Key Legal Considerations for Developing Real Estate Funds

July 24, 2021 Beth McCandry

We have already covered some of the most important considerations when starting your first multi-asset real estate fund, including how it is structured, what type of investors you are targeting and whether to use a closed-end fund or an open-ended fund. The capital and real estate markets have proven to be strong and offer investors opportunities to deploy capital as the country continues to open up. After you’ve established your first real estate fund, there are a number of additional considerations to consider when creating additional funds, particularly if the total regulatory assets the funds manage exceeds $ 110 million or if additional country jurisdictions are involved.

We asked Jonathan Needell, President & Chief Investment Officer of Kairos Investment Management, for advice on a new fund manager based on his experience in setting up numerous real estate funds. “Raising a subsequent fund often increases AUM to the point where a manager is not exempt from registration,” Needell says. “That requires significant investments in operational infrastructure, including investment, investor relations, cybersecurity and compliance.”

GROWTH OF YOUR INVESTOR BASE

For your first fund, you likely included investors with whom you already had a relationship. As you move from the first fund to your second or third fund, you may have a marketable track record, size or targeted fundraising sufficient to attract institutional investors, registered investment advisory platforms and possibly placement agents. It is important to be aware of whether you are acting in a manner that generally solicits and broadly promotes investment opportunities in your fund. If so, Rule 506 (c) of the Securities Act contains requirements that must be followed, such as: Generally, if the more general Rule 506 (b) of the Securities Act is followed due to no solicitation or solicitation, investors still need to be “accredited investors” but there is no logistical barrier to taking reasonable steps to verify this Fact.

“QUALIFIED CUSTOMERS” OR “QUALIFIED BUYERS”

Another area that a follow-on fund manager should be aware of is whether their investors are “qualified clients” or “qualified buyers”. If the fund manager is registered with the SEC or is based in certain states, the fund manager may not be able to charge a performance fee (ie, carried interest or advertising) to investors who are not “qualified clients” as defined in the Advisers Act of 1940. A “Qualified Client” has a technical definition that includes an individual with assets under management by the Investment Advisor of US $ 1 million or more or a person with net assets of US $ 2.1 million or more (excluding their primary residence).

Another consideration is whether it is necessary to certify that investors are “qualified buyers” as an exemption from registration under the Investment Company Act of 1940 may be required depending on the number of intended investors and fund portfolios all investors are “qualified buyers”. “Qualified Buyers” means an individual who has at least $ 5 million in investments and a company who has at least $ 25 million in investments. Decisions about the type of investor base and potential number of investors can add significant costs, disclosure, and complexity for fund sponsors.

TAX STRUCTURING AND ACCOUNTING

While your first fund was primarily domestic, raising capital outside of the United States can be effective for you. If you are attracting non-US investors, experienced tax advisors are required to build an efficient and responsible tax structure. There are numerous ways to create an appropriate tax structure, including through the use of US or non-US feeder funds or blocker companies.

The appropriate structure for your fund ultimately depends on the identity, preferences and jurisdiction of your investors. For example, if you have a pension plan investor, they are structurally sensitive to avoid non-tax income, and if you have a German investor, a special purpose vehicle may be required to be formed under German law.

Larger funds create bespoke vehicles for new investors by creating parallel funds. Co-investment funds are separate funds that invest alongside the main fund but are created to meet various tax, regulatory or other requirements of certain investors. When a complex structure is used, you need to closely track expenses, including employee expenses, and allocate them to the various funds.

INVESTMENT ADVISOR QUESTIONS AND COMPLIANCE

If you have more than $ 110 million in regulatory assets under management (RAUM), you must register with the SEC as an investment advisor. SPACE is the sum of the market value of all investments managed by a fund or family of funds that a venture capital company, brokerage firm, individual registered investment advisor or portfolio manager manages on behalf of their clients.

As an investment advisor, you are a “trustee” for your advisory clients (ie funds and accounts you manage). This means that you are fundamentally obliged to act in the best interests of your clients and to provide investment advice in the best interests of your clients. You have an obligation to your customers to show undivided loyalty and the highest level of good faith. You should not engage in activities that are contrary to the interests of any customer and you should take steps that are reasonably necessary to meet your obligations. If you cannot avoid a conflict of interest that could affect the impartiality of your advice, you must fully and openly disclose the conflict. In addition, you must use reasonable care to avoid misleading customers and you must fully and fairly disclose all material facts to your customers and prospects.

As a registered investment advisor, you are required to adopt and implement written policies and procedures appropriately designed to prevent violations of the Investment Advisers Act of 1940, including: portfolio management processes, accurate disclosure, proprietary trading, protection of client assets, safeguards for protection the privacy of customer records and information, trading practices, marketing, valuation and fee ratings, and business continuity plans. You need to take other steps including preparing and preparing regular Form ADV submissions, adopting a code of ethics, Comply with the necessary provisions in your consulting contracts with customers and subject yourself to SEC compliance audits. Registration requires significant investments in infrastructure, including system, compliance, cybersecurity, investor relations, among other things.

EXTERNAL FUND MANAGER AND INVESTOR RELATIONS

Depending on the size and complexity of your fund (including cash distribution waterfall or liquidity rights, number of investors, information rights and other obligations to investors), it may be necessary or advisable to appoint an external fund administrator. A fund manager can help you with the logistics of your fund and provide services that include partnership accounting, financial reporting, capital call and dividend processing, maintenance of investor capital accounts, treasury services, auditing and tax support, and coordinated fulfillment of all investor services. As your investor base grows, you will likely need experienced investor relations staff to handle investor reporting, outreach, and relationships.

EMPLOYEE PARTICIPATION AND EQUITY INCENTIVES

As you move from your first fund to subsequent, larger funds, you may need to hire more staff, including acquisition teams, to invest the funds raised. Experienced employees often expect the opportunity to participate in fund investments (without fees or carry) and to participate in the profits, either by participating in the sponsor’s carried interest or by participating in certain fee income of the sponsor. Creating a market capital incentive program requires coordinated corporate, securities, employment, and tax planning.

CONCLUSION

This article discussed some basic considerations for moving from your first real estate fund to subsequent funds.

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