The real estate joint venture (JV) is an investment vehicle that marries investment or development competence on one hand with capital on the other to invest in a real estate platform. The investment or development competence is supplied by a "sponsor" (the individual or entity that creates, operates, and executes on the business plan for the JV) while the capital is generally supplied by a mix of debt and equity, referred to collectively as the "capital stack."1 This article focuses primarily on the capital investment (or "LP")2 arm of the JV, and, more particularly, a specific source of equity: the private equity fund (PE Fund).
In large-scale, commercial real estate investing, there are multiple avenues to fund the equity portion of the capital stack for a project. Most commonly, equity is: (i) self-funded by the project sponsor; (ii) syndicated among "friends-and-family" investors, high-net-worth individuals, or family offices; or (iii) raised by partnering with an institutional partner or fund (collectively, "capital investors"). Very often, these types of investors attribute large portions of their investment portfolio to "alternative investments" (i.e., not traditional publicly-traded stocks, bonds, and cash and cash equivalents)—most notably private equity and real estate.
Real estate is an attractive investment for capital investors because of a variety of important attributes, notably tax efficiency, cash flow, intrinsic value of an underlying hard asset, and a large market of buyers and sellers. Still, real estate investing presents certain risks: (i) real estate investing is a highly capital-intensive business, in comparison to most other types of investments; (ii) real estate investing is highly specialized across asset classes (e.g., retail, office, industrial, hospitality, multifamily, etc.); and (iii) real estate investing is impacted significantly by geographic considerations. The combination of being an attractive investment asset class and being a capital-intensive, specialized business creates a perfect environment for the real estate JV:
LP investors are willing to form JVs with sponsors who share disproportionately in the profits due to their ability to execute on a particular investment strategy and their specific knowledge and expertise.
The JV structure is, in its base case, straightforward.3 The structural considerations become more complex, however, once investors are identified. Different laws and regulations apply, and different accommodations will need to be made, with respect to the JV depending on the nature of the investors. Are they domestic or foreign? What type of entity is investing and with what proclivities? If a US entity, is it tax-exempt or not? If foreign, what is its country of origin and classification status (e.g., sovereign wealth fund, qualified foreign pension fund, bank holding company, insurance company)? More complicated yet, in addition to these other considerations, what if the LP is a PE Fund?
This article addresses how JV investing in real estate with a PE Fund (as opposed to other, more traditional, LPs/sources of capital) leads to unique business, formational, transactional, and regulatory implications. To that end, the article provides a general overview of PE Funds, including how they are structured and funded, and explains why the structure and funding of PE Funds matters for JV investing. It also addresses a variety of hot topics impacting JV investing with a private equity fund with an emphasis on the current regulatory environment that must be navigated to ensure compliance with federal and state laws and regulations. Finally, it addresses certain structuring considerations in connection with JV agreements, including those related to management, capital calls and timing considerations, permitted transfers, and exit strategies.
GENERAL DISCUSSION OF PE FUNDS AND INVESTMENTS
What is a PE Fund?
A PE fund is an investment vehicle formed to enable large investors to select a professional investment manager to invest in primarily "private" investments.4 While PE Funds can be used for a variety of investment strategies (such as leveraged buyouts, venture capital, M&A, real estate, and others), this article focuses on private equity investing in real estate, through JVs.
How is a PE Fund constructed?
A PE Fund is organized as either a limited liability company (LLC) or limited partnership. The entity is typically formed in Delaware,5 and an election is made to be taxed as a partnership so taxes on profits are only paid at the partner level, rather than at a corporate level and then again on distributions to partners. As discussed below, however, prudent counselors should keep additional structuring options in mind to address the needs of certain investors to be taxed at a corporation level (e.g., foreign investors and non-profits).
A PE Fund is established by a sponsor and is nearly always set up as a special purpose vehicle (SPV or SPE) subsidiary of the sponsor's main company. The sponsor will also generally provide for itself to have the primary authority to act on behalf of the PE Fund entity, whether as the manager, managing member, or general partner, depending on how the PE Fund is organized (the sponsor is referred to generally herein as the GP).6 Especially in the context of a limited partnership—in which the GP is truly a general partner—the use of an SPE is important for shielding liability.
