The Real Estate Fund Lifecycle Webinar Series | Part 3: Winding Down Your Real Estate Fund

With nearly 20 years of experience in real estate and private equity accounting, Zhi has extensive expertise in fund operations, capital activities, complex fund structures, and waterfall calculations. Now, what makes today's discussion particularly timely is that the fund wind down process brings legal tax operational considerations together in a very real way. Throughout parts one and two, we've highlighted how interconnected these disciplines are and that becomes especially apparent as a fund moves toward the final stages of its lifecycle. Thank you all for being here. Let's jump right in. When we were talking in part one, we spent a lot of time discussing fund documents and how important it is to think through terms at launch. One section that probably doesn't get nearly as much attention is say management fee, carry calculations or fundraising provisions is the section dealing with the end of a fund's life. So let's start there.

What does the LPA typically say about a fund term and extension options? And what does that conversation with LPs look like when a GP needs another year or two to finish up the job? Yoni, would you do the honors and start us off?

Yoni Tuchman:With great pleasure and relish. Thank you for asking. I strongly agree with what you said. We spent the most time in part one of this series thinking through and discussing how you design the fund. Part of why that's so important, that was a longer session than today's session is when you thought about it and designed it well, you've thought about not just the carry, the waterfall, the management fees, but you've also thought about what we're talking about today. Take the analogy of the watch that you wound up. The work is enwinding it. So you wound it up in phase one or in the first part of this webinar, you designed how it's going to end from the beginning. And so what the LPA will always virtually always say is a few things. Number one, your fund is going to have a life. It's going to have a lifespan and your LPA, your LLC agreement, your governed document is going to say, "This fund will live," and I say live colloquially, this fund will have a term of seven years, eight years, nine years, 10 years, typically in that range.

That's the first thing that the LPA will say. And then it will say that there are circumstances and ways in which that term can be elongated, can be extended. So let's just take a 10 year fund. Your agreement will say with your investors, "This fund will have a 10 year term." And then it's also going to say that at the end of that 10 years, your fund can live longer, usually a year or two in your discretion, the GP's discretion to extend the fund's life. So again, we have the fixed term of, let's say 10 years, then we have maybe a unilateral GP extension for a year or two. Then we have additional extensions typically baked into your governing agreement, your partnership agreement that says after the term is ended and after the GP may have exercised its right to unilaterally extend the funds term, it can then get extension approvals from usually a majority in interest of the investors, sometimes the LPAC, if there's a limited partner advisory committee to fund, they sometimes can give that right to extend.

And so you have this 10 years plus two plus let's say on additional year with LP consent, you have 13 years. Now what happens after this 13 years is over? Is there like a gun that's put to the fund's head and the fund drops? No, the fund still lives and this is the thing that's not stated in an LPA, but I think is super important because a lot of funds GPs don't realize this when they think of a 10 year plus two plus one, let's say a 13 year fund at the end of that period of time, those periods of time, the fund still lives. All that's changing is now the fund is in liquidation and we'll talk more about this. I'm sure, but you're still collecting your management fees typically. You're still operating like you did during the first 10, 12, 13 years of the fund, except your mindset has changed and now all you're looking to do is dispose of assets and close up shop.

But I just say that emphasize that 10 plus two plus one, 13 years, again, for argument's sake, because those are not untypical numbers, doesn't mean that everything dies right then. It could live another year, another two years. There's no set time and LPAs, partnership agreements typically don't even discuss this or talk about how long this can last. Under Delaware law and state law general, this could last a fairly long period of time. So that's kind of the in a nutshell of what the LPA will say and won't say.

Christine Wu:In terms of extension provisions, how much does it matter whether those provisions were negotiated upfront at launch versus having to go back to investors years later and ask for approval?

Yoni Tuchman:So if you value your management fee, you should bake these in from day one because if you need to go get approval to extend, there's always a negotiation. There's always what's in it for me as an LP and fairly so, reasonably so. I mentioned the fee. Even during these extensions, two plus one years, for example, very often and into a year or two of liquidation, you're still collecting your management fee. But if you have to go get approval from investors to extend the fund's life, they're going to have a lot of questions, number one. They're going to want to know why you need to extend. They're going to understand clearly what are the assets that the fund still has, what's their value, what's the plan to dispose of them? And then they're going to expect that they're not going to be paying you maybe at all during that period.

