Partners for life

One of the recent trends in the area of real estate funds is the prevalence of smaller, investment club-type funds. Investors want to feel that they can understand and relate to the assets that are being acquired, and the ultimate example of this may be single-property funds, whether the property is an office building, a retail park, a hotel or a student accommodation block.

Traditional structures such as limited partnerships can still be appropriate for these types of funds. In a limited partnership, the investors are essentially passive ‘limited partners’ (limited in the sense of having limited liability), and the fund managers represent the ‘general partners’ in the partnership who are responsible for overall management.

Despite this distinction between the roles of limited partners and general partners, investors can exercise real influence over the shape of the fund. This raises a question – what are the key legal protections that investors should be asking for? And what requests should fund managers expect to encounter? In my experience, these are the top ten issues which investors most commonly raise:

1. Capital commitment:
Investors want to see a genuine alignment of interest between the fund and the fund managers. This often involves an expectation that the fund managers (whether personally, or through a corporate vehicle, or both) have contributed an amount of capital which is meaningful in the context of the fund as a whole.

2. Transparency on set-up costs and fees:
This is fundamental. Investors will expect clarity in regards to the set-up costs of the fund and who bears those costs, including in particular the costs of fundraising itself. Setting an upper limit on those costs is commonplace.

Transparency is also critical in relation to ongoing fees and expenses, such as annual fund management fees and transaction-based fees. Again, investors may want a cap on expenses to be enshrined in the fund documents.

Previously, it was common for annual fees to relate to the fund’s committed capital, meaning the total amount that limited partners could be called on to invest. Now, investors increasingly demand that annual fees relate to the assets actually invested, and apply to the net assets (rather than gross assets) of the fund.

3. Access to information:
Continual transparency of information is crucial, and this starts with investors carrying out their own investigations on the fund manager’s credentials, the viability of the fund manager’s business, and the structure of the fund – while also getting to know the identity of other investors. During the life of the fund, in addition to receiving audited fund accounts, investors may want regular updates on the fund managers’ strategy in response to market conditions. They may also want to have face-to-face meetings with the managers to understand the fund’s progress and prospects.

4. Clear investment criteria:
In some cases, investors may have enough confidence in the fund managers to give a very broad discretion as regards the types of investments which can be made, and the strategy to be followed. However, in many cases, investors will be very clear about the type of investments to be made – such as the type of property or the geographic diversification. This is particularly the case for smaller funds. Those investors will expect clear criteria to be built into the fund documents, so that specific investor consent would be required for any other types of investment.

5. Controls over fund governance:
In a limited partnership structure, the investors are prohibited from exercising control over the day-to-day management of the fund. If they did that in relation to a UK limited partnership, they would risk losing the benefit of limited liability. However, investors can expect to be represented on the fund’s ‘advisory board’ which is extensively legislated for in the fund agreements.

The advisory board is there to oversee the activities of the general partner/manager, such as reviewing the payment of fees and any conflicts of interest which may arise. In addition, investors may want an independent person to act as operator of the fund, even if the fund manager has the FSA permissions which would allow it to fulfil that role. The operator acts as an independent control figure over the most important matters such as the application of funds by the fund manager and the handling of distributions to investors.

6. Performance incentives:
Generally speaking, investors want the fund manager, and the key individuals involved, to be personally incentivised in relation to the fund’s success. This is usually reflected by a performance fee, or a so-called ‘carried interest’, meaning the share of the fund’s profits which is allocated to the fund manager or general partner. Investors will want to know that the majority of the performance incentive payments actually have the potential to reach the key individuals themselves, and will not, for example, be diverted to other investors in the fund manager’s business.

Investors prefer incentive payments to be calculated on a ‘whole fund’ basis, meaning that they operate in relation to performance over the life of the fund, rather than by reference to individual investments. This avoids the need for clawback if performance fees are paid which relate to one profitable investment, but then the fund subsequently makes future losses.

7. Fund manager focus:
Investors may want to know that the fund managers’ effectiveness will not be diluted by taking on too many projects. This may be reflected in a cap on the overall size of the fund which can be raised, and also restrictions on acting as manager of other funds until a minimum proportion of the current agreed fund has actually been invested.

8. Power to remove the fund manager:
The fund has a separate existence and legal structure which is distinct from that of the fund manager. Investor confidence in the fund manager is critical. Because of this, investors may demand the right to remove the fund manager and appoint another, without having to prove that the original fund manager is in breach of its legal obligations to the fund.

9. Exit:
For closed-ended funds (meaning funds which have a specific life-span) investors will not usually have the right to withdraw their investment until the fund’s underlying investments have been realised. This means that the only viable exit route may be for investors to sell their participations in the fund. Investors will therefore want to understand what role the general partner/fund manager has in the sale of fund participations (such as the ability to approve or veto transfers), and whether participations first have to be offered to existing investors (a right of first refusal).

Ultimately, investors want a relationship with fund managers who have the skills and the connections to create opportunities in the current investment climate. They also value a close relationship with their fellow investors, so that there is a genuine community of shared interest.