January 8, 2009

Strategies for Responding to Liquidity Needs of Investors in Real Estate Funds

As a result of the current economic downturn and global economic credit crisis, some investors find themselves over-allocated to investments in private real estate funds because their private real estate investments have not been written down in value to the same degree as their public investments (the so-called “denominator effect”). In addition, many large pension plans, foundations and endowments have suffered well-publicized losses in the public equity markets.

These pressures facing such investors are compounded by the fact that the virtual shutdown of the credit markets has dramatically reduced the volume of real estate transactions in the marketplace, which in turn has reduced the amount of distributions that real estate funds are able to make to their investors. Despite these liquidity constraints on investors, the current reduction in cash flows and sale proceeds means that many real estate funds may encounter an even greater than expected need to call capital from investors in the near term in order to fund operating costs and debt service, and to complete development or capital improvement projects.

A number of investors have begun to make requests to real estate fund sponsors in an effort to address this disconnect between their internal capital constraints and allocation issues and the requirement to fund future capital calls, including:

  • Requesting the fund sponsor to reduce or terminate the investor’s future capital commitment
  • Requesting the fund sponsor’s consent to withdraw with respect to a portion of their interest
  • Requesting the fund sponsor to agree not to call capital from the investor for a specified period of time
  • Requesting the fund sponsor’s consent to a transfer of all or a portion of the investor’s interest in the fund

The purpose of this advisory is to highlight the issues that real estate fund sponsors should consider when evaluating any such requests from investors and to provide some thoughts on potential ways in which real estate fund sponsors may be able to address their fund’s capital needs while being responsive to investor liquidity constraints. 

What should a fund sponsor consider when responding
 to such investor requests?

It is critical that prior to discussing alternatives with investors, fund sponsors are well-versed in what the fund sponsor is permitted to do and the consequences of various actions under:

  • The fund’s organizational documents
  • The partnership law or other laws governing the fund and the fund sponsor, in particular the fund sponsor’s fiduciary duties and other potential liability of the fund sponsor
  • The fund’s contractual obligations, such as side letters and credit facility agreements
  • Securities laws, ERISA and tax laws

Each of these areas is discussed in more detail below.

Political/Precedential Considerations

While this advisory largely focuses on the legal issues that fund sponsors should consider in responding to such investor requests, one of the most important issues that fund sponsors must confront is the political and precedential effects of their actions in this regard. Fund sponsors will desire to maintain the goodwill of their investors and, as a result, will be motivated to find solutions for their investors’ liquidity constraints. The second portion of this advisory is intended to provide some alternatives for fund sponsors to consider in order to address their investors’ liquidity constraints while also protecting the fund’s interests as a whole. As part of protecting the fund’s interests, fund sponsors should be sensitive to the precedential impact of their actions with respect to any individual investor. Even if allowing an individual investor to withdraw or reduce its commitment does not trigger a contractual “most favored nations” right of other investors (as discussed below), other investors may nonetheless expect similar treatment. The concerns associated with each of the factors discussed below (for example, the fiduciary duty concerns associated with permitting an investor to withdraw or reduce its commitment) are heightened if a large number of investors are permitted to withdraw or reduce their commitment, and ultimately the stability of the fund may be threatened by such events.

Fund Organizational Documents

The fund’s organizational documents should be carefully reviewed to determine whether the fund sponsor has discretion to take any contemplated actions. For example, the fund agreement will generally not allow for capital calls other than on a pro rata basis and will generally not be structured to accommodate allowing individual investors (but not all investors) to reduce their commitment and thereby be overfunded relative to their revised commitment. Also, the fund agreement may provide that investor withdrawals are prohibited except in limited circumstances, such as to avoid ERISA violations or avoid the fund having ERISA plan assets. While the fund sponsor will typically have authority to permit transfers, the fund’s organizational documents will often contain provisions limiting the ability to effect transfers if the transfer would adversely affect the fund’s tax, ERISA or other status, and the fund sponsor will be subject to the fiduciary duties and liabilities discussed below in determining whether to permit a transfer.