We'll give you our permission to extend if you end our management fee or reduce our management fee to some extent or another. So way better to have the length and the runway that you think you'll need from the get - go rather than to have to go barter late in the fund's life when you're at that extension period and you're needing to get it.

Christine Wu:Yeah, I think that's a great point. And that seems to be a recurring theme throughout the lifecycle. The more clarity and planning upfronts, just fewer surprises later on, right?

Zhi Man Huang:Yeah.

Christine Wu:And I guess when a fund does extend, what actually changes from an operational tax or even legal standpoint that managers should be thinking about? Maybe Z, I'll turn this one over to you first.

Zhi Man Huang:Thank you, Christine. So as Janie said, operationally, this fund is still going running really, meaning that you have ongoing NAV, you're maintaining your account balances, your investor reporting, you might have another audit, you have to pay management fees, but in addition to that, you're also paying your service providers.That includes legal, fund admin and tax compliance. Now at the end of the life, your asset base is much, much lower, meaning you might have one asset, two asset remaining. However, your total fee requirement or your overhead stays the same. So now you have additional pressure operationally that you didn't have say in the middle of the life cycle of the fund. At that end stage, you should really be thinking about setting up reserves, looking at your reps and warranties, just having enough cash flow and budgeting that will allow you to go into the end of the life of a fund.

Christine Wu:Agree. Anything you want to add, Yoni?

Yoni Tuchman:I'm sorry. I said I would add what investors are probably going to be louder during this extension and wind down period. When things were just going and they saw their capital being deployed and they were excited, it's great. But when things get old, when things get stale, like, wait, I thought I was going to be at this already. Where's my money? Where's my liquidity? And they may understand that, look, real estate, it's illiquid. The timing doesn't always work to get out to monetize investments when the fund's life happens to be winding down that was set years and years earlier, things happen, but I feel like in my experience, they're going to need more handholding. So to the point that was just made, your fee is going to be smaller because assuming that your fee is based on the invested capital at that time, it's a shrunken, it's a smaller base upon which to charge the fee.

But ironically, the handholding involved is probably increased. So your staff is going to be fielding more phone calls and more kind of nervous investors, "Hey, what's the plan? When are we going to get out of the fund?" Every investor's greatest fear is to be stuck in a zombie fund. They're lost in a partnership. They can't get out. The partnership has this on asset that it can't get rid of and we're stuck and we're paying fees and then they get nervous. Well, maybe the manager's holding onto this asset because they like to receive the fee. You see how this could be a very toxic kind of dynamic that can develop. I'm painting a worst case scenario. I'm not saying this is routine at all, but I have seen where this dynamic kind of the seeds are planted and investors get almost disgruntled, frustrated for sure. What's the plan?

When are we going to get out of here? And so bear that in mind.

Ryan Sievers:So Yoni, I think it's interesting really quick. In year 12 or 13, all of the home runs have been hit. So what's left? It's all the assets that have problems like legal environment, whatever it might be. And so you're having a hard time getting rid of those and you're trying to maximize value, but they're there for a reason, let's put it that way. And so having that investor attention to that I think is a very real thing.

Yoni Tuchman:Yeah, that's a great point. I guess the hum drum assets are never the last ones. You could expect it to be like the worst assets are the ones you're left holding the bag kind of, what do we do with these? And sometimes you have the opposite. Sometimes you have the really good assets that the GP does not want to part with

Zhi Man Huang:Because

Yoni Tuchman:They see a lot more upside in these assets and shucks, the fund's term is over or what do we do? We got to liquidate our portfolio, but I don't want to part with this. And that's when there's other mechanisms come into play that maybe we'll talk about continuation vehicles and there's a whole industry around that, but that's a great point. There's always a story at the end of the fund. It's either a good story or not a good story. No middle ground.

Christine Wu:Yeah. I think every manager starts a fund with an investment thesis and an expected exit strategy. But as we all know, market don't always cooperate. So I guess what are some of the trade-offs managers need to be weighing as they evaluate the different paths when they have assets such as won't sell?

