Funds and Indirect Real Estate briefing September 2012
Exiting a private real estate fund: strategy, planning and processes Summary and implications The timing of an exit is key to maximising returns to investors and is, therefore, a critical stage in the life of a private real estate fund. This briefing discusses: the typical life of private real estate funds; reasons why an early exit from a fund may be sought; key considerations in planning an exit; fund rollovers and fund extensions as mechanisms for prolonging a fund’s life beyond the agreed exit date; final processes that fund managers must undertake before a fund can be wound up; and the creation of follow-on funds at the end of a fund’s life and secondary trading as an alternative exit route.
Life of private equity real estate funds Most private real estate funds will expect to terminate at the end of their fixed life although, as discussed later in this briefing, this is not always the case, particularly if market conditions are not favourable at the planned termination date. This section looks at the expected life of closed-end and open-ended funds and the flexibility open-ended funds may afford to investors wishing to redeem their investments. Closed-end funds The life of a closed-end fund is set in order to reflect the investment strategy developed by the fund manager. When promoting a fund to potential investors, the fund manager must demonstrate how it will create returns. This will include identifying when assets should be sold to create the best return. This could be after completion of an active asset management programme or when market values have increased in the targeted sector. To allow time to achieve its projected returns, a private real estate fund usually has a fixed life of between five and 10 years. The diagram over the page illustrates that a closed-end fund with a lifecycle of 10 years could
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Ask a question If you have any questions please contact Deborah Lloyd, Partner T +44 (0)20 7524 6370
[email protected] Recent briefings Eurozone survival or break-up: key considerations for fund managers Despite recent initiatives to stabilise the Euro and its banks, an exit from the Eurozone cannot be ruled out. This briefing gives practical and legal guidance to fund managers when considering the impact of a Eurozone exit. Buying property debt There are commercial opportunities in buying real estate debt from banks at a discount and unlocking the value in the properties that secure these loans. This briefing explores the process of buying property debt, focusing on practical issues. Readiness for sale – a guide for streamlining property transactions The IPF guide, co-authored by two Nabarro Real Estate partners, is designed to help clients undertake property transactions smoothly. The Funds and Indirect Real Estate team To find out more about the team and our capabilities click here
September 2012
Funds and Indirect Real Estate briefing Exiting a fund
typically start to wind down at year seven, but may need to rollover to achieve best value on exit (see also “Fund rollovers” below). Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Equity raising Commitment period Holding period Rollover Wind down
Open-ended funds Open-ended funds allow investors to redeem their interests against the fund. Although usually associated with the retail market and regulated funds, they are also seen in the institutional market and are often described as semi-open-ended. This is because redemptions are restricted in time and/or amount. Open-ended can also mean that the fund remains open to new equity at any time during the life of the fund. Core funds are more likely to be structured as open-ended. This is because the nature of the underlying assets means that they can more easily be sold to meet redemptions as they arise. Following the global financial crisis (GFC) in 2008–2009, many pension fund investors were seeking more stable returns and preferred core funds with little or no debt exposure. An open-ended fund can have a fixed or an indefinite life, although the norm is around 10 years. Apart from redemptions (see below), the fund terms are similar to closed-end funds. Redemption mechanism It is common to have a lock-in period for the first two to five years of an open-ended fund. This ensures that there is a period of stability to allow the fund manager to build the asset base. In this period, no one can redeem. There are several ways in which redemptions work. A typical example is described below. A typical example of a way in which redemptions work After the lock-in period, if an investor wishes to exit the fund (either totally or in part), it Notice of redemption will give notice to the fund manager. The fund documents are prescriptive as to when the notice can be served.
Redemption period
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The fund manager must seek to redeem units within a prescribed time period, say, six months. This is very different to retail funds, which adopt daily dealing and settlement in seven days. The redemptions can be “matched bargained”. This means that an existing or new investor will buy the units for a price agreed with the seller. This may be the fund manager’s preferred option as it retains the assets under management. If this cannot be achieved, however, alternatives include using cash reserves (which may not be sufficient), the sale of assets, raising debt or new equity.
Funds and Indirect Real Estate briefing Exiting a fund
September 2012
A typical example of a way in which redemptions work As large redemptions may not be in the best interests of remaining investors, it is common for there to be a cap on the amount of redemptions allowed in any one year (for example, 10 per cent of the NAV). This raises the issue of how to prioritise between investors. One method is to allow each investor a right to redeem 2.5 per cent per Annual redemption caps quarter. Any spare allocations from other investors can be allocated to those wanting to redeem more units. Alternatively, redemptions can operate on a “first come first served” basis. This does mean that an open-ended fund is fairly illiquid. Redemptions do not facilitate trading in and out of a fund but allow investors to adjust their weighting.
