Private Equity Real Estate Fund Structures: A Primer

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Birgo

For investors that want to diversify their capital and access attractive risk-adjusted returns, a private equity real estate fund can be a compelling option for consideration. However, tiptoeing into the world of private fund investing can be intimidating and complicated.  The structure and terms of private equity funds can seem difficult to digest on the surface, but investors should familiarize themselves with the basics prior to investing. 

Let’s explore the structure and unique features that exist within private equity real estate funds. 

Legal Structure

The purpose of a private equity real estate fund is to pool together capital from various sources in order to invest in assets that align with a particular niche strategy. To achieve this, a professional investment manager, or “sponsor,” initiates the fund and solicits investments from various sources of capital. 

The parties enter into a legal agreement, which is typically either a limited partnership agreement or a limited liability company operating agreement. The purpose of this agreement is to govern the operations and dictate the terms of the fund. In the case of a limited partnership, this agreement involves limited partners (LPs) as the investors and a general partner (GP) as the investment manager. Generally speaking, the limited partners contribute capital but are otherwise silent, or passive investors; they have no oversight over the fund or its acquired assets, nor do they have any liability beyond the amount of their investment.

Fund Term

At the outset of a fund, the sponsor will dictate the term, or duration, or the fund. Real estate is generally considered a long-term asset class, and fund investments tend to have longer time horizons than single deal investments. Most often, the length of the agreement is from five to ten years, although some funds are “evergreen” with no specified termination date. Additionally, many funds have optional term extensions, which may or may not require the approval of investors. It is common to see two, one-year extensions at the discretion of the sponsor; this allows for flexibility on fund liquidation, so that funds are not forced to sell assets in adverse economic conditions strictly because of the fund term. The term length should be consistent with the specific fund’s strategy, and must be clearly outlined in the fund’s governing legal documents. 

Sponsor Co-Investment

In order to align incentives between investors and sponsors, most often the fund manager contributes capital to the fund as well. Birgo Capital firmly believes that a strong co-investment by the sponsor is an absolute necessity in any syndicated real estate investment. Investors should be wary of a real estate fund or deal wherein the manager does not have “skin in the game” -- if the fund does not perform well, the sponsor should participate in the pitfalls of imprudent investment decisions. Generally speaking, sponsor co-investments range from 2% - 10% of total fund committed capital.

Preferred Return

The preferred return is the annual percentage return on investment that investors are entitled to receive on their capital contribution prior to the sponsor’s participation in the fund’s performance. Many real estate funds aim to meet the preferred return through cash distributions, but the preferred return will accrue if it is not paid current. For example, if a fund has a preferred return of 7% but the investors are receiving a 5% annualized distribution, then the investors are accruing a 2% annual return on investment that generally must be paid to investors prior to the sponsor’s participation in the returns.

Preferred returns are not a required feature of all funds; they are favorable to investors, and they provide a significant incentive for sponsors to achieve a minimum baseline of expected annual returns. The prevailing market rate for preferred returns in real estate funds is anywhere from zero to eight percent. 

Promoted Interest

For investment returns generated in excess of the preferred return, most funds have a “promote” or “carried interest” that takes effect. The promote is a form of incentive-based compensation for the sponsor. It is the portion of the return generated above the preferred return that is allocated to the fund manager to reward the manager for success. Typical carried interest rates are anywhere from 10% to 50%, and some funds have “tiered promotes” wherein the manager incentive increases disproportionately as the returns exceed specified return thresholds.

A brief illustration can help investors better understand the preferred return and promoted interest. Let’s assume a fund has a 6% preferred return and a 30% promote. If an investor contributes $100,000 to the fund and in year one the fund achieves a 16% gross return, the first 6%, or $6,000, would be allocated to the investor as the preferred return. The sponsor is entitled to 30% of the remaining profits, so in this case the sponsor receives $3,000, and the remaining $7,000 is earned by the investor. In total, the investor achieved a 13% net return and the sponsor was rewarded with $3,000 for successfully generating profits in excess of the preferred return.

Management Fees

Real estate fund sponsors are also compensated through various fees charged to the investors. There is no shortage of fees that fund managers charge to investors, and investors should be certain to understand the fee arrangements in place. Birgo Capital believes that fund managers should primarily be compensated based on investment performance, and they should be diligent to ensure that as much investor capital as possible is put to work generating returns. Management fees within a private equity real estate fund can include fund formation fees, committed capital fees, asset management fees, acquisition fees, property management fees, financing fees, guarantee fees, and disposition fees. Indeed, management fees within a real estate fund are a broad enough topic to warrant their own article! All Birgo investors receive very clear documentation spelling out what fees are charged to the funds, and we align incentives by ensuring that we are primarily compensated based on fund performance.

Capital Contributions

Funds have different ways of accepting capital from investors. Some funds operate on a first come, first serve basis, wherein investors contribute 100% of their capital commitment up front, and that capital is accepted at the time of investment. Other funds operate on a capital call basis; in this scenario, investors will make an up front commitment, but the sponsor will determine when the funds will be contributed based on the timing of acquisitions and other cash uses. Investors should have a good understanding of what the expectations are for the timing of capital contributions within a particular fund before making a decision to invest.

Other Considerations

In addition to what has already been discussed, there are many other relevant features that investors should consider when evaluating the structure of a real estate fund. Some of these are as follows:

Clawbacks:  A clawback provision would require the sponsor to contribute back to the fund distributions previously received if certain thresholds are not met. Clawbacks protect investors from fund performance suffering late in the fund’s life by ensuring that sponsors work hard to maintain fund performance even after they have received significant cash distributions. 

Catch-ups: A catch-up clause allows the sponsor to collect a portion of the returns after the preferred return has been met but before a carried interest amount is split with investors. Funds that have catch-up clauses are less favorable for investors.

Reporting: Some funds report monthly, some report quarterly, and some may only report annually. Investors should understand how frequently they can expect to hear status updates from the sponsor. 

Third party oversight: Some funds are audited by third party CPA firms, some are reviewed, and some have no formal financial statement oversight. More external oversight over fund financials is generally a good thing for investors. 

Advisory committees: Funds will at times elect to appoint certain investors or outside experts to an advisory board or committee, which adds a layer of accountability and expertise for sponsors. Investors should consider whether or not the fund has this in place.

Conclusion

Private equity real estate funds are tremendous vehicles that enable investors to pool capital together under the management of an expert and access unique investment strategies while diversifying risk. However, not all funds are created equal, and investors should educate themselves on the fundamental features of real estate funds prior to investing. 

If you have additional questions on fund structures, or are interested in discussing an investment with Birgo, schedule a call with us today.

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