Private Equity Real Estate Fund Formation

Private Equity Real Estate Fund Formation: Capital Raising, Regulatory Issues, and Negotiating TrendsCapital Contributions, Allocation of Profits/Losses, Clawbacks, Return of Capital, Fees, Conflicts of Interest, and More

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THURSDAY, NOVEMBER 4, 2021

A 90-minute encore presentation with interactive Q&A

Matthew Posthuma, Partner, Ropes & Gray, Chicago

Heather L. Preston, Partner, Kilpatrick Townsend & Stockton, Atlanta

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Private Equity Real Estate Fund Formation

Agenda

• Overview of Real Estate Funds

• Real Estate Fund Formation Issues

• Securities and Regulatory Issues

• Select Fund Terms

• Tax Cuts and Jobs Act Impact on Real Estate Funds

7

Overview of Real Estate FundsWhy Do A Commingled Fund?

Advantages More investors More discretion More assetsDisadvantages Harder to raise money More laws to comply with – securities, tax, ERISA More complicated structure

8

Overview of Real Estate FundsFund Strategies

Core Core Plus Value Added Opportunistic

Specific Property Types

Debt

Real Estate Businesses

9

Overview of Real Estate FundsFund Entity

Delaware limited partnership – most common

Limited liability company – certain state and foreign tax disadvantages

Off-shore (e.g. Cayman, Luxembourg) –foreign investors may prefer, corporate blocker

10

Overview of Real Estate FundsSponsor Entities

General Partner – manages fund, special purpose entity, may receive carried interest

Management entity – often registered investment adviser, receives management fee

Special limited partner – sometimes receive carried interest

Sponsor co-investment – through one of above or separate entity

11

Overview of Real Estate FundsFund Entities

Parallel fund for different types of investors Investments through REIT or non-REIT holding

subsidiaries Each investment owned by special purpose

entity Institutional fund may have JVs with third party,

often developer or operator

12

Real Estate Fund Formation Issues

Structures – Investor Types

Structure typically driven by mix of investors, their tax preferences and the investment strategy of the Fund• U.S. Taxable Investors• Tax-Exempt Investors Generally – Pension Plans, IRAs,

Educational Endowments (Unrelated Business Taxable Income (UBTI); Debt-Financed Property; Fractions Rule)

• “Super” Tax Exempt Investors – State Pension Plans • Foreign Investors Generally (FIRPTA, ECI, FATCA) • Sovereign Wealth Funds

13


Structures – Limited Partnership

Sponsor GP

U.S.Taxable; Super Tax

Exempt Investors; Tax Exempt Investors*

Fund LP

Management Fee

Property LLC Property LLC

Investment Manager Carried Interest

*Qualified Organizations can invest directly if Fund LP is fractions rule compliant

14

Real Estate Fund Formation IssuesStructures – LP with Corporate Blocker

Sponsor GPU.S. Taxable;

Super Tax Exempt; U.S. Tax Exempt

Fund LP

Management Fee

Property LLC Property LLC

Investment Manager Carried Interest

U.S. Tax Exempt*

US Corporate Blocker

*Use of blocker by tax exempt will depend on whether LLC is fractions rule compliant.

15

Real Estate Fund Formation IssuesStructures – Series LLC/ Corporate Blocker

Sponsor Manager,

LLC

US Taxable and Super

Tax Exempt

Series LLC

Foreign; U.S. Tax Exempt*


(Series 1)


(Series 2)

Foreign; U.S. Tax Exempt

Property LLC(Series 1)

Property LLC(Series 2)

Investment Manager

Management Fee

Carried Interest

DebtDebt

*Use of blocker by tax exempt will depend on whether LLC is fractions rule compliant.