Separately, the sponsor will engage an affiliated investment advisory entity through a management agreement or investment advisory agreement (the Investment Manager). The Investment Manager will: (i) run the day-to-day operations of the PE Fund; (ii) employ the team involved in the fund investment services and operations; (iii) evaluate, make, and oversee investments and dispositions; and (iv) complete reporting and administrative functions of the PE Fund. In consideration for these services, the Investment Manager will be reimbursed for its expenses and will be paid an investment management fee (most often one to two percent of assets under management, depending on the track record of the sponsor, size of the PE Fund, and other economic factors). The Investment Manager in a PE Fund is subject to certain regulatory securities requirements, which are described in detail below.
The GP will then seek LP investors to invest in the fund on a "blind pool" basis (i.e., where the fund manager has broad discretion to identify, underwrite, and execute on transactions, potentially subject to certain parameters/mandates set forth in the fund documents). The fund itself does not have direct operations, but rather is an investment holding company that makes investments in portfolio companies or, pertinent to this article, JVs.
It is also important to note that PE funds are structured as closed-end funds, meaning that there is a window of time in which the sponsor raises capital for the fund (typically 12 to 18 months) after which the fund cannot accept new capital. This is one of the distinguishing characteristics that separate PE Funds from hedge funds (which, unlike PE Funds, often allow for capital to flow in and out of the fund on an ongoing basis). Once funds are raised (or during the fund-raising process, depending on the cycle), the "investment period" will begin. The investment period is a finite period of time for the Investment Manager to deploy the capital, typically two to three years from the last capital closing.
Another notable feature of PE Funds is that not all of the capital committed by investors is deposited at the outset of the fund. Rather, investors contractually agree to capital commitments, which are called over time by the Investment Manager when new investment opportunities are selected.
Once the PE Funds have deployed the capital into actual investments, there is a hold period in which investments are held, then liquidated. Most often, the fund has an overall time horizon of 10 years from first closing, and, potentially, an extension right of up to three years. The extension may be at the discretion of the GP or, in some instances, might require approval of an investment committee comprised of the GP and certain key LP investors.
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1. At a base level, the real estate "capital stack" is comprised of equity and debt. There may be numerous tiers in each category and there are various legal rights and priorities associated with each. This article focuses solely on the equity portion of the capital stack.
2. The investors in a real estate JV are colloquially referred to as LPs, and the sponsor is colloquially referred to as the GP. It is worth noting that although GP and LP emanate from limited partnership vernacular, they are often used even when the investment vehicle is an LLC (which is most common), notwithstanding the fact that the legal terms for such parties in an LLC context are Manager (in a manager-managed entity) or Managing Member (in a member-managed entity), as it relates to the sponsor party, and Member, as it relates to the capital investor.
3. As a practical matter, JVs are generally organized as LLCs or limited partnerships, most often formed in Delaware, with a managing member or general partner that is an affiliate of the fund manager and one or more other members or limited partners that are investors.
4. There is often confusion about whether the "private" in PE refers to whether the fund itself is a non-public investment or whether the fund places money in non-public transactions. Historically, the answer was generally "both," but over the past several years a number of the most famous and successful PE Fund managers (not the individual funds themselves) have actually started trading on the public markets (e.g., Blackstone, KKR, Apollo, among others). While there are countless PE Fund strategies, it's generally better to think of the "private" part of PE as the type of investment made by the fund itself (although even that isn't always the case, since some PE funds invest in publicly traded securities).
5. Selection of Delaware as the jurisdiction of formation and the governing law with respect to PE Funds is nearly universal, for a variety of reasons. Delaware is well known for having: (i) ultimate contractual flexibility for establishing governance of LLCs and limited partnerships under LLC agreements and limited partnership agreements; (ii) easy to navigate statutory and administrative legal regimes for business entities; (iii) the most sophisticated body of case law and specialized courts for addressing business disputes in a (relatively) expeditious manner; and (iv) familiarity and acceptability to investors.
6. See supra note 2.
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.