What securities laws govern private equity real estate funds, and what factors must fund sponsors take into account when operating one?
AN EARLIER ARTICLE, “How to Set Up a Private Equity Real Estate Fund,” introduced the contemporary structure of private equity funds, explored the motivations for sponsoring a fund and provided an overview of the considerations that fund sponsors must take into account. Part II reviews the securities laws that govern private equity funds, explores the most common offering terms and discusses fund operations. It is not intended to be an exhaustive review of private placements or securities laws.
Securities Laws, Regulation D And the Offering Memorandum
Jan A. deRoos
Note that any firm contemplating the creation of an investment fund should retain legal counsel and an experienced financial team to assist with the process of raising capital and administering the fund. Sponsors commonly also work with placement agents, intermediaries who advise and assist in setting up funds and raising money from investors, particularly if the sponsor is looking to raise equity beyond a narrow network of investors.
The creation of an investment fund using a private equity offering can be accomplished without registering with the Securities and Exchange Commission (SEC), as long as the offering conforms to the requirements of Regulation D of the Securities Act of 1933. The act has been updated over time; this article refers to the current rules. These were most notably revised by the JOBS Act of 2012, which eased various securities regulations to encourage funding of small businesses. They were further refined by amendments in 2016 that revised the rules for the exemptions for registration.
Regulation D establishes two exemptions from the registration requirements of the Securities Act, Rules 504 and 506. Regulation D also establishes two fundamental types of investors: “accredited investors” and “non-accredited investors.” Accredited investors are those investors with a personal net worth in excess of $1 million, excluding the value of their home (individually or jointly with their spouse), or investors with annual income in excess of $200,000 in the past two years and a reasonable expectation of the same in the current year ($300,000 jointly with their spouse). If one of these criteria are not met, investors are considered non-accredited. In addition, directors, executive officers and general partners of the sponsor and business entities are considered accredited investors regardless of their income or net worth.
Rule 504 allows sponsors to raise up to $5 million annually without SEC registration. Funds can come from any number of investors, accredited or non-accredited, and the sponsor is not subject to any specific disclosure requirements. The investment offering is “restricted” in that interests granted to investors may not be sold without registration. Although Rule 504 provides an exemption from SEC registration, sponsors must comply with state “blue sky laws,” which are designed to protect investors against fraudulent sales practices and activities.
Under Rule 504, sponsors are not generally allowed to solicit or advertise the offering of interests to the public, but the rule may allow those activities if specific requirements are met. Most notably, sponsors who follow state securities law exemptions, called the Small Corporate Offering Registration (SCOR), may advertise the offering provided that the sponsor sells interests only to accredited investors. While Rule 504 allows for the sale of interests without specific disclosure requirements, sponsors should be mindful of antifraud provisions that require any information provided to be free of false or misleading statements.
Rule 506 allows sponsors to raise unlimited funds as long as they follow a very specific set of standards, which fall under two broad categories, Rule 506(b) and Rule 506(c).
Under Rule 506(b):
- The sponsor can offer the fund to an unlimited number of accredited and up to 35 non-accredited investors. All non-accredited investors must be sophisticated or be advised by an investment adviser who is. The SEC defines a sophisticated investor as someone with sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.
- There are no specific rules for disclosure to accredited investors, but the sponsor must make significant disclosures to non-accredited investors that are generally the same as for registered offerings, including financial statements. Any information provided to accredited investors must be made available to non-accredited investors.
- The sponsor must make itself available to answer questions from prospective purchasers.]
- The sponsor may not solicit investors or advertise the offering.
Under Rule 506(c), a company may solicit investors and advertise the offering, provided that:
- All investors in the fund are accredited.
- The sponsor takes reasonable steps to verify that investors are indeed accredited, beyond receiving a statement by the investor – for example, reviewing tax returns, bank or brokerage statements and similar documents.
- Investors do not sell their interests for at least one year.