16


Structures – Private REIT

Subsidiary REIT

Sponsor GP

LPInvestors

110 Preferred Investors

Fund LP

Investment Manager

Carried Interest

17

Real Estate Fund Formation IssuesStructures – Private REIT Requirements Ownership Tests

• 100 Shareholder Minimum• 5 or fewer persons cannot own more than 50% of the value of the REITs

stock during the last half of the taxable year Shares must be freely transferable Annual Income Tests / Quarterly Asset Tests

• 75%/95% Gross Income Tests• 75% Asset Test/ 10% Securities Test/ 20% Taxable REIT Subsidiary / 5%

Securities Test

Required Annual Distributions (90% of REIT taxable income) REIT is not a particular type of corporate entity (but must be a

domestic entity) Prohibition on Preferential Dividends

18

Real Estate Fund Formation IssuesStructures – Private REIT Requirements “Domestically Controlled REIT”

• U.S. investors must own, directly or indirectly more than 50% of the value of all of the REIT shares

“Pension-Held REIT”• REIT that would not have qualified as a REIT if it is predominantly held by

“qualified trusts” (more than 25% by a single qualified trust; or more than 50% owned by 1 or more qualified trusts owning more than 10% of value)

• Re-characterizes a portion of the income from an “unrelated trade or business” resulting in UBTI for pension funds owning more than 10% of the value of the REIT

Prohibited Transactions Tax• 100% tax on income from “prohibited transactions”, generally income from

sales in the ordinary course of business• Statutory safe harbor

19


Structures – Investor Preferences

Investor Type Rental Real Estate –Fractions Rule Compliant (all passive)

Rental Real Estate –Non- Fractions Rule Compliant

Operating Real Estate Business(Assisted Living –Hotels)

Dealer Property

Taxable U.S. Investors

LP LP LP LP

Super Tax-ExemptState Government Plans

LP LP LP LP

Tax ExemptQualified Organizations

LP Blocker/REIT Blocker/REIT(w/TRS)

Blocker

Tax ExemptIRAs; Other Charitable

Blocker/REIT Blocker/REIT Blocker/REIT(w/TRS)

Blocker

Foreign Blocker/REIT Blocker/REIT Blocker/REIT(w/TRS)

Blocker

Sovereign Wealth Funds

Blocker/REIT Blocker/REIT Blocker/REIT(w/TRS)

Blocker

20

Securities and Regulatory IssuesSecurities Laws Securities Act of 1933

• Private Placement, avoid public offering and registration with SEC• Reg. D – accredited investors

• Individuals –• $1 million net worth (excluding house) or $200k income ($300k with spouse)• Series 7, 65 and 82 licenses• Knowledgeable employees

• Entities - $5 million in assets, registered investment advisers• Filing with SEC, plus state “blue sky” filings

506(b)─ No general solicitation─ Pre-existing relationships with investors

506(c)─ General solicitation permitted─ Reasonable steps to verify accredited investors

• Reg. S – non-US persons outside US• remember to comply with foreign securities laws (e.g. AIFMD)

21

Securities and Regulatory IssuesSecurities Laws (cont’d)

Securities Exchange Act of 1934• Restrictions on inducing purchase or sale of securities unless

registered as broker with SEC

• Limited exception for “associated person of an issuer”

• Consider hiring placement agent

• Avoid ’34 Act Registration – 10-K, 10-Q, 8-K, etc.

− No more than 2,000 (500 who are not accredited investors)

22


Investment Company Act of 1940• Avoid registering as investment company with SEC• 3(c)(1) – 100 or fewer beneficial owners

– avoid look through – 10% owners

• 3(c)(7) – all beneficial owners are qualified purchasers– individuals with $5 million in investments, companies with $25 million in investments– “knowledgeable employees” don’t count toward 3(c)(1) and 3(c)(7) requirements

• 3(a) – not engaged primarily in business of investing in securities and not more than 40% of its total assets are investment securities– owned real estate not securities– general partnership–like interests not securities– joint ventures– subsidiaries

• 3(c)(5)(C) - acquiring mortgages and other interests in real estate, not open-end fund

23


Investment Advisers Act of 1940• Required generally to register as investment adviser with SEC if

advise others, for compensation, as to the purchase or sale of securities

• Ongoing compliance and reporting• Client being advised is fund (not investors)• Does fund invest in securities or just in owned real estate?

