Using Feeder Vehicles to Keep Capital Raising on Track
By Frank Falbo, Partner at Mayer Brown At several NAREIM meetings, Mayer Brown has contributed valuable insight to managers on the changing legal statutes the real estate investment industry must abide. In this article, Frank Falbo of Mayer Brown considers some key facets of incorporating high net worth individuals into feeder vehicles for a fund. Continuing challenges in fund raising have led many real estate fund sponsors to turn to additional sources of capital including high net worth investors. However, many fund sponsors have concerns dealing with high net worth (‚ÄúHNW‚Äù) investors from both a practical and legal perspective. As HNW investors generally invest smaller amounts than institutional investors, a larger number of HNW investors are typically needed in order to meet fund raising goals. This creates a greater administrative burden on the fund sponsor from a reporting and investor relations standpoint. In addition, some fund sponsors believe that HNW investors are more likely to sue them if they are unhappy with performance. As an alternative to admitting HNW investors directly into a fund, fund sponsors have been increasingly turning to HNW feeder vehicles, especially those managed by third parties, as a means to access this pool of capital while protecting against the potential downsides. Feeder vehicles may provide some insulation for fund sponsors, but they are not bullet-proof and come with their own complications as well. Feeder vehicles generally are vehicles through which one or more investors make an investment in a particular fund. Feeder vehicles can be sponsored by the fund sponsor or sponsored by a third party (e.g., a banking entity forms a vehicle through which their HNW clients can invest). Feeder vehicles sponsored by the fund sponsor are in many cases formed for institutional investors that have particular tax concerns (e.g., foreign investors in non-tax treaty jurisdictions that seek to use a leveraged corporate blocker feeder structure to reduce U.S. federal income tax and minimize U.S. tax filing obligations). Although feeder vehicles sponsored by third parties may also be structured to achieve certain tax benefits, they are often formed to pool HNW capital and provide the added benefit of placing a barrier between those HNW investors and the fund. More specifically, the fund will treat the feeder vehicle as a single investor except in certain circumstances, such as when a HNW investor in the feeder vehicle defaults. As a result, the fund will only need to deliver reports and interface with a single party, usually the third party institution, instead of multiple HNW investors. This not only provides administrative simplicity, but many sponsors believe that the third party institutional manager will view fund matters in a similar manner to the other institutional investors in the fund, providing alignment among the investors that might not otherwise exist if the HNW investors had invested directly in the fund. However, a feeder vehicle managed by a third party sponsor presents risks not otherwise present in the offering of fund interests. The offering of interests in the feeder vehicle is being conducted by the third party sponsor and, therefore, is outside of the direct control of the fund sponsor. Although fund sponsors may take the view that the offering of interests in the feeder vehicle is separate from the offering of the underlying fund interests, the SEC might disagree. More specifically, the SEC may determine that, because the feeder vehicle was set up for the sole purpose of investing in a single fund, and the fund sponsor has consented to the structure, the fund sponsor should at least share responsibility for the offering of the feeder vehicle interests. If the SEC were to take this view, the fund sponsor may be forced to share responsibility for material misstatements or omissions in the offering materials of the feeder vehicle. The SEC‚Äôs determination may be influenced by factors such as the extent to which the fund sponsor is involved in the marketing of the feeder vehicle interests and/or in the preparation of the governing documents of the feeder vehicle. Moreover, to the extent that the feeder vehicle is targeting investors outside the U.S., the non-U.S. laws may impose obligations or liabilities on the fund sponsor. The offering of the feeder vehicle interests may also raise concerns from an anti-money laundering and anti-corruption perspective. In addition to these regulatory concerns, the feeder vehicle structure might not insulate the fund and the fund sponsor from direct claims brought by the investors in the feeder vehicle. Feeder vehicle investors may claim that a court should permit a direct right of action by the feeder vehicle investors against the underlying fund and fund sponsor. In order to memorialize the business understanding regarding the relationship between the feeder vehicle and the fund, and to provide protection against such risks, the fund sponsor should require contractual protections and appropriate disclosure. The fund sponsor and feeder vehicle investors should acknowledge the feeder vehicle as the sole investor in the fund so that there is no direct contact between the fund and the feeder vehicle investors. The fund sponsor should also require that the feeder vehicle investors contractually acknowledge (typically in the subscription agreement for interests in the feeder vehicle) that fund sponsor is not offering feeder vehicle interest, but this process is conducted by the feeder vehicle sponsor. In addition, feeder vehicle investors should waive all rights to bring claims against the fund, the fund sponsor, and their respective affiliates. Investors should also acknowledge that such fund parties do not owe any contractual, fiduciary or other duties to the feeder vehicle investors. Furthermore, the fund sponsor should require feeder vehicle investors to abide by the same confidentiality provisions applicable to direct investors and consider making the feeder vehicle and/or its sponsor liable for breaches of such obligations. The fund, the fund sponsor and their respective affiliates should be made express third party beneficiaries of these contractual acknowledgments, waivers and agreements. It is important to note that there is no certainty that these contractual acknowledgments, waivers and agreement of the feeder vehicle investors will be enforceable as a court and/or regulator may not view such provisions (particularly the waiver of rights) favorably. The fund sponsor should require that the feeder vehicle sponsor agree: (i)¬†¬†¬†¬†¬†¬†¬† to include these feeder vehicle investor acknowledgements, waivers and agreements into the feeder vehicle‚Äôs governing documents and/or each subscription agreement for feeder vehicle interests and provide appropriate disclosure of such matters in the offering materials for the feeder vehicle (ii)¬†¬†¬†¬†¬†¬† that the offering materials and statements made in connection with the feeder vehicle offering will not be inconsistent with, contradict or alter the underlying fund offering materials (iii)¬†¬†¬†¬†¬†to comply with all laws, regulations and other requirements (including applicable securities, anti-money laundering and anti-corruption laws) in connection with the offering of the feeder vehicle interests (iv)¬†¬†¬†¬† to provide for indemnity from the feeder vehicle sponsor (or a credit worthy affiliate) for breaches of its contractual obligations Some fund sponsors desire more direct rights relating to the offering process for the feeder vehicle interests. This increased control may provide additional protection against potential liabilities but may also increase the chance that the SEC or other regulators view the offering as being conducted by both the feeder vehicle sponsor and the fund sponsor. This risk may be mitigated somewhat by structuring the fund sponsor control rights as veto rights rather than affirmative approval rights so as to reflect the reality that the fund sponsor is seeking to mitigate risk rather than control the offering process. In many cases, the underlying fund and the feeder vehicle for HNW investors will each be treated as a partnership for U.S. federal income tax purposes. In that event, the tax issues of concern to individual HNW investors (including capital gain versus ordinary income character of income, application of passive activity and at-risk limitations, and limits on miscellaneous itemized deductions) will generally be the same as those of concern for HNW investors investing directly into the underlying fund. In the event the HNW feeder vehicle or the fund is not treated as a partnership, or if the feeder vehicle is targeting investors with particular tax sensitivities, such as non-U.S. investors or HNW investors investing through charitable trusts or private foundations, additional tax issues arise that may complicate the structuring of the fund and/or the feeder vehicle, particularly where the third party sponsor has not identified all of its investors prior to the feeder vehicle making a commitment to the fund. ¬†  It is important to note that because the feeder vehicle is formed for the purpose of investing in the underlying fund, the investors in the feeder vehicle will need to meet the same securities law qualifications imposed on direct investors in the fund.