Setting the unit price
The price is usually set at the quarter before the redemption payment is made. The price is based on the NAV less an amount to represent the cost of liquidating part of the assets. This is usually two to three per cent. Redemptions may work in normal market conditions but in adverse markets the idea is flawed. Assets cannot be sold for the prices they are valued at and the NAV of the fund is artificially high meaning investors are paid too much on exit. Most fund documents allow the fund manager to suspend redemption if it is not in the interest of the investors as a whole. This is what happened in 2008–2009 when the UK property market collapsed.
Exiting early from funds Not all funds run to the full term originally agreed. There are several reasons why a fund may be terminated early and the fund manager would usually seek to have control of this process. Here are some examples: Investor vote The fund manager may recommend that it is an optimal time to sell assets and exit the fund early. A vote by investors is often required to approve this. However, the more opportunistic the style of the fund the more likely this will be at the total discretion of the fund manager, although sometimes investors can demand an early exit if 75 per cent vote in favour of it. Default by the fund manager The fund manager can usually be removed for default where there has been a material breach, fraud, wilful misconduct or gross negligence. As it is very difficult and time-consuming to prove default, many investors are now requesting a no-fault removal of the fund manager clause to be written into the fund documentation. However, to enforce a no-fault provision requires approval by 75 per cent of the investors. If the fund manager is removed a replacement would be lined up to take over although the fund could also be wound up. Change of control/loss of key persons The fund documentation may require investor consent for a change of control of the fund manager or replacement of key persons. If this is not forthcoming and the fund manager can offer no remedy, either removal of the fund manager or the wind-up of the fund could be a solution. Legal/tax changes Funds are structured based on the current law and tax treatment. With the high use of offshore locations, it is conceivable that the tax treatment may change making it economically unviable for the fund to continue. The fund manager, with a vote of approval from investors, may then wind up the fund. Although this is a standard provision in many cross-border funds, it has rarely been used in practice.
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September 2012
Funds and Indirect Real Estate briefing Exiting a fund
Planning an exit An exit is the final step in the overall Reporting equation of value creation, but there are A key theme with investors is reporting and transparency. Throughout a fund’s life investors will a number of things the fund manager will want to be kept informed of the fund manager’s need to consider when planning an plans and actions for exit. A lack of information will appropriate exit strategy to ensure value add to investors’ concerns and doubts about a fund is delivered to investors manager at this critical time. Fund managers must demonstrate constantly that they are on top of the situation. The banks will also be keen to understand the fund manager’s proposals on each debt facility. Debt Debt facility terms often coincide with the fund term. If assets are sold early, loan break costs will need to be considered and calculated, particularly swap instruments that if marked to market can have a hefty value – positive or negative. If the fund term overruns, the cost of extending or refinancing must be factored in. In the difficult economic conditions of 2012, due to the lack of availability of debt, it may not be possible or could be expensive to refinance for a short period, but the fund manager may not want to be pushed into an early sale of assets. However, refinancing may be the best option and sometimes a loan facility ring-fenced to an asset can be valuable if it can be transferred to a buyer. Sales The fund manager will be looking to see if best value can be achieved by single asset sales or by a portfolio sale. This will be dependent on the nature of the assets. For example, a portfolio of student housing accommodation or retirement homes in one jurisdiction may have additional value sold as a portfolio. A more diverse portfolio may benefit from individual sales. A valuation of the assets will give the fund manager and investors information on the likely fund returns once the cost of repaying the debt, meeting other liabilities, cost of winding down and payment of the carry are taken into account. The next step is to appoint selling agents to seek buyers for the assets. Depending on the portfolio, Fund rollovers specialist advice may be required to achieve the best value. There can be benefits in selling the Most funds give the manager flexibility to rollover the fund assets in their holding structures, which may avoid if it is not timely to exit at the original proposed date. Fund local transfer taxes. documents will usually allow a one-year rollover at the Tax advisers should also be consulted on the tax implications of selling the assets as this could have an impact on the net returns. Lawyers will also be instructed to prepare a data room of material for inspection by potential buyers and to process the disposals.
fund manager’s discretion. Investors will still want to know the benefit to them of a rollover. Investors are increasingly seeking more control and it is common for such a decision to be approved by the advisory board. A second one-year rollover may also be permitted with the approval of the advisory board. Any extension after that requires the consent of at least 75 per cent of the fund investors.
Some fund documents allow distributions to investors in specie. This means transferring assets to investors at the end of the term. However, this is very rare in the real estate sector as property cannot easily be divided between investors as it is in large lot sizes.