The fund sponsor should also carefully review the default provisions set forth in the fund’s organizational documents. As part of considering an investor’s request to reduce its commitment, withdraw, transfer or defer capital calls, the fund sponsor should assess (1) the ability of the investor to fund future capital calls if such requests are not honored and (2) the fund’s remedies in the event of a default. While many of the issues discussed in this advisory are also relevant to defaults, addressing investor defaults also raises additional issues which are beyond the scope of this advisory.

Legal Considerations: Fiduciary Duties, Broker-Dealer, Confidentiality, Disclosure

Fiduciary Duties

A fund sponsor is subject to fiduciary duties to the investors in its fund. The nature and scope of those duties are in large part defined by the laws under which the fund is organized and the terms of the fund’s organizational documents. In addition, if the fund’s assets include “plan assets” subject to ERISA, the fund sponsor’s decisions with respect to such investor requests will be subject to the ERISA fiduciary standards applicable to such a fund. As a general matter, when considering a request from any investor in this context, the fund sponsor should consider the interests of the fund as a whole. As a result, in considering whether to allow a particular investor to reduce its commitment or withdraw, to defer capitals calls or to permit a transfer, the fund sponsor should consider the effects of these actions on the other investors and on the fund as a whole, such as:

  • How will this action affect the fund’s ability to implement its intended business strategy? 
  • Will this action require other investors to fund a greater portion of their capital in particular assets, and thereby reduce their diversification in those assets? 
  • Is this action inconsistent with the expectations of other investors?
  • Will this action expose the fund to risks of failing to qualify for securities law, ERISA or tax exemptions or failing to achieve certain intended benefits or otherwise have an adverse impact on any other investor?
  • Will this action reduce the borrowing capacity of the fund under its subscription secured credit facility or any other credit facility?

Because individual investors may be in different positions with respect to their own allocation issues and liquidity constraints, fund sponsors may find themselves in a difficult position in trying to accommodate all of their investors’ needs. In this regard, fund sponsors should consider all of the facts and circumstances and bear in mind their fiduciary duties to the fund as a whole.

Broker-Dealer; Investment Adviser

In the case of transfers, fund sponsors need to be careful not to act as a “broker,” which would require registration with the SEC and/or implicate state law requirements. Fund sponsors that rely on the exemption from SEC registration available to advisers with fewer than 15 clients also need to be careful to avoid being deemed to provide investment advice to either the transferee or the transferor in connection with the transfer such that neither the transferee nor the transferor is deemed to be a “client” for purposes of such exemption. The determination of whether the fund sponsor is acting as a “broker” or the transferee or transferor qualifies as a “client” of the fund sponsor will vary depending on the particular circumstances. Accordingly, fund sponsors should consult with their counsel to address these issues prior to becoming involved in any transfers, particularly if an ERISA investor is involved.


As part of permitting a transfer, the fund sponsor will generally be asked to provide a limited waiver of the fund agreement’s confidentiality requirements in order to permit the transferor to disclose certain fund information to the transferee. Accordingly, it is important that the waiver narrowly and precisely define the extent to which the transferor is permitted to disclose confidential fund information to the transferee, that each prospective transferee enter into a confidentiality agreement whereby it agrees to protect all such information it receives, and that the fund sponsor have confidence that such confidential information will in fact be protected.

Disclosure Requirements; Anti-Fraud Provisions

In evaluating an investor request to withdraw or reduce its commitment or defer capital calls, fund sponsors should consider the disclosure obligations to prospective and existing investors.

With respect to prospective investors, a fund sponsor is liable under federal and state securities laws if, in connection with selling securities, it makes an untrue statement of a material fact or omits to state a material fact that is necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. A significant reduction in commitments to the fund may require a fund sponsor to disclose to prospective investors that the existing fund size and/or target fund size has changed. Moreover, a fund sponsor would need to consider how such a reduction in commitments and the prospect of possible future reductions may affect the future stability of the fund’s resources and whether the actual and/or potential impact of these changes is a material fact that should be disclosed to prospective investors. Any agreement to defer capital calls for a period of time would require a similar analysis.

