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Marcia E. Facey is an assistant general counsel with The Northwestern Mutual Life Insurance Company in Milwaukee, Wisconsin, and the vice-chair of the Real Property Division Life Insurance Company Investments Committee.
As investors seek to diversify their direct equity real estate portfolios, real estate opportunity funds have become an attractive and unique vehicle for investments in domestic and overseas real estate markets. Investors may find, however, that certain property types are difficult to add to a direct equity portfolio, or an investor may lack the development and management skills to enter into a real estate market, especially in a foreign jurisdiction. These challenges and risks are minimized by investing in a fund that is created by a sponsor that has special expertise and a demonstrated track record with the investment strategies that it proposes to execute in a specific market, such as acquiring land and developing retail centers in Mexico, investing in real estate and real estate companies in the United Kingdom, or acquiring, repositioning, and disposing of real estate and real estate-related investments in Japan. This article discusses some of the legal issues involved in these types of transactions.
What Is a Real Estate Opportunity Fund?
An investment in a real estate opportunity fund is essentially the purchase of a limited partnership interest in a limited partnership or the purchase of a membership interest in a limited liability company that invests in real estate, either directly or through real estate operating companies. In most transactions, a limited partnership is formed by an entity known as the sponsor, and the sponsor then takes the role of general partner and manager of the limited partnership. An investor subscribes to the fund as a limited partner and commits to invest a certain amount of capital. Over a specified period of time—the investment period or commitment period—the general partner will call an investor's capital and use the capital to purchase real estate projects or real estate operating companies. These assets are then owned, repositioned, sold, or held by the limited partnership, depending, of course, on the investment strategy. The sponsor/general partner is compensated for its role by receiving a management fee and by sharing with the investors in the cash flows from the operation and sale of the fund's investments. The life cycle of a real estate opportunity fund is usually eight to ten years. Although interests in a real estate opportunity fund are considered a type of security, these interests are generally exempt from registration under the Securities Act of 1933, as amended, by reason of the exemptions provided by section 4(2) of the Securities Act and rule 506 of Regulation D of the Securities Act.
It is of the utmost importance that legal counsel for an investor in a real estate opportunity fund review the private placement memorandum and the limited partnership agreement for the fund. Although there are numerous issues to consider and negotiate, this article focuses on five topics that are ever present in a foreign real estate fund transaction: the distribution section, side letter, tax concerns, key man provision, and foreign currency risk. The attorney should review, investigate, and understand each of these areas when advising an investor client who is interested in a real estate opportunity fund created for the purpose of investing in overseas real estate.
One of the most important provisions of a limited partnership agreement for a real estate opportunity fund, domestic or foreign, is the distribution section. This provision specifies the minimum internal rate of return (or preferred return) of the investor/limited partner, sets forth the manner in which a limited partner will receive its preferred return and return of its initial capital investment, and details the sponsor's compensation in the fund, which is commonly referred to as its "carried interest." The cash flow distribution (or waterfall) for a foreign real estate opportunity fund usually provides for payment of the preferred return on the capital contributed by the limited partners as the first hurdle; that is, the investor receives its expected return first from the net cash proceeds of the fund. The investor generally receives a return of its capital as the second hurdle of the waterfall, and the next two hurdles usually include a percentage split between the sponsor and the investor in which the sponsor receives its carried interest. Distributions in foreign funds tend to be made on a cumulative basis and not on an investment-by-investment basis. This approach is advantageous to the investor because it gives priority to the investor's receipt of its preferred return and initial capital investment before any cash flows are allocated to the sponsor/general partner.
When negotiating the distribution section of a limited partnership agreement for a foreign fund, it is reasonable and prudent to request an express prohibition against in-kind distributions. Because an investor seeks to receive cash from investment in a foreign fund, the receipt of a fee interest in property that is located in a foreign country or a percentage interest in a foreign real estate operating company would almost always contravene the investor's portfolio objectives.
In most real estate opportunity funds, a side letter is negotiated between the general partner and each limited partner. The side letter is an important document for the investor because it often contains rights and benefits that are above and beyond those provided for in the limited partnership agreement. When an investor must comply with certain legal or regulatory requirements that are particular to the investor, the side letter is the appropriate tool to use to supplement the limited partnership agreement. A side letter also can be used to provide a large investor with certain financial incentives that are not offered to the other limited partners. Because the general partner may have made these side agreements with other limited partners, an investor will want the opportunity to review the side letters provided to other limited partners and request the same rights or benefits. A provision commonly known as the "most favored nations" provision accomplishes this by requiring that the general partner provide copies of all side letters to the investor and grant the investor with the same rights and benefits offered to the other investors under certain circumstances.
Because a limited partnership agreement, domestic or foreign, contains numerous tax provisions, counsel for the investor should have expertise in tax law or work with a tax attorney. If not already included in the limited partnership agreement, certain tax provisions should be requested in a side letter to shield the investor from negative tax consequences that may arise, particularly in foreign funds. For example, certain provisions of the Internal Revenue Code or tax treaties may change the status of a limited partner so that the limited partner may be considered a taxpayer in an overseas jurisdiction by virtue of its investment in the fund. To address this serious concern, the investing limited partner might ask the general partner for a covenant that the fund not make any investment that would cause the limited partner to have a "permanent establishment" in any country other than the United States. If the investor has a "permanent establishment" in another country, its worldwide income would be exposed to taxation in that country. Most general partners of foreign real estate opportunity funds are sensitive to this issue and agree to provide such a covenant. This issue is particularly important when the fund makes direct investments in foreign real estate instead of investments in foreign real estate operating companies.
Key Man Provision
The expertise of a sponsor is often tied to a team of real estate professionals who have a significant amount of experience in management and development in a specific real estate sector. Because the expertise of one or more individuals may be critical to a fund's success, especially in a foreign country, a limited partnership agreement should contain a key man or key person provision, providing that if a lead individual leaves the sponsor's team, then the general partner will cease making new investments and no longer have the right to call capital from the limited partners. This provision has the result of shutting down the fund's pipeline for new investments until such time as the key person is replaced.
Foreign Currency Risk
Because exchange rates may fluctuate when exchanging U.S. dollars for foreign currency, the fund, and ultimately the partners, can be exposed to some level of currency risk, depending on the foreign jurisdiction. Hedging is the most common strategy used by investors in overseas markets to reduce exposure to foreign currency risk. When reviewing the limited partnership agreement, an investor should inquire whether the general partner has the authority to hedge and to what extent the general partner will engage in hedging to reduce foreign currency risk.
Investing in real estate opportunity funds can provide an investor with access to foreign real estate markets while minimizing the risks and challenges inherent in direct investments in such markets. The five topics covered in this article are some of the critical and essential concepts that an investor and investor's counsel must consider when evaluating an investment in a foreign real estate opportunity fund. As with all other investment vehicles, time will reveal the effect, if any, that the current economic crisis will have on the formation of, and negotiations related to, foreign real estate funds and whether provisions that are considered acceptable to the market today will be the same customary provisions of tomorrow. Yet, given the continuing challenges of developing the expertise necessary to invest directly in foreign real estate markets, foreign real estate opportunity funds continue to provide a unique alternative investment vehicle to achieve the diversification that many investors seek.Return To Issue Index