Structuring a Real Estate Debt Fund

 Real estate lending funds are established to provide lending capital to real estate acquisitions, projects, and development efforts.  Prospective real estate lending fund managers often have to determine when it is appropriate to set up an open-end fund versus a closed-end fund.  Because real estate assets are typically illiquid, most real estate funds are established as closed-end funds.  However, real estate lending funds involve debt instruments, which can often create more liquidity and can often be valued more accurately than the underlying real estate. Managers and investors alike often prefer an open-end fund when possible, which allows investors to make ongoing investments and redemptions during the life of the fund, and which allows managers to continuously deploy capital into new loans as funds are raised.  However, not all real estate lending fund strategies are suitable for the open-end fund structure.

Exploring Open-End Structures

Open-end structures refer to real estate debt funds that do not have a defined term and allow for ongoing subscriptions and redemptions by investors.  This means that investors can enter or exit the fund at any time, subject to certain restrictions.  Open-end structures provide liquidity to investors, as they can easily buy or sell their interest in the fund.

In an open-end fund, investors make capital contributions that the fund sponsors can generally deploy immediately.  Open-end funds usually allow investors to make ongoing redemptions at predefined periods (monthly, for example), subject to limitations, so long as the redemption is feasible and would not interrupt fund operations.  To facilitate capital contributions and redemptions, the lending portfolio is valued, with the assistance of the fund's outside fund administrator.  

Open-end funds also allow the fund manager to continuously deploy capital into new loans as funds are raised.  However, the open-end structure can also present challenges, as the fund manager needs to manage investor inflows and outflows while maintaining an appropriate level of liquidity and diversification.

Analyzing Closed-End Structures

In contrast with an open-end fund, a closed-end fund provides a finite lifespan for the lending fund.  In a closed-end fund, capital is not immediately contributed to the fund.  Rather, investors make capital commitments, which the fund sponsors call as needed to deploy for specific investments.  Once investments have been made, investors typically cannot make ongoing redemptions.  Rather, investors are repaid when liquidity events occur, and as distributions are made within the fund's distribution waterfall.

Importantly, closed-end funds do not require ongoing valuation of the portfolio.  Rather, the fund relies upon the distribution waterfall to return capital as the fund receives income from interest payments, principal payments,  or third-party sale of the notes.  For lending funds that have uncertainty regarding the valuation of their assets, a closed-end fund would be preferable.  Likewise, funds that do not have a sufficient expectation of ongoing liquidity, or funds with too much concentration in large loans should consider a closed-end structure 

The Two Key Factors: Valuation and Liquidity

The two main considerations for determining whether to launch an open-end real estate lending fund versus a closed-end fund are: (i) valuation precision; (i) portfolio liquidity

Valuation

Open-end funds rely on the ability to precisely value assets on an ongoing basis to facilitate ongoing capital contributions and redemptions. When any additional capital is contributed to the fund, and upon each redemption from the fund, the net asset value of the fund must be calculated to preserve accuracy of the capital accounts of the respective investors.  Secured real estate lending instruments tend to be able to be valued more precisely, even when the underlying real estate asset is not. 

Liquidity

To facilitate an open-end structure, the real estate lending fund must maintain sufficient liquidity to be able to satisfy ongoing redemption requests.  In an open-end fund environment, investors make periodic redemption requests, usually at pre-defined periods (monthly, quarterly, etc.).  Investors are required to give advanced notice (usually from 30 to 90 days) prior to a redemption date.  To limit the total capital that can leave the fund during any redemption period, most funds implement a redemption gate, which restricts redemptions to a certain threshold (for example, 20% of total net asset value of the fund within a given quarter).

Open-end lending funds must be sufficiently diversified and have staggered maturity dates (or note sale) to be able to meet ongoing redemption requests.  Lending funds with strong deal flow with moderate size loans and shorter maturity dates are usually a good fit for an open-end fund structure, while those with concentrated portfolios with longer maturity dates may lack the liquidity needed for an open-end fund.

Conclusion

Most private equity real estate funds, which invest in illiquid real estate as the underlying asset tend to require closed-end structures. On the other hand,  real estate lending funds, which hold note portfolios secured by real estate, often have the needed liquidity and are capable of sufficiently precise valuation precision to facilitate an open-end fund structure.