In the previous lessons, we have been focused on joint ventures. In this lesson, we will begin our discussion on Fund Structures. When a fund structure is considered, there are five investor transaction selection criteria. Let’s review these criteria.
The first criteria are the Numbers. The numbers need to work. Investors need to remember to follow the calculator and not their heart! It is necessary to be dispassionate about the property and focus on the numbers – this is not a time for emotion. Let the numbers lead your decision-making process.
The second criteria is Sponsorship. Value-added transactions have an inherent risk and good operators are a key to success. In a lending situation, good sponsorship is essential, as he/she will have to navigate problems and be adept in refinancing or selling the project as the exit. In lending situation, the sponsor’s financial strength may need to carry the deal during soft periods.
The third criteria is Alignment of Interests. The risks and rewards should be equally disbursed among all those involved in the transaction. This typically means the sponsor’s equity is at risk as the first loss money. If the project does well, everyone should do well. Debt has fixed return and equity has an unlimited return. Understanding where the debt portion of a transaction stops and where the equity begins is a key to making smart investment decisions.
The fourth criteria are the Key Events. It is important to understand the “key events” and the probability of achieving the event. Each transaction typically has one or two “key events” that must take place in order for the project to be successful. Understanding each project’s “key event” is critical to making good real estate decisions. Smart investors understand what has to happen and probability of it happening. This essentially defines the risk in the transaction.
The final criteria is the Back-Up Plan. Good investors look beyond the key event and understand what the economic outcome is should the key event not happen. In the best deals, the back-up plan has a higher probability than the key event, and if the back-up plan is implemented, it means the project makes little money or breaks even.
As we have discussed in this course, private equity is a source of capital investment that usually comes from individuals and institutions with a high net worth. These investors are looking for equity when investing their money into real estate deals. When private equity deals are done, there are five considerations and focus areas that the investors and borrowers need to be concerned with.
The first focus area is Investee Management. At this point, the investors implement the quick-win strategies and how the management team what level of effort you expect. After the first six months, involvement may taper if all is going well, but there will still be bursts of effort required. These bursts may relate to new acquisitions, poor performance, new strategies, or anything until the investment is exited.
The second focus area is Debt Management. In deals with debt, a surprisingly large amount of time is spent dealing with banks. This is especially true of the initial application and covenant reporting.
The third focus area is the Exit. The exit process is often quite different from the purchase process because it is a time when you welcome investment bankers into your firm with open arms. You may first contact potential trade buyers directly, but either way, you want to focus on securing the best sale price.
The fourth focus area is Investor Management. The investors in the fund need loving too! After all, you are having fun with their money. You should keep in touch with them regularly to “spread the love,” but you may also have to deal with them if any capital call defaults arise.
The fifth focus area is Regulation. The dirty part of private equity is dealing with tax, accounting, legal, etc. related to the fund, the firm, and the stakeholders. However, it is essential and essentially boring!
The most diverse role within the five focus areas would have to be Investee Management. This is because you must help with any number of roles with the investee.
The first step in capital formation is to “call the capital.” There are three capital formation options for calling the capital. The first is the Call Fund. With the call fund, the investors are obligated to fund. This option is extremely punitive to your capital partner if they do not fund!
The second option is the Pledge Fund. The Pledge Fund is basically, “if I like the deal, I will fund.” This is a very weak structure and there are no guarantees the investor will ever fund the deal.
The third option is the Fully-Funded Fund. This is the pre-funded option or negative arbitrage. This is not an efficient option. This option forces the fund manager to take unnecessary risks.
The second step in capital formation is the Business Strategy. Just like any business strategy, the borrower needs to have a clear plan for the fund, what it will be used for, and how the strategy will be implemented. The Business Strategy should include four main areas.
The first area is the Fund Purpose. It is important to remember that SPECIFICITY GETS FUNDED. You need to have a clear purpose for the money and explain this purpose within the strategy. Keep in mind, you are not around to “throw away” money.
The second area is the Investment Strategy. What type of investment strategy will you use for the Fund? Are you a capital provider? Are you a HML Lender? Are you buying and operating assets? Before making the decision, you should consider the pros and cons of each and then make your investment strategy.
