Luxury Simplified Guide to Terms used in Private Equity Funds for Real Estate Investment
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Transcript of Luxury Simplified Guide to Terms used in Private Equity Funds for Real Estate Investment
Synopsis This document provides a brief overview of the terms commonly used in Private Equity funds used for Real Estate Investment. Potential Investors are encouraged to also read around the subject and seek third party advice to improve their familiarity with the subject. Descriptions have been kept general in nature and do not specifically focus on any individual Private Placement Memorandum from our group of other entities.
L u x u r y S i m p l i f i e d , 9 5 B r o a d S t , C h a r l e s t o n , S C , 2 9 4 0 1
Guide to Terms used in Private Equity Funds for Real Estate Investment
Guide to Private Equity Terms 2
Disclaimer
This Guide has been prepared by LS Group (“LSG”) for the exclusive use of recipient (together with its subsidiaries and affiliates, the “Recipient”) using publicly available information. LSG has not independently verified the information contained herein, nor does LSG make any
representation or warranty, either express or implied, as to the accuracy, completeness or reliability of the information contained in this presentation. Any estimates or projections as to events that may occur in the future are based upon the best judgment of LSG from publicly
available information as of the date of this presentation. Nothing contained herein is, or shall be relied upon as, a promise or representation as to the past or future. LSG expressly disclaims any and all liability relating or resulting from the use of this presentation.
This presentation has been prepared solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. All securities are offered through LSG partner, Turnstone Securities LLC, member FINRA | SIPC. The
Recipient should not construe the contents of this presentation as legal, tax, accounting or investment advice or a recommendation. The Recipient should consult its own counsel, tax and financial advisors as to legal and related matters concerning any transaction described herein. This presentation does not purport to be all-‐inclusive or to contain all of the information, which the Recipient may require. No
investment, divestment or other financial decisions or actions should be based solely on the information in this presentation.
This Guide has been prepared on a confidential basis solely for the use and benefit of the Recipient. Distribution of this presentation to any person other than the Recipient and those persons retained to advise the Recipient is unauthorized. This material must not be copied,
reproduced, distributed or passed to others at any time without the prior written consent of LSG.
Guide to Private Equity Terms 3
Accredited Investor A term used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by certain government filings. Accredited investors include individuals, banks, insurance companies, employee benefit plans, and trusts.
In order for an individual to qualify as an accredited investor, he or she must accomplish at least one of the following:
• Earn an individual income of more than $200,000 per year, or a joint income of $300,000, in each of the last two yearsand expect to reasonably maintain the same level of income.
• Have a net worth exceeding $1 million, either individually or jointly with his or her spouse.• Be a general partner, executive officer, director or a related combination thereof for the issuer of a security being
offered.• An employee benefit plan or a trust can be qualified as accredited investors is total assets are in excess of $5 million.
In a General Solicitation offering (e.g., Reg. D (506) ) , additional information will be required to confirm the Investor’s accredited status.
Base Management Fee A Base Management Fee is charged to the fund and paid by investors. This fee should be designed to cover the day-‐to-‐day costs of investing in, managing and perhaps ultimately selling real estate. There are a variety of ways that this fee is structured. In some cases, there is a straight fee, say 1 to 2% on commitments to the fund. After the end of the investment period, the fee would normally be based on Net Asset Value (NAV) . The investment period is the period in which the fund is acquiring real estate assets and typically would be in the three-‐ to four-‐ year range. Gross Asset Value (GAV) is sometimes also used as a basis of calculation though NAV more often produces stronger alignment between Investor and Sponsor.
Carried Interest Carried interest is also known as “Carry”, “Promote” or “Performance Fee”. Put simply, carried interest is the profit that accrues to the fund Sponsor. It is normal practice for a non-‐core strategy fund to have a preferred return or hurdle rate over and above which the carried-‐ interest calculation would kick in, hence the term ‘distribution waterfall’. The waterfall gives an increased return to the Sponsor as performance targets are reached, quite often this is a tiered approach, say achieving a IRR tiers of 7.5 and 15% improves the promote from 25 to 40%.
Casht on Cash Return A Cash-‐on-‐Cash Return (“CoC”) is the expected annual cash return on the Investor’s investment, without compounding. Stabilized investments typically project a CoC of 7% to 12%.
Claw-‐Back Clause When liquidating an investment fund, if the Investors were distributed less than the agreed Preferred Return, they “claw-‐back” the missing amount from the carried interest distributed to the fund manager. The claw-‐back clause is triggered at the very end of the fund.
