How to Effectively Wind Down a Real Estate Investment Fund

Closed-ended, real estate private equity funds (“RE Funds”) are generally created with a limited life, with the expectation that all contributed capital, hopefully along with excess amounts, will be returned to investors.  Fund managers are experts at raising and investing capital. From Q3 2017 to Q3 2019, 285 real estate investment funds raised more than $250 billion^[1]. With this level of activity, the fund manager’s primary focus is to deploy this capital, invest wisely, and nurture and harvest its investments.

The wind-down or termination process is often not a primary focus in the overall management of a fund. This process often ends up as an afterthought to be dealt with years down the road. While there is no set playbook for fund wind-down or termination, developing a preliminary plan outlining the steps necessary to have an orderly wind down as early as possible in the RE Fund’s life cycle benefits the fund manager.

Significant issues may arise if an orderly plan is not implemented. Straggling investments will need to be liquidated in an orderly fashion to avoid a fire-sale situation that may reduce overall returns. Sufficient cash must be retained at the RE Fund to meet the remaining operating and dissolution costs. Failure to do so may require a clawback of distributions from investors or for the fund manager to absorb the cost—neither of which are preferred. Keeping investors informed at the end of the RE Fund life is also crucial to maintaining relationships and confidence as the manager gears up for the next fund. Lack of preparation shows disorganization and may leave investors less confident in the fund manager’s abilities.

Consider the following items when creating a wind-down plan:

Notify Investors

Fund managers should properly inform investors that the RE Fund has entered the wind-down phase and detail its termination plan. Plan details may include (1) the timeline to realize remaining investments; (2) projected future distributions; and (3) estimated dissolution costs.

Notify Vendors

Plan termination will require help from service providers such as lawyers, accountants, fund administrators, registered agents, and so forth. Inform these service providers that the RE Fund is winding down so they have sufficient time to perform their services. Lawyers may need to draft extension agreements or review the existing governing documents for any contingencies, accountants should project taxes and estimate future expenses, and registered agents may have to inventory existing entities for dissolution and estimate of costs.

Estimate Operating Expenses and Dissolution Costs

Estimate the RE Fund’s operating costs for the period until final termination and costs of dissolution. This will help to determine the amounts to hold back from distributions to meet the fund’s future cash flow needs. Failure to do so may lead to the fund manager having to pay costs (e.g.; management, legal, accounting and dissolution) out of pocket.

Realize Remaining Investments

An RE Fund may hold several investments at its term end. This may be because the asset is not in a salable condition (development deal in process), market conditions for that location or asset class have deteriorated, or management believes additional value can still be extracted. Regardless, revisit underwriting assumptions, project a realistic timeline for divestment, and consider alternatives if a sale is not viable:

• Extend the Fund – Most governing documents include options to extend the life of the RE Fund. Extensions can also be obtained with investor consent. An extension gives the fund manager more time to realize the original investment thesis or find investment alternatives.
• Liquidating Trusts/Escrow Account – Transfer the remaining portfolio to a liquidating trust or escrow account in which the investors can appoint a trustee to manage the investment.
• Make In-Kind Distributions – Transfer the remaining portfolio to a subsidiary investment entity of the RE Fund, which will then distribute the equity interests to investors.

Identify Contingent Liabilities

Fund liabilities and expenses will be incurred as part of termination and should be settled prior to dissolution. Consider any contingent liabilities during the divestment and dissolution phases. Such liabilities may relate to tax positions, title issues, environmental issues, or some other. Consult your legal counsel and tax advisors about creating title insurance and environmental indemnity or reserve funds to account for these liabilities.

File and Report

Audited financial statements, final tax returns and Schedule K-1s, state agency filings, and other filings or reports may be needed during termination, including:

• Final Audited U.S. GAAP Financial Statements – For RE Funds managed by an SEC-registered adviser, liquidating financial statements are required in the final year of operation under the custody rule. They must be prepared in accordance with U.S. GAAP and consider whether it is necessary to convert from a going concern basis of accounting to the liquidation basis of accounting. Because RE Funds typically have a limited life that specify a liquidation plan, they are often exempt from the liquidation basis of accounting.
• Tax Compliance – Prepare and file final federal and state tax returns and Schedule K-1s for the last year of operation and investor distribution. Tax return extensions can be filed to extend the tax return due date  by six months.
• State Compliance – Dissolve the RE Fund and its special purpose entities in the state in which they were formed, and cancel its registration in states where it’s registered to do business. For example, an entity formed in Delaware but doing business in California must file a Certificate of Cancellation of an LLC with Delaware and Certificate of Cancellation (Form LLC-4/7) with California. All applicable cancellation fees and annual filing fees must be paid upon dissolution and cancellation.
• Regulatory – Fund managers that are RIAs may be required to file with the SEC due to changes in AUM from the liquidating fund. These include Form ADV, Form PF, and Section 13 filings. Consult your legal counsel.
• Bank Account Closure – Close bank accounts that will no longer be used.

Distribute Remaining Cash

RE Fund distributions are outlined in the governing documents and typically include the return of capital with a preferred return to the investors. Excess distributable proceeds are normally allocated between investors and the fund manager in accordance with the RE Fund’s waterfall model. Give special care to the final distributions to ensure that both adequate reserves are available to cover existing liabilities, such as payables to vendors, and verify carried interest per the waterfall is accurate to prevent excess distributions to the fund manager. Taking a more conservative approach to distributions in the last year of operation gives the fund manager flexibility in case of unexpected expenses.  

The wind down of a fund is no simple undertaking and requires the skillful input from several sources. The fund manager should develop a plan, consider the aforementioned issues, and coordinate with services providers so that the wind-down process runs smoothly.  

[1] https://irei.com/wp-content/uploads/2019/10/TrendWatch_102219.pdf