Investment advisers (whether or not registered) are subject to certain anti-fraud provisions under the Investment Advisers Act. With its adoption of an anti-fraud rule in 2007 targeting investment adviser conduct with respect to pooled investment vehicles (including registered funds and certain unregistered funds), the SEC served notice that it will be devoting particular attention to not only the conduct of fund sponsors and disclosures made in connection with fund offerings, but also fund sponsor conduct and disclosures with respect to existing fund investors. Given the SEC’s heightened sensitivity to the treatment of prospective and existing fund investors and the rule’s relatively high standard of conduct (mere negligence may result in a violation), fund sponsors, particularly those registered with the SEC and subject to inspection, will want to consult with their counsel to analyze their proposed responses to investor liquidity needs in light of these anti-fraud provisions.

Contractual Obligations

Side Letters

Certain fund investors may have side letters containing “most-favored-nation” (MFN) provisions which enable such investors to elect to receive similar rights as those granted to other investors in their side letters (subject, in some cases, to size or other limitations). Those MFN provisions must be carefully considered when a fund sponsor is faced with a request from an investor in this context. Depending on the nature of the MFN provisions, permitting an investor to withdraw, reduce its commitment or transfer may allow other investors to exercise similar rights under their MFN provisions. As noted above, even if an investor is not able to elect a right to take similar action based on an MFN right, fund sponsors should also carefully consider the precedential effect of permitting an investor to take any of these actions and whether it will lead other investors to seek similar treatment.

Credit Facility Implications

A real estate fund’s subscription secured credit facility may be the most viable near term liquidity solution for many funds and investors. However, fund sponsors must pay careful attention to the “rules of the road” with respect to these facilities when evaluating investor requests for withdrawals, commitment reductions or transfers.

The first thing to remember is that most credit facilities obligate the borrower (the fund) to deliver to the lender prompt notice of any notice it receives from any investor that the investor will not fund a capital call, wants to terminate its commitment, wants to transfer its interest or take other similar actions relating to the investor’s capital commitment (this may be true even if the fund sponsor has no intention of honoring such a request). Similarly, the borrower is obligated to provide simultaneous notice to the lender of any notice the borrower sends to any investor(s) in this regard.

Next, the fund sponsor must be cognizant of the potential impact many of these actions may have on the fund’s borrowing capacity under the credit facility. If the investor at issue is “Included” for purpose of calculating the fund’s borrowing base under the credit agreement, any withdrawal, commitment reduction or termination or transfer would result in an “Exclusion Event” whereby that investor’s capital commitment would be excluded from the borrowing base. Note that any default by an investor with respect to its subscription obligations, including a failure to fund a capital call, will also result in an Exclusion Event. In addition to reducing the fund’s overall borrowing capacity, in certain cases an Exclusion Event may necessitate a significant capital call upon the investors in order to re-balance the credit facility.

Unfortunately, many credit facilities include an even more problematic remedy for the lender in the case of certain investor defaults. While the Exclusion Event remedy is intended to address particular investor default issues, if investors constituting 15% or more of the total fund capital commitments default in funding their capital commitments, it is often the case that an overall event of default is deemed to have occurred under the facility, entitling the lender to demand repayment of the entire facility. Needless to say, this is a scenario that should be carefully monitored and thoughtfully anticipated, with a goal of never crossing such 15% default threshold.

When considering an investor request, the fund sponsor must be aware of the credit facility lenders’ consent rights in this regard. Typically, any termination or reduction of an investor’s capital commitment, withdrawal, or transfer of an investor’s interest will require at least the Administrative Agent’s consent, and very often the consent of all or a percentage of the lenders in the syndicate. Fund sponsors should also keep in mind that there is a common exception to the “non-recourse” nature of these credit facilities as they relate to the fund sponsor in cases where the fund sponsor consents to any of these types of investor requests without obtaining the requisite lender consent, with the result being that the lenders could sue the fund sponsor directly for any losses the lenders incur in that instance. An overlay to this consent requirement is the fact that many of the older subscription lines are currently significantly below current market rates and, as a result, lender consents may be conditioned upon the fund agreeing to provide some form of economic incentive to the lenders.

