United States: Creatively Completing Your Capital Stack: The Emergence Of Real Estate Sponsor Equity "GP" Funds

Last Updated: July 5 2016
Article by John J. McDonald and Paul A. Steffens

As the real estate boom continues to reach new heights, capital constrained real estate private equity sponsors are increasingly raising “GP” funds to provide some or all of the sponsor equity contributions for their real estate investment vehicles, instead of making such sponsor equity contributions themselves.1 While GP funds can provide sponsors with a new and creative way to complete their capital stacks, they can also raise fundamental issues concerning the allocation of risk and reward between the sponsor and the outside investors. This article discusses some of the issues implicated by GP funds and summarizes certain key deal terms of GP funds.

Sponsor Equity

Real estate investment vehicles, whether they are structured as single-property joint ventures or “blind pool” funds investing in several properties, typically require the sponsor to provide a substantial portion of the equity capital – up to 20% – that is used to acquire and develop or otherwise improve the properties, with the remainder of the equity capital coming from outside investors.

Skin in the Game

Outside investors in real estate investment vehicles typically require sponsors to make equity contributions in their investment vehicles to enhance the alignment of interests between the sponsor and the outside investors. Outside investors typically argue that sponsors having “skin in the game,” consisting of their own capital at risk in investments made by the investment vehicle, helps to mitigate the risk of the sponsor making unwise investment decisions that lead to losses and incentivizes the sponsor to make successful investments.

Other Incentives

While sponsors do not dispute these possible benefits, they typically respond that reputational damage and inability to raise subsequent real estate investment vehicles are sufficient incentive for them to not make unwise investment decisions. Also, the sponsor typically provides between 5-10% of the equity capital for the GP fund that provides the sponsor equity component of the underlying real estate investment vehicle’s capital, which often is fairly significant relative to the sponsor’s net worth. Further, since the vast majority of sponsors’ compensation is tied directly to the performance of their investments through their promoted interest, they are sufficiently incentivized to make successful investments without being required to make substantial sponsor equity contributions. Finally, there is the practical reality for successful sponsors that, due to their success in sourcing multiple attractive real estate opportunities and the “back-end” nature of their promote compensation from other investment vehicles, they are often capital constrained and so have more opportunities available to them than can be pursued if they are required to make substantial sponsor equity contributions to all of their real estate investment vehicles.

An Attractive Investment

Investing in a GP fund, rather than in the underlying real estate investment vehicle, can be attractive to investors because GP funds typically offer investors greater financial return potential. That is the case because the sponsor typically receives a larger percentage of the investment vehicle’s profits relative to the amount invested as compared to the outside investors, due to the sponsor also providing the “sweat equity” of sourcing and managing the investment vehicle’s investments. Sponsors raising GP funds are essentially monetizing that sweat equity by substituting outside investors’ capital for their own capital in satisfaction of their sponsor equity contribution obligations to their real estate investment vehicles.

A threshold issue for sponsors considering raising a GP fund is ensuring that the outside investors in the underlying real estate investment vehicle are comfortable with the sponsor equity coming from other investors, rather than from the sponsor’s own funds. For the reasons discussed above, some outside investors may be opposed to the sponsor utilizing a GP fund, while others may be amenable to the sponsor doing so. Once any such concerns have been addressed, the next step for the parties is structuring and negotiating the GP fund.

Key Deal Terms

Since GP funds are relatively new, they do not yet have an established body of “market” deal terms. The terms of GP funds can vary significantly depending on the relative negotiating strength of the sponsor and the GP fund investors, as well as other factors. However, some common GP fund deal terms have emerged over time, which are as follows:

Distribution Structure. GP funds typically employ the customary private equity fund distribution structure in which the investors receive back their invested capital, plus a preferred return on that invested capital, and any remaining profits are divided between the outside investors and the sponsor according to an agreed-upon split ratio. The outside investor/sponsor profit split ratio sometimes changes in favor of the sponsor as successively higher internal rate of return (IRR) hurdles are reached. Sometimes, once the outside investors receive their preferred return, there is a “catch up” so that the sponsor ultimately receives the agreed-upon percentage of the GP fund’s total profits. The profit split among the sponsor and the GP fund investors may be determined on an investment-by-investment basis or on an aggregate basis. Since GP fund investors typically participate in all or a portion of the promote paid by the underlying real estate investment vehicle (as described below), the GP fund’s profit split often exceeds the standard 20% for the sponsor.

