New Course: Private Equity Fund Structure and Management
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How does one go about creating a partnership to raise equity for ongoing real estate investment?
THIS ARTICLE INTRODUCES the contemporary structure of private equity real estate funds and outlines the steps necessary to create and properly manage a fund. It discusses the motivations for creating a fund and the factors that should be considered when setting one up. A future article will examine how securities laws impact the offering and management of a fund, as well as typical offering terms.
In its simplest form, a real estate private equity fund is a partnership established to raise equity for ongoing real estate investment. A general partner (GP), henceforth referred to as the sponsor, creates the fund. The sponsor asks investors, known as limited partners (LPs) to invest equity in the partnership. Those funds, along with money borrowed from banks and other lenders, will be invested in real estate development or acquisition opportunities.
In general, the LPs provide the bulk of the equity capital and are passive investors who have chosen to invest in an offering presented by the sponsor. LPs earn an early return of capital and a preferred return on capital invested. Sponsors provide some of the equity capital, secure the investment opportunities, manage the real estate and the fund, and earn fees that typically are based on its performance.
A real estate private equity fund differs from capital that comes from friends and family and joint ventures. Investments by friends and family are generally not subject to an extensive partnership agreement, and each dollar of equity investment is treated equally. Joint ventures are generally set up for a specific purpose on a single investment wherein each partner adds specific value to the investment. One example is a joint venture among a landowner, a developer and a money partner. None could complete the investment without the others, and the joint venture is specific to one investment. Real estate private equity funds, on the other hand, are created to invest in a series of deals with a standardized risk and reward structure created for the overall fund in which the sponsor and LP participate unequally.
Jan A. deRoos
The 50 largest private equity firms have collectively raised $280.8 billion and the 20 largest real estate private equity firms have each raised more than $4.5 billion over the past five years, according to the PERE 50 2017, PEI Media’s annual ranking of the world’s largest private equity real estate firms. But the real estate fund structure is also available to smaller investors. Creating a real estate fund allows the sponsor to accomplish the following:
Diversify and expand funding sources. A sponsor with a pipeline of potential investments can use a fund to take advantage of deal flow that would not otherwise be available. The capital-raising strategy should, however, focus on the sponsor’s history, the experience of the team, the potential for returns, alignment of interests and clearly identified opportunities.
Diversify holdings. The most reputable developers with the best track records are able to find investment opportunities in their home markets that are outside their traditional property type focus, opportunities outside their historical geographic focus, or some combination of both. A private equity fund can provide the scale that will allow the sponsor to take advantage of these opportunities, generating returns over a larger capital base and potentially lowering the risk of the firm.
Invest in larger, higher-quality projects. A capital-constrained sponsor can use a fund to invest in larger, more complex projects. Additional partners also enable the developer to share the risks with their investors to create a better risk-return balance on large, complex projects that the sponsor could not take on alone.
Obtain better terms from banks and other lenders. A fund with a larger capital base, diversity of investments and lower-risk projects can result in less costly debt and mezzanine capital for the fund sponsor and its investors, increasing the equity returns for both the sponsor and the LPs.
Provide an alternative to mezzanine capital. This advantage is highly dependent on the nature of the investments and the credit risk of the sponsor.
Develop projects using fund-level financing in lieu of project-by-project financing. This can allow the sponsor to move more quickly to take advantage of a rapidly developing market or a fluid environment. Having permanent or “take-out” financing in place facilitates conversations with construction lenders and landowners who may be reluctant to engage on a project without an identifiable permanent financing source.
Earn fees from the fund, including a promoted interest. The fund sponsor may find that its business has matured to the point where it is a market leader. In this case, the sponsor obtains all of the benefits outlined above plus the ability to earn a promoted interest and fees from the fund structure as a reward for its success.
While motivations may differ among sponsors, the private equity fund structure can provide significant rewards when properly executed. The key is to have a clear strategy for creating the fund and to execute against that strategy.
Three Key Considerations
While there are myriad factors to take into account when setting up a fund, three key considerations are foundational to success in establishing the fund and efficiently raising capital from the limited partners.
1) The first consideration is the amount of equity capital to be raised, including organizational fees. The minimum fund size is generally considered to be $20 million, although crowdfunding platforms have reduced this in some cases. While organizational costs are proportional to fund size, the lower floor for organizational fees is about $400,000. Although the sponsor is able to recoup these fees from the fund once the capital is raised, the sponsor must carry these costs during the formation period. These include formation costs for the legal entity or entities, filing fees, accounting fees, regulatory brokerage costs, clearing costs and the cost of producing marketing documents.
While the fund’s equity capital will be combined with debt capital to create the total pool for investing, a well-executed fund needs to balance potential deal flow with fund size to ensure that the fund can produce sustainable returns for the LPs, and that it is not so small that a follow-on fund needs to be launched. The timing of flows to and from the fund also must be considered. In general, LPs start earning a preferred return on their capital as soon as the funds are invested. Thus, in addition to obtaining a commitment from each LP for the total amount invested, wise sponsors stage the pay-in to match the fund’s anticipated timing of investments.
2) Sponsors must be clear-eyed about the amount of time, energy and seed funding required to launch a fund. The sponsor is responsible for all aspects of the fund: organizing the fund, which includes generating a partnership agreement, offering and subscription documents; securing investment opportunities; securing loans and other financing; managing the fund; operating the properties; preparing partners’ tax returns; and responding to accounting and audit matters, to name only the highlights.