ERISA and Tax Considerations

Fund sponsors should carefully consider the effects of any proposed withdrawal, commitment reduction or transfer on the fund’s ERISA or tax status, or on any intended tax benefits. As discussed above, permitting a withdrawal, commitment reduction or transfer that has any of these effects may result in liability for the fund sponsor.


A proposed commitment reduction, withdrawal or transfer of an interest should be evaluated from the perspective of the fund’s ERISA status. In particular, if the fund is relying upon the “less than 25% benefit plan investors” exception from plan assets status, the fund sponsor should take appropriate measures to ensure that the reduction, withdrawal or transfer will not threaten compliance with such exception. Any assignment documents should contain representations designed to confirm such compliance.

In addition, transfers to or from an ERISA plan can potentially constitute a prohibited transaction under ERISA which, in turn, would typically require rescission of the transaction. Accordingly, fund sponsors should consider including representations in the transfer documents from both the transferor and the transferee to the effect that the proposed transfer will not give rise to a non-exempt prohibited transaction under ERISA or Section 4975 of the Code or constitute a violation of any comparable law applicable to government plans.

Finally, funds relying on the “venture capital operating company” exception or “real estate operating company” exception from plan assets status should consider whether any potential commitment reduction, withdrawal or capital call deferral could have an impact on the fund’s ability to satisfy the 50% “good assets” test applicable to these exceptions.


Reductions in commitments, transfers and withdrawals all need to be evaluated in light of the fund’s tax-related transfer restrictions and any other potential tax impact on other investors in the fund (including the fund sponsor). The nature and extent of the potential tax issues will depend on the structure of the fund and the terms of its organizational documents. Fund sponsors should carefully review the tax implications of any such actions with their tax counsel and accountants.

Fund sponsors of funds that utilize REITs in their structures need to evaluate whether any potential reduction in commitment, transfer or withdrawal may result in the REIT potentially failing the prohibition on REITs being “closely held,” failing to maintain its status as a “domestically-controlled REIT,” or becoming a “pension-held REIT.”  While the covenants contained in the fund’s organizational documents and side letters need to be reviewed, the fund sponsor should also evaluate whether a proposed action could otherwise adversely affect other investors, as such actions could raise fiduciary duty and/or investor relations issues.

For any fund that is organized as a partnership, transfers should be evaluated in light of the “publicly-traded partnership” rules and any transfer restrictions related thereto in the fund’s organizational documents in order to ensure continued treatment as a partnership for federal income tax purposes.

If the fund has a built-in loss on its assets (i.e., its adjusted tax basis in its assets exceeds their fair market value), a transfer of interests in the fund may require the fund to adjust the tax basis of its properties under Section 743 of the Internal Revenue Code. To the extent the fund is a “fund of funds,” invests through joint ventures or otherwise holds its investments through lower-tier partnerships, any such lower-tier partnerships may also be required to make a “743 adjustment” in respect of transfers of fund interests. These adjustments could result in significant additional accounting costs and complexity for the fund and for the lower-tier entities. Depending on the terms of any lower-tier partnership agreement, the fund may be liable for any such additional costs incurred by the lower-tier partnerships. In most fund agreements, the fund-level costs will be passed along to the transferee, but fund sponsors should review their fund documents carefully to understand the exact extent to which they may be entitled to pass along such costs, especially as it relates to lower-tier partnerships, and should discuss any potential 743 adjustments with their accountants.

Any proposed reduction in the capital commitments or contribution obligations of one or more investors may raise issues for a fund if the fund’s organizational documents are structured to comply with the “fractions rule” or if it otherwise liquidates in accordance with capital account balances. The limitations inherent in those forms of agreements may prevent the investors from fully achieving the intended economic result of the reduction, potentially leaving too high or too low a balance in some investors’ capital accounts vis-à-vis others. Also, arrangements that result in management fees that are not strictly proportionate to commitments are generally not permitted under the fractions rule, and thus alternative approaches may need to be considered. Fractions-rule funds may also be limited in their ability to specially allocate expenses associated with a transfer to the transferor and/or the transferee. Withdrawals at a discount to fair market value could raise fractions-rule issues for a fund as well as potential tax issues for the non-withdrawing investors in the fund.

