Using a Fund of Funds for Investing in Apartment Complexes
By Christopher Levarek
“Never Depend on a Single Income. Make Investment to Create a Second Source.”
- Warren Buffet
When investing into real estate with larger transactions or assets, there comes the need to partner on the management. The larger the deal, the more partners or people need to be involved to ensure the success of the management plan and the overall deal necessities are met.
As this occurs, legal entities are created to facilitate the deal from both a finance and legal perspective. One such entity which holds great value but is commonly misunderstood is the “fund of funds”.
What is a Fund of Funds?
Source : Raising Capital for Real Estate by Hunter Thompson
At it’s base, a fund of funds is a LLC or what’s called a “special purpose vehicle”, SPV. It simply means that it is an entity created for a specific function. Similar to an LLC created for ownership in a real estate property, the “fund of funds” llc too fulfills a needed role. It acts as the entity to which investments are made and then through the entity are invested into a larger deal or sponsor acquisition.
So for example, a sponsor or managing partner creates LLC “Fund 1”. The sponsor or managing partner then raises capital for either a singular specific property deal or for multiple deals or asset classes.
Once the investor capital or investments are made under the LLC “Fund 1” to reach a certain ceiling(max value of raise), the sponsor or managing partner then invests as a single entity, LLC “Fund 1” into a vetted partner real estate acquisition which will fulfill returns and criteria as established with the Fund investors.
In essence, it simply adds a entity, the fund, between the main deal and the investors. This entity then accepts investments to invest into the larger deal through the entity.
Why a Fund of Funds?
So why would any sponsor or investor want to be involved with a fund of funds?
Let’s start with the sponsor or managing partner of the investment.
Sponsor
Typically, a sponsor or managing partner has two fundamental reasons to start a fund of funds.
Reason # 1 : Negotiation or Control of Compensation :
The sponsor or managing partner does not want to or can not be included as a General Partner in the sponsor deal. Due to this, they need to ensure they also receive compensation for their efforts.
By creating a fund of funds, the sponsor can ensure that they have negotiating power for their own compensation by including into the fund of funds paperwork or negotiating with the sponsor of the overarching deal.
Reason # 2 : Quality Control
The sponsor or managing partner cares about their network and investor base and wishes to keep control of certain elements of the deal. By controlling the entity investing, the sponsor can ensure all the elements of distributions, investor communications and deal fundamentals are met according to their criteria. This gives control to the sponsor and ensure their investor base are taken care of rather than simply passed on to the larger deal.
Investor
Ok, so now why would an investor want to be in a Fund of Funds?
Reason # 1 : Access to the Deal
Typically, the investor has a relationship with the sponsor and has found this investment through the sponsor. This simply means that without that relationship, the deal would not be present. The investor could go around and invest in the larger deal however, the lack of relationship and familiarity with the main deal sponsors can present some issues.
Reason # 2 : Diversification
Fund of funds can be structured to participate in multiple overarching deals. Similar to a REIT, real estate investment trust, these funds can invest in multiple assets of similar or varying class thus diversifying risk for investors in the fund. It is worth mentioning, this is not always the case and these terms must be specified in the PPM or paperwork of the fund and approved by the investor upon signing of the documents.
Reason # 3 : Favorable Terms
As the fund of funds is investing into a larger deal and bringing a substantial amount more then any single investor, the fund could have more favorable terms as negotiated by the sponsor. Rather than a typical investor return which would align with the overarching deal, the entity could be getting +1%, +2%, etc for simply bringing more equity to the table. This could then be passed onto investors in the fund.
In Final
A fund of funds can be a very useful and beneficial entity for investors and sponsor alike. The above are only some of the common reasons for using such an entity. There can be complexities and additional pros/cons with using a Fund of Funds, so we always recommend consulting a securities attorney or working with the sponsor to ensure the terms are understood. As always, Invest Smart!