Concerns over the net worth and liquidity of private equity funds are increasingly causing disputes and delays in commercial real estate transactions, Schulte, Roth & Zabel’s Jeffrey Lenobel told Mortgage Observer.
“I represent a lot of private equity and disputes and extensive negotiations happen on virtually every deal where a guarantee from a private equity fund is involved,” said Mr. Lenobel, head of the of the New York-based law firm’s real estate group.
The Lawyers’ Issue
With private equity investors now playing such a pivotal role in commercial real estate deals, those investors are now asked to sign guarantees ranging from non-recourse carve-out guarantees to environmental indemnity agreements to completion guarantees in construction deals. A leading cause of friction is unmanaged expectations, wherein lenders expect a consistent and concrete proof of income and liquidity, according to Mr. Lenobel.
“The first and threshold issue is that just because a private equity firm has a series of funds doesn’t mean that fund II can guarantee the obligations of fund I,” he said. “These funds, for the purposes of guarantees, are separate entities and I don’t think the investors in one fund would have any interest in guaranteeing the real estate held by investors in a different fund,” he added.
The concerns are multilayered. During the investment period of a given fund, there is little if any liquidity, Mr. Lenobel said. Instead, the value of that fund comes from uncalled capital commitments made by various investors and is, essentially, theoretical.
“At the point, if a lender says, ‘O.K. private equity fund, you need to guarantee the obligations, what’s your net worth?’, you are going to look at the fund’s financial statement during this investment period and see that it virtually has no assets and virtually no equity,” he explained. In those situations, disputes often arise between lenders and private equity investors over whether uncalled capital commitments count as assets.
After the investment period, when all of the capital has been called and a private equity fund owns several assets, a different issue arises. Since the average lifespan of a private equity fund is relatively short compared to most real estate companies, REITs and pension funds—in many cases between seven and 10 years after the investment period—the sale of a private equity fund’s assets may raise new concerns about its net worth. As a fund sells off its assets, the liquidity and net worth tests often imposed by lenders can yield unsatisfying results, making it more difficult for that fund to prove its solvency.
“Everybody has to look at the timing of the tests imposed by lenders on private equity funds,” the real estate attorney said. “This will avoid unexpected problems.”
In order to comply with customary net worth and liquidity covenants, private equity funds can mitigate guarantee concerns by holding onto a percentage of their assets to establish reserves and also by establishing third party lines of credit, among other measures, he said.
In most cases, lenders just need to manage their expectations, he added.
“Lenders are starting to understand how funds work and that is paramount to these issues, since private equity funds are among thebiggest players in the real estate industry today,” Mr. Lenobel told MO.