Six Considerations When Structuring Your Fund

Once you have decided on the type of fund, based on your asset strategy, financial model and your capital raise plan, you will then need to consider the finer details, including how to structure your fund to maximize your opportunity to raise capital and minimize administration headaches. In our experience working with real estate managers across the country and with nearly every conceivable asset type and strategy, we have identified six key considerations you should think through regarding fund structure.

Duration of the fund

Is your fund going to have a specific end date or will it be an evergreen fund? For first-time Managers, having a specific end date may help in raising capital. Investors will know when they are likely to get their money back and therefore increase the probability they will invest.

Redemptions (open-ended funds)

Regardless of the duration of your fund, for all open-ended funds you need to make some decisions around how you plan to redeem investments in the fund if any investors want their money back.

For all open-ended 506 Regulation D funds, a lock-up period is required for investors, with the term dependent on the nature of your fund (for example, whether you have long-term or short-term deals). If an individual does need to redeem inside the lock-up period, there is generally a penalty attached. Redemption requests should be handled on a first-come, first-served basis, which avoids any inequitable or preferential treatment to investors.

Unit price calculations

This is one of the most overlooked and misunderstand considerations when structuring your fund. Your calculations need to be fair and equitable for investors coming in and out of the fund at different times. This becomes increasingly difficult as the assets perform or don’t perform, and the risk profile of the assets continually fluctuates. Valuing your assets too conservatively unfairly rewards investors who join later and therefore reap unearned upside. Similarly, valuing your assets too aggressively unfairly rewards early investors and may additionally increase the likelihood of taking a write-down. Considering how you are going to manage unit price calculations is an important factor of setting up a fund.

Use of leverage

You need to decide whether you are willing to take on fund and/or asset-level debt. How? When? With what restrictions? Something to keep in mind is that taking on debt may impact your ability to raise capital, particularly from IRA investors investing as equity members (as opposed to Note Holders), as it can generate Unrelated Business Taxable Income (UBTI).

Asset level fees

Your asset level fees will have a big impact on your ability to raise capital, with investors particularly sensitive to these types of fees. For example, in a mortgage pool fund, who is keeping the points and any other asset related fees like origination and exit fees? It is important to understand how you plan to allocate all fees and the implications of those fees to both your returns and ability to raise capital.

Waterfall

The Waterfall for your fund will dictate who gets paid, and in what order. Typically, the order is as follows:

  1. Fund expenses: accounting and audit fees and similar expenses
  2. Management fee: while it may seem counterintuitive, investors typically prefer managers to be compensated. If a manager is only taking asset-level fees, when the market turns the manager may have no incentive to continue to manage the fund through difficult times. Management fees ensure managers have an incentive to manage a fund to its completion
  3. Preferred return: this should encompass both the rate of the preferred return and determining whether it is cumulative
  4. Profit split/performance fee: Your financial model should provide guidance for what is realistic when it comes to rates for management fees, preferred return and any profit split

When structuring your fund, do it in a way that your interests and the interests of your investors are as tightly aligned as possible. Avoid the temptation to over-complicate terms that will create investor confusion and administrative headaches in execution.

Lance Pederson

It pays to seek advice early and often when it comes to structuring your fund. It’s worth a mint to get that advice from people who have walked in your shoes and intrinsically understand the complexities. If you have questions on structuring your fund to maximize capital raising and minimize pain, please feel free to reach out to Lance Pederson at lance.pederson@redwoodrea.com.

 

 

Nothing in this article is intended to be or should be construed to be legal, accounting, or other professional advice that requires a license to provide. Anyone acting on the information contained in this article should consult with independent professional advisors. As part of Redwood’s advisory practice, all of our fund creation clients enter into an attorney/client relationship with qualified securities counsel.

Fund Management 101: Fund Type Considerations When Structuring Your Fund

Once you have decided to make the transition to a Fund structure, the hard work starts.  The first challenge is figuring out how to structure your fund. Among the multitude of considerations, the top questions include what type of fund would work best with your asset strategy and how will fund structure maximize your opportunity to raise capital?