– fund or account is “securities portfolio” if at least 50% of value is attributable to securities

– Private fund (3(c)(1) or (3(c)(7)) deemed to be securities portfolio

• Exempt reporting adviser– registration “lite”

– less than $150 million of AUM in private funds

24

Securities and Regulatory IssuesERISA

Funds want to avoid holding “plan assets” under ERISA• higher fiduciary standard• prohibited transactions with affiliates

Exceptions to holding plan assets• Participation by “benefit plan investors” is not “significant” (less

than 25%)– Corporate pension plans, Taft-Hartley, 401(k), IRAs, etc.– NOT governmental plans, foreign plans, foundations and

endowments

• Operating company– Venture capital operating company (VCOC)– Real estate operating company (REOC)

25

Select Fund TermsFund Documents

Teasers, flip books, term sheets

Private placement memorandum (PPM)

• business sections prepared by sponsor

– strategy, sponsor, management team bios, maybe track record

• legal sections prepared by lawyers

– term sheet, risk factors, conflicts of interest, securities, tax, ERISA, world sky

• supplement before investor closings if terms change, fund acquires assets, other changes

Partnership agreement Subscription agreement – investor representations, power of attorney Side letters with specific investors – consider MFN

26

Select Fund TermsTerm and Marketing and Investment Periods

• Fixed life – 7-10 years• Investors make capital commitments to fund during

marketing period (6-24 months) • Minimum commitment for first closing• Fundraising cap• Organizational expense cap• True-up payment for subsequent closers

• Manager can call capital without restriction during investment period (2-5 years), more limited thereafter

• Key person event suspends investment period (90 days – 1 year)

27

Select Fund TermsAdvisory Board

• Composed of representatives of unaffiliated LPs or other third parties

• Waive conflicts and investment restrictions• Sometimes ability to engage own counsel and

other advisors• Typically no duties to other LPs

28

Select Fund TermsManagement Fees

• 1-2% of Commitments• Step-Down to “Invested Capital”

• End of Investment Period• Successor fund beginning to accrue Management Fees

• Invested Capital• Are contributions for management fee and/or non-investment related Fund

expenses included?• Adjustments (dispositions, refinancing, written off/written down)

• Fee offsets for broken deals, monitoring fees• Is it included in the LP’s commitment?• Acquisition or disposition fees (0.5-1%) (rarely)

29

• Carried interest (10-20%) paid to sponsor after investors receive return of capital plus performance hurdle (6-12%)

• Calculated on deal-by-deal (less common) or portfolio-wide basis (more common)

• Catch-ups (sometimes) - manager gets higher share of distributions after preferred return until reach 20%

• Tax distributions

• Clawback (often)

• End of fund (sometimes interim)

• after-tax

• escrow or guarantee for smaller sponsors

Select Fund TermsCarried Interest

30

Select Fund TermsOther Fees Investment Level Fees

• Affiliates of the Sponsor may provide property management, leasing, brokerage, construction, design and similar services to investments of the Fund− Compensation for such services are excluded from the management fee offset

How to price affiliated services

• Fee Schedule

• Arm’s-length pricing as determined by the GP

• Cost-plus

• Rates approved by the Advisory Board

• Disclosure to the Advisory Board or LPs

31

Select Fund TermsLeverage Limitations

Property by property Aggregate property portfolio Incurrence test

• Cost v. fair value

Guarantees – recourse v. non-recourse Cross-Collateralization Refinancings

32

Select Fund TermsSubscription Facility

Revolving credit facility secured by capital commitments of investors

Borrowing base based on unfunded capital commitments and creditworthiness of investors

• Borrowings must be repaid as capital is called• Typically get credit for institutional investors only, no HNW

Eligible investors may deliver investor letter and opinion Often excluded from leverage limitations

33

Select Fund TermsOpen-End Fund Terms

Perpetual life New investments quarterly based on NAV Redemptions quarterly, subject to available cash Management fee- 1% or lower based on NAV Sometimes performance fee or carried interest, often based

on exceeding index Often core

34

Select Fund TermsCo-Investment Funds

Main fund does not have enough capital to do deal Co-invest alongside main fund Invest and divest at same time and on same terms Co-invest LPs pay lower management fee and carried

interest Side car, main fund investors, third parties

35

Select Fund TermsClub Deals

Small number of “like-minded” investors Discretion “in a box” or no discretion Opt in or out of deals Lower management and performance compensation

36

Tax Cuts & Jobs ActCovered Topics

Limitations on Interest Deductibility Carried Interest Taxation Qualified Business Income Deduction Opportunity Zone Funds

37

Tax Cuts & Jobs ActInterest Expense Deductibility Limitations Section 163(j) limits deductibility of net business interest expense

to 30% of “Adjusted Taxable Income”