Due Diligence An investigation or audit conducted by a registered broker-‐dealer of a potential investment it will be offering accredited investors. Due diligence serves to confirm all material facts in regards to an investment offering and generally refers to the care a reasonable person should take before entering into an agreement or a transaction with another party.
Electronic Funding Portal An Electronic Funding Portal (“Funding Portal”) is a web-‐based marketplace that offers investment participations to accredited investors. It also provides secure on-‐line access to confidential information (e.g., Private Placement Memorandums, Financial Projections, Offering Documents, Videos, etc.) pertaining to the relevant investment opportunity. Some more sophisticated Funding Portals offer an online fulfillment process (e.g., money transfer, escrow accounts, electronic signatures, investor accounts and reports, etc.) .
Guide to Private Equity Terms 4
Financial Industry Regulatory Authority (“FINRA”) A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange’s regulation committee. The Financial Industry Regulatory Authority (“FINRA”) is responsible for governing business between brokers, dealers and the investing public.
Fund Fees - Other Sponsor and Fund Fees The chart below sets forth the most commonly agreed-‐upon types of additional Sponsor and Fund fees, representative ranges, and the frequency of which those fees are charged:
Fund Performance Metrics The Sponsor would most commonly cite the return potential of its Fund (or targeted projects tor investment) in terms of Cash-‐on-‐Cash Return (“CoC”) , or Internal Rate of Return (“IRR”) .
Fee Type Range Frequency
Acquisition 1.0% to 3.0% of purchase price of real estate. One-‐time
Finance 0.5% to 1.5% of indebtedness. One-‐time
Loan Guaranty 0.5% to 2.0% of guaranteed indebtedness. Annual
Property Management 3.0% to 5.0% of gross collected rents. Recurring
Asset Management 1.0% to 2.0% of gross collected rents, where the Sponsor does not provide property management services.
Recurring
Leasing “Market” based on type of real estate and locale. Paid based on leasing activity
Construction Management 1.0% to 3.0% of total cost of improvements. Paid based on construction activity
Disposition 1.0% to 3.0% of sale price of property, although sometimes this is couched as a brokerage fee, in which case the Sponsor may charge a customary brokerage commission, usually 6.0%, unless a cooperating broker is involved in which case the commission is typically split.
One-‐time
Fund Organization $50,000 (est.) relating to initial legal, tax and accounting expenses to the formation of the Fund One-‐time
Placement Agent 7.0% of the gross proceeds raised. One-‐time
Escrow 0.45% on the amount of a single distribution with a minimum fee of $600 and a maximum 6-‐ month fee of $3,000. An administrative fee of $150 for each additional escrow distribution that occurs after the first distribution within the first 6-‐month period.
Paid based on drawdown activity
Transaction Monitoring 1.0% of total gross assets under management. Payable to the Transaction Service Administrator, a fiduciary serving on behalf of the Investors in monitoring activities of the Fund and Sponsor.
Annual recurring
Equity Distribution
(Preferred Dividends, Equity Repayment, Profit Distributions)
0.65% per distribution amount. Minimum fee of $150 per distribution and a maximum annual fee of $600.
Paid based on distribution activity
Guide to Private Equity Terms 5
General Solicitation Offerings On July 10th, 2013, the SEC issued new final regulations allowing public advertising and solicitation of Regulation D offers to accredited investors. This exemption is also referred to as a “506©” offering.
Internal Rate of Return An Internal Rate of Return (“IRR”) is the rate that makes the present value of contributions made by the Investor equal to the present value of distributions received by the Investor. An IRR is a valuable metric because it takes into account all cash flows and the time value of money thereby providing the Investor a benchmark by which it can evaluate competing investments. IRRs typically fall within the 12% to 17% range.
Management Fee A fixed quarterly fee, based on a percentage of the Fund’s assets under management, to cover the Sponsor’s costs of operating the Fund. Example of Fund costs would be: 1) making the opportunity available to the Investors, 2) staff salaries and 3) ongoing legal, accounting, audit, tax matters and other administrative expenses. We would contemplate a minimum fixed annual fee of 2.0%.
Minimum Investment Unit A Minimum Investment Unit (“MIU”) is the smallest dollar amount an investor can make on any one transaction. The MIU is determined by the Issuer and Placement Agent as a function of the overall size of the transaction and the targeted number of investors allowed in the offering.
Organization and Set-Up Costs This is one of the more straightforward fees. This is where the costs of setting up and structuring the fund are expensed to the fund and ultimately paid by the investors. The organizational costs should not recompense the fund sponsor for the general overhead of set-‐up costs associated with running the firm. It is normal to have a cap amount stated in the legal documentation, which can vary considerably depending on the complexities associated with the target investor base and the target countries for investment.