The third area is to consider how you will make money. There are three main options for the fund: Refinance, Rent, or Sell.
The fourth area is Your Edge. What is special and what is different about how you will make money? In this area, you need to consider how you will differentiate yourself and what makes your fund important.
The third step in capital formation is the Fund Investments. With the fund investment, there are three considerations.
The first consideration is the Investment Matrix. Within the Matrix, it is important to consider what the limits will be for the following:
- Property types
- Geographic constraints
- Product concentration
The second consideration is the Investment Committee. There are three main questions to consider for the Committee. Who approves the investment? What is the process? What are their expectations?
The third consideration is Blind Pool vs. Portfolio. Will the fund investment begin with a book of businesses or starting a fund?
These are all important considerations that need to be made when setting up the fund structure.
The fund will result in three different types of returns. The first is the Gross Returns. The Gross Returns are the returns of the Fund overall. For example, 15% IRR. This is how well the fund does before any money is taken out. The second is Net Returns. Net Returns are the returns to investors after the fees have all been paid. For example, 12% IRR. The third is Multiples. Multiples are the cash back on the original investment. Examples include 1.5x, 1.75x, and 2.0x. If you invest $1mm and eventually receive $2mm back, that is a 2x return.
Once the structure of the fund has been decided upon, it is important to determine the terms of the funds.
The first is the actual length of the fund (term of fund). The main question here is “how long is the life of the fund?” The second term to consider is the Call Provisions. With the provisions, the investor needs to decide how long they have to fund the capital calls. The third is the Capital Call Default. In this area, the main consideration is the penalties to the LPs if they do not fund. The fourth terms consideration is Distributions. In this terms area, when the distributions will be paid out needs to be determined, such as paying to LPs quarterly or annually These distributions are not usually monthly.
As you gain experience in the industry, it is important to know the commonly used terms within capital formation.
- Recycling: How long are calls good for? Can you reuse money after distributions?
- Investment Period: How long the investment manager has to deploy/invest the money.
- Term of Fund: How long is the life of the fund?
- Distributions: Paying the LPs. How often will they be paid? What constitutes a capital event that will trigger a distribution?
Within capital formation, there are five institutional rules of engagement.
- Better Be Ready to Execute: “Use it or lose it.” Better have a “pipeline” of potential deals.
- Most Institutional Investors Generally Favor Smaller Funds That Live Off Incentive (and Not Management) Fees: Counter argument that high compensation attracts the best players.
- Consistency of Track Record: No “pass” for financial crisis.
- Teams that Love Each Other and Works Well Together: Cohesion
- Diligence of Downside Cases: Using good “robust” models. Structure away the risk. Sponsors/Funds with track record buoyed by home runs to offset losers that are unattractive.
There are four fund structures that should be considered.
The first structure is Private Capital with Dedicated Allocation. In this structure, you would find 4-5 investors who build a business with you. You would not openly solicit and you would not go to pensions or hedge funds. This structure is “our club” and we are going to focus on doing deals and putting that capital to work. Investors with the capital seek qualified person(s) to manage their investments. Others may be receptive to your strategy. There are no capital raise needs. The big issues with this structure are discretion and economics.
The second structure is Institutional Capital Alignment. This structure is an aligned investment agreement with an institution. The JV is structured with an institution. You do not have to raise any money, and assets are on the institutions books. With this structure, you do not own the assets and you do not control the credit committee. You do not have any discretion. This is considered a “scary” structure since there is so much uncertainty. There is also existing capital in place and approval is in a box. Others involved may be employees, contractors, or co-investors.
The third structure is Fund Joint Venture/Facility. With this structure, the economics are established up front. This is the most popular structure today as discretion is shared. This structure is easier to set-up and since the sponsor knows your product, there will be alignment. However, interests between the investor and sponsor are aligned. Most times a management fee will be paid to the sponsor and the sponsor must provide a business plan. This type of structure is more of an originator or broker arrangement and there is the ability to differentiate yourself via co-investment.
There are four fund structures that should be considered for the deals. For this assignment, discuss what each of these structures is and explain how it works.