• “interest” broadly defined, picks up “original issue discount” and can include guaranteed payments for the use of capital

• “Adjusted Taxable Income” calculated similar to: EBITDA for years beginning before January 1, 2022 and EBIT for tax years beginning on or after January 1, 2022

Complexities applying rules to pass through entities and partner loans

Exemptions for Certain Businesses• Less than $25 million gross receipts, unless business a “tax shelter”

• Electing Real Property Trade or Business

38

Tax Cuts & Jobs ActInterest Expense Deductibility Limitations

Electing Real Property Trade or Business – one-time irrevocable election to opt out of application of Section 163(j) and interest expense deductibility limitations• “Real Property Trade or Business” – any real property development,

redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Electing taxpayer required to depreciate real estate assets using a slower depreciation system• Residential Real Estate – 30 years versus 27.5 years

• Non-Residential Real Estate – 40 years versus 39 years

39

Tax Cuts & Jobs ActCarried Interest

Section 1061 requires a three-year holding period for an investment fund manager’s share of capital gains earned through an investment fund (including a real estate fund) to be eligible for long-term capital gains rates

3-year holding period requirement applies only to holders of “applicable partnership interests” (API)• Partnership interest transferred in connection with substantial services to an

applicable trade or business

• “applicable trade or business” is any trade or business activity that consists of (i) raising and returning capital and (ii) either (A) investing in or disposing of real estate held for rental or investment or (B) developing real estate held for rental or investment

40


U.S. Department of Treasury issued Final Regulations on January 7, 2021. The Final Regulations are generally not effective until January 1, 2022, however taxpayers are permitted to apply the Final Regulations prior to that date if applied consistently.

Relevant Exceptions for Real Estate Funds

• Section 1231 Gains –− gains from the sale of property used in a trade or business (including rental real estate)

− application to triple net leases

• Capital Interest Exception –− applies to allocations in respect of a fund manager’s capital if the allocations are made in a

“similar manner” (or “reasonably consistent”) with limited partners with a significant aggregate capital account balance in a fund (more than 5%).

− Capital interest allocations must be clearly identified in partnership agreement and on the partnership’s contemporaneous books.

− Capital interests acquired with loan proceeds

41


Transfers of APIs to Related Persons

Lookthrough Rule for Certain API Dispositions

Carry Waivers

Distributions of API Property

42

Tax Cuts & Jobs ActQualified Business Income Deduction Individual taxpayer allowed a deduction equal to 20% of their

domestic “qualified business income” (QBI) from passthrough businesses (partnerships, S corporation, trust or estate)

REIT ordinary dividends qualify for 20% deduction without regard to income and wage limitations

Deduction is generally limited to the greater of:• 50% of taxpayer’s W-2 wages that are allocable to the QBI

• The sum of:− 25% of taxpayer’s W-2 wages, and− 2.5% of the original purchase price of all qualified property

(tangible depreciable property, including real property)

43

Tax Cuts & Jobs ActOpportunity Zone Funds

The Opportunity Zone Program offers a new opportunity to attract private placement funds for projects constructed in designated Opportunity Zones. • Elect to defer recognition of capital gains until December 31, 2026 if those

gains are invested used to acquire equity interests in qualified opportunity funds (“QOFs”) (discussed below) within 180 days of the date on which the gain is recognized by the investor

• Exclude from taxable gross income up to 15% of the deferred capital gains (if certain holding periods are met); and

• Exclude from taxable gross income any post-investment gains from the disposition of investments in QOFs or properties held by QOFs if held for at least 10 years

44

Tax Cuts & Jobs ActQualified Opportunity Fund A qualified Opportunity Fund (“OF”) is a corporation or

partnership, formed for the purpose of investing in qualified opportunity zone property and holds at least 90% of its assets in “qualified opportunity zone property.”

Qualified Opportunity Zone Property: tangible property used in a trade or business if: 1. the property is purchased after December 31, 2017; 2. either:

• the “original use” of the property in the OZ begins with the OF; or • the OF “substantially improves” the property (land not included); and

3. during substantially all of the OF’s holding period for the property, substantially all of the use of the property was in an OZ.

45

Thank You

Matthew Posthuma, PartnerRopes & [email protected] 312.845.1314

Heather L. Preston, PartnerKilpatrick Townsend & [email protected] T 650.614.6425