Except where prohibited under the fractions rule, reductions in capital commitments of some investors may require future income allocations to be made in a manner that adjusts the investors’ capital accounts to be in proportion to their new commitment percentages (assuming the reduction is intended to apply to both pre-existing and future investments). This may cause additional taxable income to be allocated to either the investors that are having their commitments reduced or the remaining investors, depending on the circumstances. Any such adjustments may require amendments to the fund’s organizational documents and therefore may require investor consent.

For fund sponsors that utilize a contribution waiver/fee offset and/or take special distributions in lieu of management fees, any reductions in commitments may result in additional risk that the fund will not generate sufficient gains (or depreciation recapture, if applicable) to permit the fund sponsor to fully recover the waived fees. Any such arrangements should be carefully evaluated with tax counsel based on the applicable situation to determine the potential impact on the fund sponsor.

What can a fund sponsor do to address the fund’s capital needs
while being responsive to investor liquidity constraints? 

For real estate fund sponsors who have recently raised a fund and have made no or limited investments, the lack of acquisition opportunities in the short term may mean that there is not an immediate need to call capital from investors. For these funds, the lack of immediate need to call capital may be enough to assuage investor liquidity concerns. In this regard, fund sponsors should be careful not to commit to refrain from calling capital unless they are also willing to inform the lenders under their credit facility and potentially inform all of the other investors. Alternatively, there may be an opportunity for such fund sponsors to obtain investor consent to extend the fund raising period or investment period (or both) in consideration for agreeing to not call capital for a period of time. This may be beneficial both to investors with immediate liquidity concerns and to fund sponsors who do not expect to be able to invest the entirety of their capital commitments in the near term due to the current freeze in the credit markets.

For real estate fund sponsors who are facing immediate capital needs or who are dealing with investors whose liquidity issues require them to take immediate action, they may consider the following:

  • Utilizing the credit facility as an alternative to capital calls
  • Favoring transfers over withdrawals or reductions in commitments
  • Making distributions that are subject to recall to increase borrowing capacity
  • Permitting limited reductions in capital commitments

Utilizing the Credit Facility

Increased or continued borrowing by the fund under its credit line as a substitute for making capital calls in the near term may be viewed as a favorable approach by many investors with liquidity concerns, while also minimizing many of the sponsor concerns mentioned above. Investors who may have been somewhat skeptical of the fund’s use of these credit facilities in the past may now become their greatest advocates, and this turn of events may present opportunities for fund sponsors to bolster their borrowing base under the credit line and their flexibility with regard to its application. The following are a number of ways this might be accomplished:

  • To the extent that the current fund documentation includes limitations on the use of the credit facility (such as a requirement that no draw under the credit facility may remain outstanding for more than a specified period of time), the current economic environment may present an opportunity to revisit the same with the investors and perhaps liberalize those provisions by way of an investor approval process.
  • Certain investors may have failed to deliver the requisite investor letter, opinion and/or financial statements to the credit facility lender in order to allow the fund to receive maximum borrowing base credit for those investors’ capital commitments. Now may be a time for the fund sponsor to revisit those issues with such investors in order to maximize the fund’s borrowing capacity, and the investors at issue may be more willing to cooperate if the alternative is a capital call.
  • Fund sponsors must typically deliver to the lenders annual financial statements for all non-rated Included investors in order to maintain their Included investor status in the credit facility’s borrowing base. If the delivery of such information is not otherwise an obligation of the investors under the fund documentation, fund sponsors have historically been reluctant to ask investors for such information. Again, the current need to maximize borrowing capacity and the investors’ desire to postpone capital calls may suggest that the time is right to make these requests for financial statements to the extent they are required by the lender to maintain Included investor status.
  • Fund sponsors should consider their extension options (if any) under their credit agreement, and anticipate how and when to most effectively initiate the same. Relatedly, if the fund sponsor is considering an extension of the fund’s investment period as mentioned above, a coincident extension of the term of the credit facility should also be pursued with the lenders.
  • As discussed in more detail below, fund sponsors may consider distributing operating cash flow and/or capital event proceeds to the investors if the fund has the ability to recall such capital pursuant to its organizational documents. Such distributions would increase the fund’s borrowing capacity under its credit facility by increasing the aggregate uncalled commitments of the investors. Note that if this distribution option is to be pursued, fund sponsors should not be quick to permanently reduce the maximum size of the credit facility as capital calls are made, which is often done for purposes of minimizing the unused fee payable by the borrower. Those reductions are typically permanent and might negate the fund sponsor’s ability to build up the fund’s borrowing capacity via distributions.
  • Fund sponsors should keep in mind that subscription line proceeds typically can be used for any permissible fund expenditure, including paying down other debt or even making distributions to investors.Favoring Transfers