In this first installment we will discuss the overall structural consideration: the type of fund.  This is a big question and will depend greatly on your asset strategy, your financial modelling and your capital raise strategy – all of which you should have figured out prior to deciding to make the transition. In relation to the type of fund, you should consider three main points:

Offering Type

The most popular fund type we work with is a 506(c) fund, which is exempt from securities registration with the SEC (but must still file a Form D). Unlike a 506(b) fund, these funds do not have significant restrictions on solicitation and advertisement to investors, including having to have a prior business relationship with your investors. However, in a 506(c) fund you are limited to accredited investors, whereas a 506(b) can have up to 35 non-accredited investors.  You must also take reasonable to steps to verify that each investor is accredited, which is more difficult than you may currently be thinking.

Open vs Closed Fund

Open-ended funds are characterized by a fluctuating unit price, with capital being raised and deployed throughout the life of the fund. Closed-ended funds on the other hand, have a fixed unit price and are defined by a finite capital raise and investment period, each with a specified end date.

Certain asset models are better suited to each type, so consider your asset strategy before making this decision. A model with a high volume of transactions and good velocity of assets may be better suited to operate as an open-ended fund (for example, a mortgage pool fund), and those strategies characterized by longer hold periods and uneven asset realizations may be better suited to a closed-ended structure (such as a deep value-add real estate fund).

Capital Structure

There are two types of offerings we generally see in funds, equity and debt. In an equity offering, your investors become members (owners of the fund) and are issued equity interests on a fluctuating (open-ended) or static (closed-ended) unit price. Principles of fair and equitable treatment of equity investors apply, in relation to issues such as redemptions and expense recognition, and in an open-ended fund, unit price calculations add a layer of complexity to this.

The other option is debt, where the fund borrows money from investors, who are called note holders. The rates and terms of notes may vary within the fund, depending on factors such as how much capital an individual investor is contributing or length of maturity for an investor’s note.

Before deciding on the type of fund, you must have an asset model with some volume, have a variable-driven financial model, and have a game plan for raising capital. These three factors will dictate the type of fund which will work best for you and your goals. For more on specific considerations see the Six Considerations When Structuring Your Fund.

Lance Pederson

Redwood works with open and closed-ended funds across the country, with a wide variety of asset strategies and capital structures. If you have questions on structuring or running your fund, please feel free to reach out to Lance Pederson at lance.pederson@redwoodrea.com with questions.

 

 

Nothing in this article is intended to be or should be construed to be legal, accounting, or other professional advice that requires a license to provide.  Anyone acting on the information contained in this article should consult with independent professional advisors.  As part of Redwood’s advisory practice, all of our fund creation clients enter into an attorney/client relationship with qualified securities counsel.

 

 

The Importance of Good Loan Servicing

A significant portion of Redwood’s clients manage mortgage pool funds. When working with these clients, some of whom have large portfolios of loans, we have seen a variety of loan servicing strategies and capabilities. Those managers who have a clear strategy and strong capabilities in loan servicing are able to more effectively manage their loan portfolios, are able to receive and distribute financials and investment returns to their investors, and more tightly control the performance of their loan portfolios.

There are two primary options when considering how your Fund should service its loans: in-house or outsourcing. Whether you are going to service your own loans or outsource that responsibility, there is a significant amount of detail about each loan which must be captured and reported on, including:

  • Interest Charged: At what point will interest be charged? Will the borrower pay any interim interest up front?
  • Payment Frequency: Will the borrower be paying interest monthly or at maturity? Will interest carries be involved?
  • Modifications: Is a forbearance agreement in place or has a full modification occurred? What unpaid interest or fees are being considered, and what additional fees will be charged?
  • Foreclosures and Bankruptcy: Will the asset need to be impaired post-foreclosure? Are there any lien positions that need to be considered?

Experienced private lenders or those with the right internal infrastructure may be able to effectively service their own loans. Some considerations fund managers may have when making a decision about whether to outsource or not: cost of outsourcing and the impact that will have on fund returns; ability to generate an additional source of revenue to managers; internal capabilities and ability to effectively source and retain talent; and whether to focus on core capabilities and allow others to provide loan servicing.

I would offer a word of caution to first-time servicers: you may run a higher risk of not being able to support a rapidly growing portfolio as compared to an outsourced servicer’s established infrastructure and ability to scale, and poor loan servicing can create a great deal of issues down the line for you, your borrowers and your investors.

Through Redwood’s activities as a third-party Fund Administrator, I have a great appreciation for the complexity of loan servicing and I urge all potential and current clients to not underestimate the potential impact of loan servicing on their financial statements.

