Conflicts of Interest in Private Real Estate Funds

Nick Wright, BA, JD, MBA, LLM (Tax)
Wright Business Law

Conflicts of interest are common in private real estate funds. A sponsor may establish the fund, control its general partner, provide management services, source investment opportunities and own other businesses that provide development, property management, construction or financing services to the fund. The same sponsor may also manage other funds competing for similar assets.

These relationships are not inherently improper. In many real estate funds, vertical integration is an important part of the business model. The legal issue is whether conflicts are properly identified, authorized, disclosed and managed in accordance with the fund documents and applicable securities laws.

Related-party transactions require particular attention. Where a private issuer raises capital under the offering memorandum exemption and is engaged in “real estate activities,” National Instrument 45-106 Prospectus Exemptions (NI 45-106) imposes additional requirements, including supplemental disclosure under Form 45-106F2 and, in specified circumstances, an independent appraisal.

This article examines common conflicts in Ontario private real estate funds, how those conflicts should be addressed in the fund documents and offering materials, and when additional securities law requirements apply.

Common Conflicts in Private Real Estate Funds

A typical real estate fund involves several related entities. An Ontario limited partnership may hold the investments, a corporate general partner may control the partnership, and an affiliated management company may manage the portfolio. Other sponsor-controlled entities may provide development, construction, property management or financing services.

Conflicts can arise when:

• the fund acquires real property from the sponsor or an affiliate;
• the fund sells property to a related party;
• affiliates provide property management, development, construction or other services;
• the sponsor or its affiliates receive acquisition, disposition, financing or other transaction-based fees;
• the sponsor invests alongside the fund;
• two or more sponsor-managed funds compete for the same investment opportunity;
• the sponsor provides or arranges financing involving related parties; or
• the manager participates in determining asset values that affect its compensation.

The appropriate response depends on the nature and materiality of the conflict. Some conflicts can be addressed through advance disclosure and contractual authorization. Others warrant independent valuation, investor or advisory committee approval, or restrictions on the transaction itself.

Related-Party Real Estate Transactions

An acquisition from a sponsor or affiliate presents a direct conflict because the sponsor may effectively participate on both sides of the transaction. The fund wants to acquire the property on favourable terms, while the related seller has an economic interest in maximizing the sale price and obtaining favourable transaction terms.

The limited partnership agreement or other governing document should therefore address whether related-party transactions are permitted and the conditions under which they may occur. Depending on the structure, those conditions may include an independent appraisal, approval by an advisory committee or disinterested investors, specified valuation procedures, or a determination by the general partner that the transaction is fair and in the interests of the fund.

The offering memorandum or private placement memorandum should also clearly disclose anticipated related-party transactions. If the sponsor expects the fund to acquire seed properties from the sponsor group, that arrangement should generally be described specifically rather than left to generic conflict-of-interest disclosure.

Documentation is also important. The general partner or manager should be able to demonstrate how the transaction was evaluated, how the price was established, what alternatives were considered and how the applicable conflict procedures were followed.

Contractual authority under the limited partnership agreement does not necessarily resolve the securities law analysis. A transaction may be authorized by the fund documents while remaining subject to specific disclosure, appraisal, registrant or other regulatory requirements.

Special Rules for Offering Memorandum Real Estate Raises

Additional requirements apply where an issuer relying on the offering memorandum exemption is engaged in “real estate activities.”

Under section 6.4(4) of NI 45-106, an issuer engaged in real estate activities must supplement its offering memorandum with Schedule 1 to Form 45-106F2, unless the offering memorandum is prepared under the qualifying issuer provision.

Schedule 1 requires additional disclosure tailored to real estate issuers. Depending on the issuer and its activities, the disclosure addresses matters such as the issuer’s real property, proposed acquisitions, development activities, property operating information and specified historical transactions involving related parties.

The rules are particularly important where an issuer has acquired or proposes to acquire an interest in real property from a related party.

