are experienced in the
Call me to schedule a legal consultation: