What Fund Managers Need to Know About a Real Estate PE Fund Structure
March 20, 2020
In this episode of Breaking Ground, EisnerAmper real estate veteran Dan Kaplan talks about the many facets of utilizing a real estate private equity fund structure, including regulator impact, risk mitigation, cash management and more.
DP:We've spoken about many of the benefits of a PE real estate fund structure. Capital access and security, the ability to leverage equity, longer investment horizon, risk diversification, and enhanced project scope. But on the flip side, there are a few things that fund managers disregard at their own peril, aren't there?
DK:Absolutely. It begins and ends with fund strategy, Dave. So I look at this from two perspectives. On the investor side, I look at this from complying with the tax requirements and the tax filing requirements that those investors have. Large sovereign wealth funds are ready to write large checks however they want the funds to accommodate them and set up a structure accordingly. So if they don't find the fund that's going to actually design a structure that meets their needs, they're going to find somebody else who will.
But just setting up the structure isn't enough. Keeping compliance is key. So whether you're setting up REITs or blockers in order to ensure that structure, if you're not keeping that structure, you're going to blow it and cause problems for your investor, and you're really not going to see them for the second fund you raise. I think more on the government compliance side, when you're no longer just a single JV, you may be subject to SEC and even state regulations, but investment managers really with more than a hundred million dollars under management have to register, and that sets up a whole new level of compliance on their part.
There's many standards and depending on the facts and circumstances of the fund, but I guess the key issue and key takeaway here is getting expert guidance on compliance that you don't run afoul of the myriad of the regs that are in place.
DP:Okay. Risk mitigation is always a big topic. What are the key points here?
DK:Okay, so in risk mitigation, especially for what I say for emerging managers, emerging managers came out of a place that has a larger infrastructure. When you're starting your own fund and launching a fund structure, outsourcing, I think the industry consensus, is key. And it provides a number of benefits. So you have additional transparency, you have a segregation of duties and functionality, and also you're allowing yourself to focus on your core competency, which is investing in and managing your investors' funds. You don't have the focus or necessarily the attention and time being consumed with managing that back office function.
Another area I guess I would say that is not just from a financial reporting perspective but the biggest area that we're seeing now in the area of non-financial statement risk is the area of cybersecurity. This is a must. I mean, it really circles back to what investors are looking for from their fund manager and that we see constantly with respect to funds. They want not just doing the diligence on the accounting function but a diligence on the actual IT platform because the integrity of investor data is just the most critical component. And there is people constantly trying to penetrate your security. We see it on a regular basis, so I can't overstate that enough.
DP:Sure. I mean, the fund manager has to get it right every time. The bad actors only have to get it right one time. So sounds like another area where a seasoned business consultant can be of big value in cybersecurity.
DP:Investors tend to have some strong feelings about cash management, don't they?
DK:Yes, they do. I mean, investors, at the end of the day, what they're looking for is return, and they want return, whether it's through their pref or the capital appreciation. But the fund manager needs to balance that in terms of deploying the cash most efficiently but at the same time flexibly. So managers have tools at their disposal, like a credit line, but when they're using the credit line, the investors aren't necessarily getting the returns they want, at least on their capital invested. So the manager really needs to find the proper balance between getting that money deployed and cost effectively and efficiently, because also investors don't want to be subject to multiple calls because that's an inefficient use of their time. So poor management ultimately can have a really disastrous effect on the fund's performance, but it can also impact the GP as a whole in their returns.
DP:Now while the fund's back office infrastructure is typically obscure to investors, they can often tell a buttoned-up operation from a substandard one, can't they?
DK:So, Dave, that used to be the case, but now the requirements of investors in terms of performing due diligence is much more detailed and really a deeper dive. And that includes at the fund administration level. So, as a fund administrator myself, we normally host the diligence teams working on behalf of clients, and they really want to ensure that not just the end product, meaning a optically pretty financial statement is completed, but they want to see the meat and potatoes behind it. So they want to understand the infrastructure. They want to understand that the systems being used are industry standard and that the firm is operating under really the strictest controlled environment possible.
That includes things like having a SOC 1 Type 2 report issued yearly, and you really want to look for that to know that any provider is subject to the strictest of industry standards and best practices.
DP:I realize your list of concerns above is not all inclusive, so any final thoughts?
DK:Just from my experience, what I've learned is managers need to focus on the core aspects of their business, and if they're focused on anything but, they're not going to be able to compete. So I think having the best support in terms of the teams, whether it's back office counsel or risk management, you can't go wrong.
DP:Thanks, Dan, for your time and insights today.
DK:Thanks for having me, Dave.
DP:And thank you for listening to Breaking Ground as part of the EisnerAmper podcast series. Visit eisneramper.com forward slash R-E, as in real estate, for more information on this and a host of other topics. And join us for our next EisnerAmper podcast when we get down to business.