Preferred Return Investors typically receive a “Preferred Return,” calculated on the total amount of their capital contribution while held by the Fund. In today’s market, this return can range from 7% to 10% depending on a multitude of factors (e.g., nature of contemplated investments; Sponsor’s size, financial strength and track record, etc.) . The Preferred Return is not a guaranteed dividend, and typically accrues until such time as cash distributions are available. The basic premise is that the Investors should receive a minimum return on their capital and the return of their original capital prior to the Sponsor receiving a share of the profits. In other words, the Sponsor is typically playing for the “back-‐end” pay-‐off in the profit distribution for their professional skill in selecting and managing the Fund.
Preferred Return “Catch-up” Once the Preferred Return and original investment is returned to the Investors, the Sponsor typically will receive a profit allocation equal to a portion of the total Preferred Return allocated to the Investors (usually in the same percentage as the Waterfall) . The purpose of including a Preferred Return “Catch-‐up” is to allow the Sponsor to have some participation in the Fund’s profits (so long as the Preferred Return has been allocated to the Investors) . This feature ensures that the profits resulting from a successful Fund are allocated per the agreed upon Waterfall, and conversely, the profits from a marginally successful Fund will be primarily allocated to Investors rather than the Sponsor.
Profit Distributions (The “Waterfall”) In private equity investing, distribution waterfall is a method by which the capital gained by the fund is allocated between the Investors and the fund manager. In a real estate investment fund, the fund manager manages the committed capital of the
Guide to Private Equity Terms 6
Investors. When distributing the capital back to the Investor, the fund manager will allocate a percentage amount based on a previously agreed Waterfall structure (the “Waterfall”).
A waterfall structure can be pictured as a set of buckets or phases. Each bucket contains its own allocation method. When the bucket is full, the capital flows into the next bucket. The first buckets are usually entirely allocated to the Investors, while buckets further away from the source are more advantageous to the fund manager. This structure is designed to encourage the fund manger to maximize the return of the fund.
A standard distribution waterfall is defined by difference phases: Recovery, Preferred Return and a Promote.
• Recovery Phase: As long as the capital raised hasn’t been fully returned to the Investor, the whole distributed amountis allocated to the Investors.
• Preferred Return Phase: The Preferred Return is typically a fixed hurdle rate (typically 7% to 10%). The PreferredReturn is an IRR that needs to be reached by the Investors before the fund manager gets some return on its investedcapital.
• Promote Phase: Above the Preferred Rate phase, every proceeds will be distributed based on the Promote or carriedinterest (typically 20% to 40%). This means that the fund manager will receive 20% to 40% of the distributed amount,while the Investors will share the remaining 80% to 60%.
Most Waterfalls are calculated on a deal-‐by-‐deal basis that calculates IRR hurdle thresholds for each deal. At the end of the fund, a Claw-‐back provision may be activated if the final IRR calculated at the fund level is below what has been paid to the fund manager (e.g., the fund manager paysu back a portion of its promote distribution at the end of the life of the fund) .
Real Estate Investment Fund A special purpose entity (a Limited Partnership or Limited Liability Corporation) established for making equity investments in one or several property investments. The entity is managed by a General Partner or Managing Member (aka as a “Sponsor”) . Sponsors can be financial advisors (portfolio manager) or real estate developers (developers) . The role of the Sponsor is to select, develop and managed qualified real estate investments.
Registered Broker - Dealer A person or firm in the business of buying and selling securities, operating as both a broker and a dealer, depending on the transaction. The term broker-‐dealer is used in U.S. securities regulation parlance to describe stock brokerages, because most of them act as both agents and principals. A brokerage acts as a broker (or agent) when it executes orders on behalf of clients, whereas it acts as a dealer (or principal) when it trades for its own account. For example, Turnstone Securities, LLC (“TS”) is a SEC registered broker-‐dealer (investment bank) which provides placement agent services to middle market companies raising capital via Reg. D private placement offerings.
For LS Group, our partner company providing the service of Registered Broker-‐Dealer is Turnstone Securities LLC, member FINRA | SIPC.
Investment Advisory Representative (“IAR”) Personnel that work for investment advisory companies whose main responsibility is to provide investment related advice. According to regulations, IARs can only provide advice on topics on which they have passed the appropriate examinations.
Registered Investment Advisor (“RIA”) An advisor or firm engaged in the investment advisory business and registered either with the Securities and Exchange Commission (SEC) or state securities authorities. A Registered Investment Advisor is defined by The Investment Advisers Act of 1940 as a “person or firm that, for compensation, is engaged in the act of providing advice, making recommendations, issuing reports or furnishing analyses on securities, either directly or through publications.” An investment advisor has a fiduciary duty to his or her clients, which means that he or she has a fundamental obligation to provide suitable investment advice and always act in the clients’ best interests. For example, TS Advisors, LLC (“TSA”) is a California RIA providing transaction monitoring and oversight services.