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September 2012
Funds and Indirect Real Estate briefing Exiting a fund
IPO It is very unusual for an IPO to be an exit route for unlisted real estate funds. There are two main reasons for this: the IPO process is time-consuming and costly. While an IPO can offer good valuations and better liquidity for investors, the enhanced regulatory environment can be unattractive to some. A financial adviser/sponsor will need to be appointed and often investors will be locked in for a specified period. Having said that, with the increase in tax efficient listed real estate investment trust (REIT) regimes in many markets, it may be that we see more IPOs in the future. Fund extensions Although extensions can happen in any type of private real estate fund, it is more likely to apply to a core or value-added fund where investors are looking for longer term exposure to a particular real estate sector (for example, retail warehousing or student housing) rather than an opportunistic or active management strategy around a number of assets.
Fund extensions are usually coupled with the original
Fund extensions are usually coupled with changing or changing or restructuring restructuring the original fund terms. For example, the original term may be 10 years with the ability for fund terms the investors to agree one or more extensions of, say, five years. Here the lead-in time is important. A vote should not be left until the end of the fixed term. The fund manager cannot manage assets in the best interests of investors if it does not know whether the fund is to continue or wind up. A typical scenario would be for an investor vote to take place at the end of year eight. The life of the fund will be extended if 75 per cent of the investors vote in favour of it otherwise the fund will wind up at the end of the original term. Those investors who voted against the extension would have the right to choose to exit at year 10. Usually continuing investors would be given the right to buy out those who want to leave. Failing that, the fund manager will dispose of assets, raise third-party equity or seek borrowing to fund the exit. The exit price would be based on the NAV at the quarter end before payment is made less an amount to represent the cost of liquidating the assets. If the fund manager is unable to find ways to fund the exit, which has the support of the continuing investors, within, say, 12 months of the original termination date, the fund would wind up. End of term processes After the debt and asset exit strategy has been planned and executed there are continuing issues for the fund manager to deal with, which are discussed below. Distributions and payment of carried interest Interim distributions will have been made to the investors as each asset is sold and in accordance with the fund documents. The fund manager will do a final calculation of the carried interest. It is usually more tax efficient for the fund manager to take the carried interest as a capital payment. This is done by the fund manager having a capital interest in the fund vehicle. The fund manager will often use a special purpose entity for this, which is tax transparent like a limited partnership.
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September 2012
Funds and Indirect Real Estate briefing Exiting a fund
Individuals who are to receive the carried interest will own that vehicle. The diagram below shows a typical structure.
Investors
Income and capital derived from asset holding structure changes from greater than 99 per cent to 80 per cent when hurdle is reached
Fund manager
General partner
Fund manager executives
Carry vehicle limited partnership
Fund limited partnership
Capital payments to carry vehicle when hurdle is reached increase from less than one per cent to 20 per cent
Generally less than 0.1 per cent interest in the Fund
Asset holding structure
Alternatively, the carried interest can be paid as a fee under the management agreements. This route is often used if there is no one to benefit from the favourable tax treatment afforded to a capital payment as the fund manager is an institution without the internal infrastructure for its employees to benefit from other than through the group’s bonus system. The carried interest is typically calculated on a whole fund return and paid at the end of the life of the fund. It may also be paid on an asset by asset sale to give fund managers interim payments. However, this is less common today and is one of the biggest concerns The waterfall can be more complex if: for investors in relation to fees. Investors do not want to see fund managers overpaid by successful a second hurdle is added, say at 15 per cent IRR, after early asset sales. Even with escrow accounts and which the investors and fund managers share any further clawback, which are complex, the fund manager distributions at 70:30; could still be overpaid as usually 50 per cent of the the fund manager has “catch up”. In this case, after the carried interest is released in cash and only the hurdle is reached the fund manager receives distributions balance subject to clawback. until it has received 20 per cent of the IRR returned to Distribution provisions in the fund documentation will set out the waterfall of payments. Of the amounts available for distribution the first payments go to the investors until they have recovered their capital plus an annual internal rate of return (IRR) at an agreed hurdle rate.
investors. Catch up appears in less than 15 per cent of real estate funds according to a fees survey by INREV; investors want the manager to achieve a benchmark as well as an absolute hurdle. This is not often seen outside the UK. In the UK, the IPD provide a reliable benchmark; the carried interest is shared with other parties such as the asset or property manager.
Depending on the nature of the fund and the economic climate, the hurdle will be between eight and 12 per cent. Then the investors and the fund manager will share any further distributions in the ratio of usually 80:20, sometimes after a fund manager’s catch-up payment. The carried interest is usually audited by the fund’s auditors.