Yoni Tuchman:Maybe I can start and others can opine. I mean, I think there's basically... So you manage a fund and the funds term is ended and you've exercised your unilateral right to extend however much you were allowed to do so under your partnership agreement. You've gotten LP approvals to the extent that they were available and you wanted to get them to extend further. Now you're in that twilight zone of liquidation. The fund is still alive, you're still collecting your fee maybe, but you're just looking to wind down and you have assets that either you can't easily get rid of. Maybe we'll talk about in those two contexts assets that you can't sell because they're not really sellable in a profitable way at least, or they're really good assets and you don't want to sell them. So what do you do in those two cases? So I'll talk about three ideas that are done and you'll see why they apply in different cases more so than others.

So one thing you can do, although I think it's very unlikely for you to do, is literally distribute the assets in kind to your investors. And in real estate, that's very hard to do because you have a fund that owns a property and you have 30 LPs, that would mean distributing 30 interest in this underlying asset, whether the entity that holds it or directly, that's like a big pain in the neck. You may have that more likely in other types of funds that have assets that are more easily dispersed among investors like securities, right? But in a real estate fund, an in - kind distribution is probably going to be very difficult to pull off. The other thing you can do is, and I think this is fairly common, I'm curious what others see, you can appoint a liquidating trust, a trustee, a third party not connected with the management of the fund until today to take this asset off your hands the fund can shut down officially.

There's no management fee, but the trustee and there are trusts that do there, trust companies that fulfill this service, provide the service, they will just hold the asset, manage it and liquidate it under some pre-agreed set of terms. So that's fairly common. And the other thing I alluded to, the third option I alluded to, I mentioned a few minutes ago, and this is for when you have the good assets that you don't want to part with, this is when the GP can form a new fund to actually buy the asset from the old fund. And that's like a really exquisite, very fun transaction, very involved, very needy where your investors in your existing funds are often given the option and they can often elect at their discretion to either roll their interest in this fund into the continuation vehicle and continue to own a piece of the asset going forward or can get cashed out to the extent that you're raising additional capital from new investors in this new continuation vehicle to buy the asset from the existing fund.

So there's a lot involved in that transaction, but I think that's very common and increasingly common in this circumstance when you have a really good asset or a number of really good assets that outlive the life of a particular fund.

Christine Wu:Yeah, I totally agree. It certainly feels like that continuation vehicle has become a much more common part of conversation over the past couple of years. Ryan and Z, do you want to add anything from your side?

Zhi Man Huang:Yeah, I would say that from my clients, in the ideal world, you will have a 10-year fund, by year 10, you will sold off everything, you will given back your investors their pref, the capital, any excess proceeds, and then you will have another fund in place where you are raising capital. That's ideal scenario for every fund manager. I think Yadi mentioned some good alternatives when there are what he termed zombie assets or zombie fund that has that one or two assets remaining that you really cannot get rid of. I see a lot more of these zombie funds than I like, meaning that they're just one or two assets and the managers just kind of keeps chugging along that maybe if they can get over this hump of this cycle, then we can sell that asset off and then we can close up. Again, that's just the reality of it.

I mean, doing say in - kind distribution or maybe having a liquidating trustee or continuation vehicle. Again, those might work or may not work depending on the type of asset, the type of LPs that you have as well. So again, it's something to think about very closely as you approach that year eight, year nine, year 10 time period.

Ryan Sievers:Yeah, I would say I've seen liquidating trusts in a few examples, limited situations. I'd say the clients I work with generally, they do pretty well. They don't have too many laggards. You'll have a few at the end and they'll generally try to work those out within the fund the best they can. I've actually seen a few funds at the end. They have one left for a year or two and they just get rid of it. It's not worth the headache to -

Christine Wu:Cost too.

Ryan Sievers:Yeah, exactly. And then that's really what it comes down to is we have an asset left here, we're getting an audit, we're getting a tax return, we're doing all these things. There's always expenses that we're occurring every single year and if we're going to bite the bullet and the economic loss is there, might as well just realize it and get it done. So some clients will just take that approach as well. Continuation vehicle, as was mentioned, there's effort in setting that up. So you obviously want the asset to be worth it. So I think a lot of times I've seen the funds extend or continue for a year or two or three or whatever to see if they can work it out. And if they can't, they just kind of take their medicine and shut down and move on.

Zhi Man Huang:Yeah. Again, continuation vehicle is also very expensive to set up, so just another thing to think about.