NI 45-106 contains separate independent appraisal requirements for issuers engaged in real estate activities in prescribed circumstances. Where those requirements apply, the appraisal must be prepared by a qualified appraiser who is independent of the issuer and satisfy the requirements of the Instrument. NI 45-106 also addresses the use of representations or opinions concerning the value of the relevant real property and requires filing of an appraisal that is required to be delivered to purchasers.

The distinction between independent governance and independent valuation is important. Form 45-106F2 does not generally require a private real estate issuer to establish an independent advisory committee merely because conflicts exist. A particular real estate transaction may nevertheless trigger a mandatory independent appraisal under NI 45-106.

Sponsors conducting an OM raise should therefore identify related-party real estate transactions early in the offering process. Waiting until immediately before closing to determine whether an appraisal is required can delay the offering and create inconsistencies between the appraisal, offering memorandum and financial projections.

Affiliate Fees and Compensation

Real estate fund structures commonly involve several forms of compensation within the sponsor group. In addition to a management fee or carried interest, affiliates may earn development fees, property management fees, construction management fees, acquisition or disposition fees, financing fees and other transaction-based compensation.

Multiple layers of compensation create potential conflicts because the sponsor may have an economic incentive to cause the fund to enter into a transaction that generates a fee.

For example, an acquisition fee may create an incentive to deploy capital even where retaining cash or waiting for another opportunity might otherwise be preferable. A refinancing fee can create a similar incentive in relation to additional debt. Development or construction management arrangements may create conflicts when determining project budgets or selecting service providers.

The fund documents and offering materials should clearly identify material compensation arrangements, including who receives the fee, how it is calculated and when it becomes payable. Where fees are payable to related parties, the documents should also address the basis on which the fund may enter into or amend those arrangements.

Allocation of Investment Opportunities

Opportunity allocation becomes increasingly important as a sponsor’s platform grows.

A sponsor may manage several real estate funds, separately managed accounts, joint ventures or proprietary investments with overlapping mandates. An attractive property may qualify for investment by more than one vehicle.

The resulting question is straightforward: which vehicle receives the opportunity?

A fund’s governing documents should provide sufficient flexibility for the sponsor to operate its broader business while giving investors an accurate understanding of how competing opportunities will be handled. The offering materials should disclose material competing mandates and, where appropriate, describe the factors used to allocate opportunities.

Relevant factors may include investment strategy, geography, available capital, concentration limits, existing portfolio exposure, timing, transaction size and contractual obligations to other vehicles.

Where a sponsor adopts a formal allocation policy, actual practices should remain consistent with that policy and the disclosure provided to investors. Repeatedly allocating attractive investments to a sponsor-controlled vehicle while allocating less desirable opportunities to the fund can create significant governance and regulatory concerns.

Valuation Conflicts

Private real estate assets do not have continuously observable market prices. Valuation therefore involves judgment, particularly between independent appraisals or during periods of market volatility.

A conflict can arise where the sponsor or manager participates in determining asset values and those values affect management fees, performance compensation, net asset value, subscriptions, redemptions or financial reporting.

The fund documents should establish an appropriate valuation methodology and identify who is responsible for determining value. Depending on the fund, independent appraisals may be obtained periodically or when specified events occur.

Sponsors should also distinguish between an appraisal obtained as part of the fund’s ordinary valuation policy and an independent appraisal required under NI 45-106 in connection with an OM distribution. The regulatory requirements applicable to the latter must be independently satisfied.

Addressing Conflicts in the Fund Documents

Conflict provisions should be considered when the fund is formed rather than added after a transaction creates a problem.

For an Ontario limited partnership, the limited partnership agreement will normally give the general partner broad authority to manage the business and affairs of the fund. That authority should be coordinated with provisions addressing conflicts and related-party dealings.

Depending on the structure, the agreement may address:

• transactions with the general partner, manager, sponsor and their affiliates;
• affiliate service arrangements and compensation;
• allocation of investment opportunities;
• sponsor and affiliate co-investments;
• valuation procedures;
• approval requirements for specified transactions;
• standards applicable to the general partner and manager;
• advisory committee procedures;
• disclosure of conflicts; and
• exculpation and indemnification.