While many experienced real estate firms perform the majority of these activities in the course of their existing businesses, in a private equity fund environment the sponsor is governed by the strict nature of the partnership documents and offering memorandum, so attention to detail is paramount. In addition, the fund structure will require that the sponsor establish regular, organized meetings with the LPs and a consistent reporting structure, a task increasingly facilitated by software.
3) Sponsors must have a clear investment fund strategy. This is distinct from the market fundamentals, property type and location strategies that dominate the traditional real estate investment assessment. While experienced sponsors and the largest funds may be able to raise funds for a blind pool – a fund for which no individual investments are identified – first-time sponsors generally must identify specific investments that are included in the fund’s offering memorandum.
Five Types of Funds
Sponsors should be clear about where the fund will operate on the risk/return continuum and stay true to that goal. Five different types of risk-adjusted funds exist within the private equity industry. They are generally listed in order of risk and returns. The metrics that LPs concentrate on include returns, equity multiples and sheltered income. Returns include the cash-on-cash returns and the net LP internal rate of return (IRR).
1) Core. This type of fund has the lowest risks/rewards. It typically offers 6 to 8 percent net equity IRR to LPs; no/low leverage; and well-occupied, stable, high-quality assets in primary markets and locations. Its annual income return is high relative to appreciation.
2) Core-plus. This type of fund contains high-quality assets in secondary markets/locations or slightly risky assets in primary markets/locations. It offers 8 to 12 percent net equity IRR to LPs. Moderate leverage – up to 50 percent – is employed to increase equity IRR.
3) Value-add. These funds contain assets improved via re-leasing, operational efficiencies and/or redevelopment; they also include new development. They employ moderate leverage, up to 70 percent. Market/location is secondary to the opportunity to add value. Appreciation is a significant part of the overall investment returns. These funds offer 11 to 15 percent net equity IRR to LPs.
4) Opportunity. These funds offer high risks/returns. They involve repositioning and redeveloping poorly operated, vacant or outdated buildings or net new buildings on vacant land. Market/location is secondary to the opportunity. Appreciation dominates the returns, with much of the return occurring at the end of the holding period. These funds typically seek to offer more than 15 percent net equity IRR to LPs.
5) Distressed debt/mezzanine. These funds purchase senior loans, mezzanine loans or nonrated commercial mortgage-backed securities (CMBS) tranches, or make mezzanine loans. They use leverage to increase equity IRR and are not averse to owning if loans default. They offer 8 to 12 percent net equity IRR to LPs.
Sponsors need to clearly articulate their fund’s strategy and then make investments that are consistent with that strategy. The LPs seek returns in exchange for tying up their funds for several years with little control over the operation of the fund. Sponsors who can answer specific questions about the timing and magnitude of LP returns are more successful at raising capital than those who cannot. Most sponsors are able to create a fund only after they have demonstrated success, which often includes ownership of a healthy portfolio.
An excellent strategy for such a sponsor is to create two funds: a core-plus fund of existing stable assets that purchases from the sponsor’s existing portfolio and can deliver immediate returns to investors, and a value-add fund to provide capital for new development and acquisition opportunities. The sponsor thus has two clear strategies and two different risk/return opportunities for potential investors, who can choose between the two funds or can invest various amounts of capital in each, depending on the LPs’ needs.
Sponsors must carefully consider their compensation and align their interests with those of their LPs. Sponsor compensation may come from two sources:
1) The Promoted Interest. Also known as the “promote” or “carried interest,” this generally consists of a 2 percent fee based on capital raised from the LPs and 20 percent of the profits of the fund. In many cases, to align the interests of the sponsor and the LPs, the sponsor participates only in those profits above the LP investors’ preferred return.
2) Fees. Sponsors may earn additional fees for a variety of services provided to the fund. These include the following:
- Asset management fees for managing the fund on behalf of investors, generally 1.5 percent of the value of assets under management on an annual basis.
- Acquisition fees for acquiring buildings on behalf of the fund, typically 1 to 3 percent of the acquisition price.
- Property management, leasing, construction and development fees, when the sponsor provides these services in lieu of hiring an outside firm; these fees typically are based on market norms.
- Finance and guarantee fees, for securing loans and providing a guarantee on behalf of the fund, generally 0.5 to 1.0 percent of funds secured or guaranteed. Finance fees are a one-time fee, while guarantee fees are annual for the life of the guarantee.
Sponsors should not see their fund as a vehicle for generating fees at the expense of the LPs; this approach is a sure route to an unsuccessful fund. On the other hand, a sponsor that can add value in the development, acquisition and property management functions via superior management, local market knowledge and depth of experience should be willing to incorporate fees relating to these services into the fund structure.
A litmus test for fee inclusion is whether the sponsor would be willing to pay these fees if it were an LP in the fund. Sponsors should be able and willing to demonstrate that it is the promoted interest, specifically the participation in profits after the LPs have their preferred return, that drives their decision-making and aligns their interests. Further, sponsors should be transparent about the overall returns to the fund, both before and after fees and gross and net IRRs to the LP investors.
See Setting Up a Private Equity Real Estate Fund, Part 2, detailing the securities laws that govern investment funds, offering terms and fund operations.
Download NAIOP's white paper Creating a Private Equity Fund: A Guide for Real Estate Professionals.
By NAIOP former Distinguished Fellows Jan A. deRoos, Ph.D., HVS Professor emeritus, Hotel Finance and Real Estate, SC Johnson College of Business, Cornell University, and Shaun Bond, Ph.D., Frank Finn Professor of Finance, University of Queensland