Tough Times Face Private Real Estate Fund Structure

With the decline in values and transaction volume in commercial real estate, the traditional private real estate fund structure is under great pressure.

With the decline in values and transaction volume in commercial real estate, the traditional private real estate fund structure is under great pressure. Investments by institutional investors in real estate generally fall along a spectrum between, at one end, investments in fully discretionary commingled real estate funds (with multiple investors committing capital and having very little or no control), and, at the other end, investments in single institution non-discretionary separately managed real estate accounts. In the middle you have the so-called “club deals” (real estate investments by a small group of large institutional investors in a private investment vehicle) which involve varying degrees of investor discretion and control.

Investors in commingled funds are now seeking greater protections such as (a) more specific investment targets and investment strategies, (b) lower leverage limitations, (c) the aggregation or pooling of returns (with fewer investment-by-investment distribution waterfalls), (d) lower advisory/management fees , (e) better alignment of interest (i.e., more sponsor “skin in the game”), (f) increased investor approval rights, and (f) the application of transaction fees earned by the investment manager against the management fees payable by the investors.

Additionally, the time horizon for closing a traditional opportunity fund appears to have lengthened to as much as 18 months or more, with added investment manager scrutiny and reduced use of placement agents. Historically, investors in separately managed accounts engaged managers to identify suitable investment opportunities on a non-discretionary basis for lower fees than were typically charged by the managers of commingled funds. Today, separate account investors are increasingly seeking “line of sight” or “joint venture” investment opportunities, with the real estate investments being identified before the investor has even engaged the investment manager.

Some interesting issues created by the increasing use of club deals include:

• Transactions involving multiple key investors, each with approval rights, can result in additional complications, including the need of each investor to underwrite their fellow investors and the incurrence of fiduciary obligations and liabilities to other investors.
• Each investor having its investment controlled by the vote of other investors with different agendas, the conflict between investment-by-investment decision-making and the desire to aggregate returns, and the lack of the internal investor resources that are necessary to adequately and timely perform due diligence and exercise increased approval rights.
• Even where investors do not have contractual approval rights, the investment manager may face the practical problem of not being willing to proceed with an attractive investment if one or more investors expresses a preference to not make the investment.

Additionally, institutional investors now are paying greater attention to conflict issues, such as the manager’s allocation of investment opportunities among multiple investment platforms managed by the manager.

These changes all represent a reaction to the problems that were created by the decline in the commercial real estate markets. There is only one certainty; the needs of institutional real estate investors and private real estate fund investment structures will both continue to evolve as the commercial real estate markets change.