Variations on Sharing of the Promote. In some GP funds, the investors are entitled to the proceeds received from the underlying real estate investment vehicle attributable to their invested capital, but do not share in promote payments from the underlying real estate investment vehicle. However, GP fund investors more commonly receive all or a portion of the underlying real estate vehicle’s promote payments based on the premise that they would otherwise not have any incremental benefit, as compared to investing directly in the underlying real estate investment vehicle, and would bear greater risk.

Sharing of Fee Income. GP funds typically do not share in fee income received by affiliates of the sponsor for ancillary services to the underlying real estate investment vehicle, such as development, property management, leasing, construction management and financing fees. That is the case because such fee income is often attributable to discrete services being provided by the sponsor affiliates that would otherwise be provided by third parties to the underlying real estate investment vehicle, typically at market rates.

Management Fees. Sponsors of GP funds that invest in more than one underlying real estate investment vehicle typically receive management fees (either directly or through an affiliated management company) similar to other types of private equity funds. As is the case for other types of private equity funds, the management fees of GP funds are typically calculated as a percentage of the fund’s total capital commitments until the end of its investment period and a percentage of the fund’s total invested capital for the remainder of its term (the percentage typically ranges from 1.5-2.0%). Sponsors of GP funds that invest in a single underlying real estate investment vehicle may also receive management fees from the GP funds, which may be based on the amount invested and may be paid periodically or as a one-time fee upon closing the investment.

No Investment Decision-Making Rights. Although the GP fund investors are investing in the entity that makes the investment decisions for the underlying real estate investment vehicle, they are typically passive investors that do not participate in that decision-making process. That is the case because any such involvement would likely raise issues with the underlying real estate investment vehicle’s investors, which premised their decisions to invest in the underlying real estate investment vehicle based on the track record, judgment and investing acumen of the sponsor and would not welcome what they would likely view as interference from the GP fund’s investors in the decision-making process.

Timing of Capital Contributions and Distributions. GP funds typically provide for capital contributions and distributions that correspond to those of the underlying real estate investment vehicle. As a result, the term of the GP fund matches the term of the underlying real estate investment vehicle, so that the GP fund can call capital from its investors whenever the underlying real estate investment vehicle calls capital from the sponsor. GP fund investors are typically required to fund their capital contributions to the GP fund within the time period in which the sponsor is required to make the sponsor equity contributions to the underlying real estate investment vehicle. GP funds typically also make capital calls to cover any GP fund-level expenses that are not satisfied out of distributions received by the GP fund from the underlying real estate investment vehicle. Subject to holdbacks to cover GP fund-level expenses, whether directly or to replenish reserves, distributions are typically made by the GP fund to its investors within a short time after the GP fund receives distributions from the underlying real estate investment vehicle.

Sponsor Debt Guarantee Obligations. Investors in GP funds are usually not responsible for any of the “non-recourse carve-out” and/or “completion” guarantees typically provided by sponsors to lenders in connection with debt financings obtained by the underlying real estate investment vehicle. Sometimes, sponsors are able to persuade their lenders to accept the GP fund as the guarantor of those obligations rather than the sponsor entity or its principals providing the guarantees based on the rationale that the GP fund, through its capital commitments, has more substantial financial resources than the sponsor and its principals. The GP fund investors not being responsible for those guarantee obligations in situations in which the lender requires the sponsor to be responsible is sometimes cited by sponsors as being part of the rationale for the GP fund not sharing the promote payments received from the underlying real estate investment vehicle with the GP fund investors.

Information Rights. Since the GP fund’s economics are based principally on the financial results of the underlying real estate investment vehicle, GP fund investors typically receive copies of the quarterly and annual financial statements of the underlying real estate investment vehicle, along with GP fund-level financial information. The sponsor sometimes needs to obtain the approval of the outside investors in the underlying real estate investment vehicle to provide such information to the GP fund investors.

Conclusion

In summary, GP funds can be a useful tool for real estate sponsors to overcome their capital constraints and free themselves to make additional investments and can also be an attractive investment opportunity for GP fund investors. Please don’t hesitate to contact the authors with any questions that you may have concerning GP funds.

Footnote

1 Real estate GP funds are part of a growing trend among private equity funds of all types, including leveraged buyout funds and hedge funds, in which investors are increasingly making investments in the general partner entities of the funds, rather than or in addition to becoming limited partners of the funds.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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