Guide to Private Equity Terms 7
Regulation D Offerings In the United States under the Securities Act of 1933, any offer to sell securities must either be registered with the United States Securities and Exchange Commission (SEC) or meet certain qualifications to exempt them from such registration. Regulation D (“Reg. D”) contains the rules providing exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the securities with the SEC. A Reg. D offering is intended to make access to the capital markets possible for small companies that could not otherwise bear the costs of a normal SEC registration.
Securities and Exchange Commission (SEC) The U.S. Securities and Exchange Commission (“SEC”) is an agency of the United States federal government. It holds primary responsibility for enforcing the federal securities laws, proposing securities rules, and regulating the securities industry, the nation’s stock and options exchanges, and other activities and organizations, including the electronic securities markets in the United States.
Securities Crowdfunding Securities Crowdfunding is a way to raise capital for a business by accepting investments of typically lower minimum investment amounts from a larger number of investors. In other words, a “crowd” of investors helps to fund the business. Securities Crowdfunding often targets “accredited investors” via web-‐based funding portals issued as “Reg. D” Private Placements. Securities Crowdfunding can also be done via “Direct Public Offerings” via Reg D 504 (up to $1 million raise) Intrastate offerings (states vary in terms of limits or no limits) , or via Regulation A (up to $20 million or $50 million) . There are also individual state securities crowdfunding laws now in place, that typically allow issuers to raise up to $1 million via state-‐approved securities crowdfunding platforms.
Sponsor Commitment Strong alignment comes from those Funds where the fund sponsor has committed capital to the fund. Small start-‐up firms will normally have less personal capital to commit to their funds. Larger established firms may have eye-‐catching amounts of capital committed to their own funds. In each case, investors can make their own judgments, which should often be made alongside how the carried interest is allocated to the team and the vesting schedules associated with any payments.
Subscription Agreement An application by an Accredited Investor to purchase securities in a transaction offering. In most cases, the investor will also provide information in order to determine the Accredited Investor’s suitability for its investment.
Transaction Service Administrator The Transaction Service Administrator (“TSA”) is a dedicated independent RIA which monitoring and oversight services to the outside investor group for any one transaction. In its fiduciary capacity, the RIA would provide independent transaction monitoring services and oversight would include but not be limited to the following:
• Understand the transaction post-‐closing from the offering documents and discussion with TS and Issuer;• Review quarterly compliance material (financial statements and management’s discussion and analysis, and
operating budgets) delivered via the TFP;• Monitor construction draws and authorize period distributions from escrow (Real Estate/Project Finance
transactions);• Determine the on-‐going status of the transaction (stable, improving, deteriorating);• Determine a plan of action to address deteriorating situations;• Communicate with investors (via the TFP or directly) as needed (no less than annually) independent assessment
relating to the progress of the transaction;• Hand-‐off management of the transaction to legal counsel and formed investor committee in a default or severe
stress situations.
Guide to Private Equity Terms 8
Transaction Fees Funds often charge a transaction fee – whether on acquisition or disposition of real estate assets. It is normal to assume that the costs of running the portfolio including buying and selling assets are part of the base management fee outlined above with no additional charge from the fund unless they are also acting as Broker.
Total Expense Ratio (TER) The TER is sometimes called the ‘total fee load’. We have written this in BOLD as its an important metric and one worth further explanation. The real rewards for the Sponsor happen after all funds have been returned to the investor including also any IRR performance metric promised in the Memorandum.
In a well operated structure, Fees are not to be considered profit but are for management and growth of the fund. On that basis, looking to the TER is an appropriate way to rapidly understand the underlying fund performance over the investment cycle. For most funds, a simple comparison of the gross-‐of-‐fee return (including leverage) to the net-‐of-‐fee return (including leverage) would provide an indication of the total fees that would be paid to the fund sponsor.
TER can be historic or forward-‐ looking based on cash-‐flow projections with a number of specific assumptions on when the profits are made. Either way, it is preferable to analyze the impact of the total fee load under a range of possible returns. For example, an opportunity fund that hits its target return of 20 percent gross IRR might have a net IRR of 15 percent (that is, a total fee load of 5 percent) . However, if a return of 18 percent is met, then the fee load might still be close to 5 percent. Then, at a gross IRR of 15 percent, the fee load is 4 percent. Catch-‐up provisions can skew the fee load considerably, in addition to the overall preferred return and base management fee.
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