The COVID-19 pandemic has led to profound change across all aspects of our society, including the role real estate plays in work, social interaction and home life. It will take time for the real estate and investment sectors to understand and respond to many of these changes; in some cases, the process may take years. Real estate fund managers currently in the investment period of their fund's life have three strategies to consider in responding to changing market dynamics. This article explores each of these options in detail.

Option 1: Extend the current fund's investment period to preserve capital already committed by investors.

Manager outlook: Real estate fund managers who see immediate buying opportunities in the current economic environment.

Considerations:

What legal approvals are needed to extend? Many real estate fund documents give managers discretion to extend unilaterally the fund's remaining investment period for 6-12 months or even longer. Other fund documents require investor approval but allow that approval to be obtained through a relatively easy-to-implement, negative consent process.

In order to obtain investor approval, the manager may wish to build in certain investor benefits or protections for the extension period:

Reducing the management fee during the extension period or reduction of the carried interest for investments made during the extension period.
Waiving or reducing acquisition fees, disposition fees or other property-level compensation.
Tightening portfolio concentration or leverage limits for investments made during the extension period.
Requiring proceeds from all sales and refinancings of portfolio properties to be distributed to investors rather than recycled into new investments

Real estate managers should also check subscription credit facilities and other loan documents to confirm the extension does not require lender approval.

Will the extension impact service provider engagements? For instance, review the administration agreement with the fund's third party administrator to understand any differences in services or pricing that result due to extension of the investment period.

Is additional investor disclosure advisable? This disclosure information likely will focus on confirming the continued validity of the fund's existing investment strategy and providing detail on the manager's business continuity capabilities specific to the ongoing pandemic.

What other changes to the fund governing documents should be considered in connection with the investment period extension? Fund managers should review concentration, leverage and other portfolio limits, investor default remedies, ability to hold investor and advisory committee meetings over web apps (such as Zoom or Webex).

Option 2: Wind up the current fund's investment period early in order to launch a successor fund with fresh capital.

Manager outlook: Real estate fund managers with modest uncalled capital commitments left in their current fund.

Considerations:

Can the manager terminate the current fund's investment period early without investor approval?

If not, is there a negative consent process that allows investor approval to be obtained quickly and easily?
If there is a need to make follow-on investments in existing portfolio properties, consider whether these follow-on investment will be allocated exclusively to the current fund or if instead the successor fund will also be allowed to participate.
Will the successor fund in fact utilize an investment strategy that is different enough from that of the current fund that they can co-exist with overlapping investment periods?

Is the successor fund likely to be fully subscribed?

Does the manager have a favorable past performance track record that allows a successor fund to conduct a successful offering and close promptly?
Would registration as an investment adviser boost investor comfort in the manager's funds? The manager might also consider whether registration would offer needed flexibility to use more creative investment structures.
Should the manager consider a pledge fund or similar structure allowing the investor to retain some case-by-case discretion over individual portfolio property investments?

What financial and other terms should be evaluated in the process of forming the successor fund?

For instance, the manager might consider management fee or carried interest discounts for investors who commit early to the successor fund.
If the investment opportunities are not expected to present themselves right away, consider basing the management fee on called capital (rather than committed capital) and including options for the manager to extend both the investment period and term of the fund unilaterally.

How closely can the successor fund documents track those of the predecessor fund? Fewer changes generally means less legal negotiation with investors and quicker closings.

Can the manager obtain a subscription credit facility for the successor fund during the pandemic? This borrowing facility may be critical in managing cash flow, particularly as cash may be needed quickly for unique or distressed opportunities, and providing needed leverage for portfolio investments.

Can the manager obtain better pricing from service providers? Many private fund service providers are eager to have new engagements on which to work, and managers are already beginning to reevaluate their relationships with service providers.

Option 3: Continue to operate the current fund on a status quo basis.

Manager outlook: Real estate fund managers that see a pressing need to focus on the current fund's existing portfolio.

Considerations:

What are the fund's current and future cash needs? The manager will want to assess the current fund's ongoing cash needs and seek to improve cash flow:

Additional capital needs can be met by some combination of drawing on remaining uncalled investor capital, borrowing from a fund subscription facility, or using proceeds of portfolio property sales and refinancings.
The manager should review the fund subscription facility and portfolio property borrowings to seek to reduce interest expense and annual debt service and to improve other borrowing terms in the current lending environment. Given the unique circumstances of this period, commercial lenders are likely to be more willing to discuss accommodations.
The manager should review current fund portfolio concentration and leverage limits in light of adjustments in the value of portfolio properties—and seek waivers if needed.

Five years from now, real estate fund managers may look at the current environment as one of the best buying opportunities since the 2008 financial crisis. Selecting whether to extend the current fund or launch a successor fund in the current environment may be one of the critical decisions a real estate fund manager makes this decade.

Brian Farmer and Brian Daly are attorneys with Hirschler Law.

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