Yoni Tuchman:Right. It is expensive to set. It's a bunch of work to set them upThat's being paid if done right by the new vehicle that you're raising to buy the asset or substantially buy that vehicle. So hopefully it shouldn't be just more drag on the existing fund, but there's obviously a fair amount of cost involved. One thing that I've seen in this kind of wind down period that to reduce the cost is the audit. A lot of times GPs, because a lot of times the LPA itself, if it requires an annual audit, it often will not have that sunset at any point in the four corners of the partnership. It just requires an audit. But then you're in year like 13, you're like, why am I paying X dollars a year for an audit for a fund that's holding this one asset or these couple of assets that we're just trying to.

And then, but you can't just make that determination as a GP like, "Oh, I know I promised an audit and a contractually obligated to do it, but it doesn't make sense for your sake LPs. It doesn't make sense to drain resources in an audit." You may be totally right in that estimation, but you'll need to go to your LPs and get a waiver or an amendment to the LPA permitting that there should not be an audit in these later years. So that's also something you can do things proactively in these wind down years to try to minimize the cost of the wind down, like doing away with the audit and if the LPs would be okay with that.

Zhi Man Huang:Yeah. I kind of want to extend that as well just to say that most managers, they will reach out to their service providers and let them know, like service providers, meaning your fund admin, your tax compliance, et cetera, and negotiate lower fees because there's less activity, less assets, there's less activity and we're not doing as much anymore and most service providers will understand that the logic behind it. And again, they want to have continuing business, continuing relationship with you as well for funds two or three or four or five. So they are amenable to reducing fees because they know that you might be starting up your fund two.

Yoni Tuchman:Right. And at that point, you better have already started fund two.

Ryan Sievers:Yeah, you should be on fund three.

Yoni Tuchman:And they'll hopefully be working with you on that. It's a very happy cycle where everyone's giving because everyone knows that the relationship is mutually beneficial. So I strongly agree.

Christine Wu:I can't believe we only have five minutes left. This is crazy, but I just want to have one last question for everyone to close things out. So as we wrap up, I want to zoom out and look at the entire series. Over the last three sessions, we've discussed launching a fund, operating a fund, and winding down a fund. Now looking back across that entire life cycle, what is the on decision made at launch that a manager will most appreciate or most regret when a time comes to wind down? Now we can take turns.

Yoni Tuchman:I can start. Sure. I think it all comes... I can't stress this enough. I know I've said this until I'm blue in the face on all these webinars, but the design is so important. The design is so important. Phase one is so important and you will kick yourself as a GP if you were not careful in your design. Don't ever take someone else's term sheet, someone else's terms, someone else's docs, no matter who they are, no matter how successful they are, how well known they are as a firm, never take that for yourself. You need to be thoughtful of what fits you. Apropos of this conversation today, you need to give yourself the runway, the term, the extensions, the fees supporting you in those extensions and in that liquidation period to survive. And that's all baked in from day one, from the moment you put this term sheet together, you're going to have solved this problem or created the problem.

Ryan Sievers:Yeah. I'll add onto that and say from a tax perspective, planning and really understanding our clients here are the GPs or the sponsors generally. So how does your promote work? How do you end up with fancy income? Do you end up with phantom income? Do you get tax distributions? What does the clawback look like? Everyone goes into funds with the best intentions and everything's going to be great. Well, what happens if it doesn't? And you have a home run early and then your fund falters what happens at the end, especially from a GP promote perspective. So really understanding that, modeling through it, not just reading a language, but saying, okay, if this happens, then what happens to me? And so understanding that I think is crucially important.

Zhi Man Huang:Yeah. And I think my advice I would say is partnering with the correct service providers, whether that's legal, fund admin or tax because we all have a very wide range of clients. So we've seen a lot of different scenarios and I think a lot of times clients will ask me, "Hey, I have this situation. What do you think about it? Have you seen this before?" So I think partnering with the right service provider gives you a good bench to draw from.

Christine Wu:Yeah, I echo that as well. I think managers will appreciate most at wind down investing in the right foundation at launch, not waiting until the end. And I think that's a perfect place to end. One of the things that has stood out to me throughout all three sessions is how interconnected every stage of the lifecycle really is. The decisions made at launch impact operations, the decisions made during operations impact the window process, ultimately a successful fund isn't defined by just one stage. It's defined by how all of those stages work together. A big, big thank you to Yoni, Ryan, and Zhi for sharing this perspective today and thank you to everyone who joined us throughout this webinar series. Savannah, I'll pass this back to you.

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