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September 2012
Funds and Indirect Real Estate briefing Exiting a fund
Termination of contracts The fund will have entered into a number of agreements and supply contracts and these will need to be terminated. The main agreements will be the appointment of the fund manager and the asset and property managers. These will usually contain provisions for automatic termination on the sale of the last asset or on the wind up of the fund. Other service and supply contracts with administrators, custodians and paying agents, among others, will need to be checked and so too will any notice periods given to terminate them. At a property level there will have been a number of supply contracts to terminate or transfer to a buyer on the sale of the assets. Ongoing liabilities Before the fund vehicles can be liquidated, consideration must be given to ongoing liabilities. This will delay the final dissolution of the entities.
Follow-on funds Follow-on funds usually describe the fund manager’s next fund with a similar strategy. The fund documentation will usually prevent the fund manager raising a follow-on fund until the original fund is fully invested. This is so that there are no conflicts of interest on asset allocation and the fund manager’s attention is focused on acquiring assets for the first fund. However, at the end of the life of a fund it is not unheard of for fund managers to sell assets into another vehicle it will be managing. This is where corporate governance and transparency are critical and both the outgoing and incoming fund investors have to be treated fairly. The fund manager has to act in the best interests of both funds, which raise conflict of interest issues. Where this does apply, each fund should have its own independent valuer to approve the pricing to reflect the terms of sale and due diligence. The buying fund should have a separate law firm representing it. The fund manager should also seek to separate teams in its organisation with a Chinese wall to deal with the sale process. Investors should be kept briefed at all times. It is helpful if the funds have external independent directors who can oversee the process.
While there is always a risk of unknown liabilities, a fund will often have to give warranties on the sale of assets, particularly if they are sold in corporate structures. A buyer will not be satisfied in receiving A follow-on fund using the same assets is likely to have a warranties from an entity that is being wound up different strategy as the assets may have matured or need and has no assets. To avoid a retention, it is active management. Therefore, going forward the strategy common for there to be a clawback provision in the is different and attracts investors with a different risk profile. If this is not the case, the fund manager should have fund documents. Therefore, if a liability arises a been able to achieve a fund extension which may be clawback can be made from the investors. This also coupled with a restructuring if investors want revised terms. helps to protect the general partner in a limited partnership structure that would otherwise have full liability. Investors are keen to limit this in time and amount. Common provisions are a limit on clawback to two years from the last asset sale and capped at 25 per cent of all distributions. It is only after these periods have expired that the fund vehicles can finally be audited and liquidated, wound up or struck off the register as required in their jurisdiction. Secondary trading Secondary trading is the sale of units or shares in a fund so an investor can exit, in whole or in part. There is a deep divide between the markets for secondary trading of private real estate funds in the UK and other markets. The UK market has structures that allow other investors to move in and out quite freely. Elsewhere real estate funds are less flexible and more difficult to trade. How secondary trading works UK institutionally managed funds have few barriers to investors who want to sell and the documentation and procedures for the transfer of ownership are relatively straightforward. These tend to be core or value-added funds. Here informal trades work well through word of mouth or fund managers willing to act as brokers for buying and selling interests in their own funds as a service to investors. 7
September 2012
Funds and Indirect Real Estate briefing Exiting a fund
By contrast, in continental Europe and the US there are more funds at the value-added and opportunistic end of the spectrum. Assets in these types of funds are more difficult to value, with less frequent valuations. Investors are expected to hold their commitments for the life of the fund. Consent to transfer from the fund manager can either be discretionary or is not to be unreasonably withheld (in which case circumstances may be listed where consent can be withheld, for instance, where the transfer would breach law or regulation or where the transferee might be considered less able to meet the financial commitments to the fund). More importantly, the fund manager needs to provide enough information about the fund to the buyer so that a price can be agreed. A buyer will not receive warranties from a selling investor and will, therefore, need to carry out full due diligence. A typical transaction takes six weeks but could easily take up to six months. Pricing The price at which interests are sold will, for all funds, reflect the sentiments of the market. In a rising market, the price could be above the NAV to reflect anticipated growth. In a falling market, even for a fully invested fund, secondary trades may be carried out at discounts of up to 60 per cent of the NAV. During 2008 and 2009, there were cases of investors paying to transfer their interests and outstanding funding commitments because they did not want (or could not meet) those future liabilities. It is unusual that the fund vehicle will attract transfer tax on the transfer of interests. Platforms for trading It is difficult to determine the value of the secondary market but Jones Lang LaSalle estimated that it was worth $3.5bn in 2010 and $5.5bn in 20111. In Europe trading portals such as Property Match and Indirex seek to provide data and information on a secure basis on real estate funds. These have more traction in the UK than in Europe and provide introductions of sellers and buyers. However, trades are not automated and parties still have to settle their own terms of trade. Trading and settlement as it happens in the equity market is a long way off for private real estate funds.
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Jones Lang LaSalle (2012), Global Secondary Market 2011 Round-up
September 2012
Funds and Indirect Real Estate briefing Exiting a fund
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