From Redwood’s perspective as a Fund Administrator, in order to produce those financial statements, we need to determine out how much money will eventually end up in the investors’ pockets. The process is not as simple as the concept; the life of the loan must be translated from a cash basis to an accrual basis, under Generally Accepted Accounting Principles, which requires forecasting and then adjusting accounting journal entries. In our experience in working with a number of both in-house and outsourced loan servicers, we see a wide variance in loan-servicing capabilities. Invariably, those with solid loan servicing allow us to produce investment returns and financial statements in a fraction of the time than those with poor loan servicing.

 

Nate Ashley

Redwood’s Senior Fund Accountant Nate Ashley works with a number of clients who both service their own loans and who outsource their servicing to a third-party. Feel free to reach out to Nate at nate.ashley@redwoodrea.com should you have any questions or are in need of recommendations for a servicer.

 

 

Nothing in this blog is intended to be or should be construed to be legal, accounting, or other professional advice that requires a license to provide. Anyone acting on the information contained in this blog should consult with independent professional advisors.  

A Trip to NYC thanks to the new Partnership Audit Rules

For the last two years I have attended Financial Research Associates’ Private Investment Funds Accounting and Tax conferences in New York City. These events are a great opportunity to catch up on the latest trends and issues in private equity accounting. A few months ago, one of the conference organizers asked me to present. It took me a few weeks to get over my apprehension of presenting and say yes; after all, discomfort is the pathway to growth.

May’s conference focused on the impact recent changes in tax legislation will have on private equity and hedge funds. For the weeks leading up to the conference, I studied up on the new partnership audit rules for which I was a panelist.

These new partnership audit rules will impact all Redwood clients, so I will first share how these rules came about and then what Fund Managers should know about them.

From 1982 until the end of 2017, the Tax Equity and Fiscal Responsibility Act (TEFRA) served as the IRS audit regime. The IRS would audit the partnership and administer the tax down to the individuals and collect. This was a highly inefficient process and the government often ran into statute of limitations issues when attempting to enforce collections. A new audit regime was enacted as part of the Bipartisan Budget Act of 2015, effective for tax years beginning 2018, which repealed the previous procedures under the TEFRA regime. Highlights include:

  • The Tax Matters Partner (TMP) is replaced by the Partnership Representative (PR)
  • Adjustments to partnership-related items are determined at the partnership level and the corresponding tax is assessed and collected at the partnership level, as opposed to the individual level
  • Adjustments are recognized in the year the audit is concluded, as opposed to year being audited
  • Under TEFRA, partners generally retained notification and participation rights in partnership-level proceedings, but with the new rules, partners have no statutory right to receive notice of or to participate in the partnership-level proceedings.

The most critical thing to know when selecting the PR is that you are placing an incredible amount of trust in that person. Any actions they take are binding on the partnership and can be done without partner approval. If there were an IRS audit taking place, the PR would be the only person cognizant of this unless they choose to share the news downstream.

Any partnership formed in 2018 and forward should not have TMP language and should only have partnership language. It is recommended that all Fund Managers carefully review their operating agreements now to prevent future issues with investors such as the agreed upon steps in response to an IRS audit and indemnification provisions for former and future partners. Significant revisions to operating agreements may be necessary to document details including how the PR is chosen, their agreed upon due diligence process and remedies in the event that the PR or other partners fails to operate within the agreed parameters.

Due to the complexity of the PR’s role you may want to consult an attorney for guidance on structuring the key terms the fund’s operating agreement should address.

I hope that all our readers found this helpful (exciting may be a stretch). Stay tuned for my next article on highlights from the conference regarding what’s in store from the SEC and Opportunity Zones.

 

Erica England, C.P.A

Redwood’s Chief Accounting Officer Erica England C.P.A. has 10+ years of experience working in the private equity industry and is always happy to discuss how Redwood could help you with your fund administration needs. Reach out to Erica at erica.england@redwoodrea.com to learn more.

 

 

Neither Redwood nor any of its affiliated entities offer or provide any legal, accounting, or other advice that requires a professional license. None of the materials in this post or any related materials are intended to be or should be considered legal, accounting, or similar advice. No one receiving these materials may rely on them as a substitute for appropriate professional advice. Redwood strongly encourages and advises anyone receiving these materials to consult with their own independent attorneys, CPAs, and other professionals in order to ensure that any actions taken in connection with the materials complies fully with all applicable laws, rules, and regulations.