Favoring Transfers

A number of large institutional investors have begun to programmatically transfer their interests (or portions thereof) across a number of funds. In light of the alternatives of reducing commitments or permitting withdrawals, permitting transfers is generally a more favorable approach for the fund sponsor. Because the size of the fund does not change, transfers do not generally expose fund sponsors to (1) the same level of risk that the fund will not be able to execute its business strategy or (2) claims by other investors that the fund sponsor is violating its fiduciary duties by not acting in the best interests of the fund as a whole.

However, as noted above, fund sponsors need to consider a number of factors in permitting transfers, including the qualifications of the transferees, credit facility lender consents, effects on the credit facility’s borrowing base and protecting the confidentiality of fund information. A number of these matters can be addressed through coordination with the credit facility lender and requiring transferees to execute confidentiality agreements and assignment documents that confirm investor qualifications. Fund sponsors should also consider the change in make-up of the fund’s investors (both in respect of the fund sponsor’s current fund and subsequent funds) if institutional endowments, pension plans or foundations are replaced by secondary market funds or other secondary market investors.

Distribute Rather Than Reserve

Rather than reserve cash proceeds in order to fund capital needs, a fund may be well served to distribute such cash to its investors, assuming it has the ability under its organizational documents to recall such capital. This approach would address investor liquidity constraints in two respects. First, it provides investors with cash distributions, and second, the ability to recall such capital means that the fund will have greater borrowing capacity under its credit facility. The fund can therefore continue to borrow off of the credit line in lieu of making capital calls for a longer period of time. The consequence for the investors is that they will have immediate use of the cash to address their current liquidity needs. The fund sponsor should carefully review its credit facility documents and organizational documents to determine whether this is a viable option. The fund sponsor should also clearly note to investors that such returned proceeds are subject to recall in order to avoid a situation where investors have not adequately planned to meet such future recall.

In the event that the fund’s organizational documents do not permit a recall of distributions, the benefit to investors of making current distributions may be an opportunity for fund sponsors to seek to amend the fund’s organizational documents to permit or expand upon the fund’s right to recall distributions.

Reducing Capital Commitments

Two very large buyout funds, TPG and Permira, have recently reported that they have permitted all investors to reduce their remaining capital commitments to their latest funds (approximately $20 billion and $14 billion respectively) by up to 10% in the case of TPG and up to 40% (with an overall cap of $1.9 billion) in the case of Permira. In the case of Permira, investors taking advantage of the reduction would reportedly have their distributions reduced by 25% and would continue to pay management fees on their original commitments.

While giving all investors the option to reduce their commitments would generally be expected to be an alternative of last resort and needs to be considered in light of the fiduciary issues and other factors discussed above, doing so may engender investor goodwill and thus provide long term benefits for the fund sponsor and its future funds. This approach may be especially attractive to larger funds that expect difficulty putting all of the capital to work in the current environment, particularly if the fund sponsor’s economics are not significantly damaged, as in the case of Permira.