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.
The Waterfall for your fund will dictate who gets paid, and in what order. Typically, the order is as follows:
- Fund expenses: accounting and audit fees and similar expenses
- 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
- Preferred return: this should encompass both the rate of the preferred return and determining whether it is cumulative
- 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.
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 firstname.lastname@example.org.
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.