Regardless of the rule used to offer interests, sponsors must be aware of four items that affect all private placements: 1) Sponsors are required to file with the SEC within 15 days of the first sale of an interest. 2) Sponsors must not violate the antifraud provisions of federal securities laws. 3) Sponsors cannot “game the system” by creating multiple offerings that are essentially the same. 4) State blue sky laws must be followed.
Offering Materials and The Private Placement Memorandum
While offering materials are sometimes mandated, as detailed above, sponsors need to see the offering materials or private placement memorandum (PPM) as an effective and positive communication medium as well as a way to protect the sponsor from unforeseen liability. Sponsors of interests offered via Rule 504 or Rule 506(b) are often dissuaded from issuing a PPM because it is expensive to produce and not required as long as one is offering only to accredited investors. The costs range from $25,000 to $250,000, so the decision to prepare a PPM is not to be taken lightly.
If only a small number of accredited investors will be involved, the offering materials can consist of a term sheet and a willingness to allow the investors (usually as a group) to perform due diligence on the offering. When the number of potential investors or the offering is large, a formal PPM can help the sponsor effectively communicate a consistent offering to investors, help investors understand the rewards and risks of investing and protect the sponsor from alleged antifraud charges.
Operating the Fund
Factors unique to operating a fund with outside investors include the following:
Contributions to real estate funds are most easily handled in a closed-end fund raised for a specific investment or an investment set with a fixed number of investors. Using such a fund eliminates the need to value (appraise) the fund for additional investors. Most funds set a schedule for capital funding, termed “calls” that specify the dates, amounts, and terms of each round of funding. There is generally an initial contribution, with the remaining funds called as needed to fund the investment or development schedule.
Distribution of cash flows and allocation of profits are performed according to the information provided in the offering memorandum, which generally consists of a preferred return to the investors, plus the investors’ share of net profits after the preferred return. In general, investors prefer to receive their funds in the following order:
- Investors and the sponsor receive a return of their capital contributions (which are generally not taxable).
- Investors receive a preferred return, calculated on the basis of the total amount of capital held and the length of time those funds were held.
- The sponsor may then receive an allocation of the profits referred to as a “catchup,” generally in proportion to the profit split.
- Lastly, all remaining profits are divided between the investors and sponsor according to the agreed-upon promoted interest structure.
This structure helps align the interests of the sponsor with those of the investors.
Clawbacks are found in some funds with multiple investments to provide a device for the investors to receive funds from the sponsor if a later marginal investment results in an overallocation of profits to the sponsor, especially if the investors do not receive their entire return of capital and preferred return.
For example, imagine that a fund finds early success with its first project, placing the sponsor in the promoted interest, earning the majority of the profits from the venture. However, a later project becomes distressed and needs to be sold at a loss. In this situation, a clawback provision would allow the investors to get access to profits from the first project to make them whole for the return of capital, preferred return or both.
Disputes over fees and potential conflicts of interest can arise when the sponsor is seen as profiting at the expense of the investors. While sponsors generally take a fee for managing the investments in a fund, additional fees should be handled with enough transparency to show that they are not in excess of normal market rates.
Decision-making is generally handled by the sponsor on such issues as budgets, purchase and sale of investments, indebtedness and leverage, use of specific service providers, and tenant selection and management. Some institutional investors may wish to participate in operational decisions and may insist on certain provisions.
Setting up a real estate fund is a big step for many real estate professionals. This two-part series was meant to demystify fund formation and operation.
Download NAIOP's white paper Creating a Private Equity Fund: A Guide for Real Estate Professionals.
NAIOP Distinguished Fellow Jan A. deRoos, Ph.D. (firstname.lastname@example.org) is HVS Professor of Hotel Finance and Real Estate, SC Johnson College of Business, Cornell University.
NAIOP Distinguished Fellow Shaun Bond, Ph.D. (email@example.com) is West Shell Jr. Chair in Real Estate, Lindner College of Business, University of Cincinnati.