The management agreement should be reviewed at the same time. A carefully drafted conflict regime in the limited partnership agreement can be undermined if an affiliated management agreement grants materially broader authority or compensation rights.

The limited partnership agreement, management agreement, offering memorandum or PPM and the sponsor’s actual operating practices should therefore operate as a consistent framework.

Does a Private Real Estate Fund Need an Independent Committee?

A privately offered Ontario real estate fund is not generally required to establish an independent advisory committee solely because conflicts of interest may arise.

This should be distinguished from the Independent Review Committee regime under National Instrument 81-107 Independent Review Committee for Investment Funds. NI 81-107 establishes a specific governance regime for investment funds within its scope. An IRC under NI 81-107 is a regulatory body with prescribed responsibilities and should not be confused with a contractual advisory committee established by a private fund.

Private limited partnerships may instead establish an LP advisory committee, or LPAC, under the limited partnership agreement. An LPAC can provide an effective mechanism for addressing specified conflicts while leaving day-to-day management with the general partner.

For example, the LPA may require or permit the general partner to refer to the LPAC:

• material acquisitions or dispositions involving affiliates;
• amendments to material related-party service agreements;
• investment allocation conflicts;
• valuation disputes;
• waivers of specified investment restrictions; or
• other material conflicts involving the general partner or manager.

The composition, authority and procedures of the LPAC should be clearly defined. The agreement should specify whether the committee provides advice, grants approval or has another defined function, and what effect its decision has on the general partner.

LPAC approval should also not be treated as a universal cure for conflicts. Applicable securities law, registrant obligations and specific requirements such as the NI 45-106 appraisal rules continue to apply independently.

Registrant Conflict Obligations

Additional requirements arise where the manager, adviser, dealer or another participant in the fund structure is registered under National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations.

Section 13.4 of NI 31-103 requires a registered firm to take reasonable steps to identify existing material conflicts of interest and material conflicts that are reasonably foreseeable between the firm, including individuals acting on its behalf, and a client. The registrant must address material conflicts in the client’s best interest and avoid material conflicts that cannot otherwise be addressed in the client’s best interest.

These requirements may be particularly relevant where a registered firm is involved in the management, advising or distribution of securities of a private fund. Their application will depend on the registrant’s category, its relationship with the fund or its investors, and the particular conflict or transaction. Other provisions of NI 31-103, including restrictions applicable to certain transactions involving registered advisers, may also require consideration.

Registration status therefore matters when designing the fund’s conflict framework. Disclosure to investors or authorization in an LPA does not by itself satisfy the separate obligations of a registered firm.

Disclosure in the OM or PPM

Offering disclosure is a central component of conflict management.

The OM or PPM should identify material existing conflicts and material conflicts that can reasonably be anticipated from the fund’s structure and investment strategy. Disclosure should be specific enough for an investor to understand the nature of the sponsor’s competing interest and how the conflict will be addressed.

For a real estate fund, this may include disclosure of related-party acquisitions, affiliate service providers, sponsor compensation, competing funds, opportunity allocation practices, co-investment arrangements, valuation procedures and governance mechanisms.

Generic statements that the sponsor “may experience conflicts from time to time” provide limited information where the sponsor already knows that the fund intends to purchase properties from affiliates or pay substantial fees to related companies.

Where the OM exemption is used by an issuer engaged in real estate activities, the sponsor must also consider the specific supplemental disclosure and appraisal requirements under NI 45-106 and Form 45-106F2.

Disclosure should remain consistent across the fund’s documents and investor communications. Material differences among the OM or PPM, investor presentation, financial model, subscription documents and subsequent investor reporting can create both regulatory and investor-relations risk.

Practical Compliance Checklist

Ontario real estate fund sponsors should consider the following when establishing and administering a conflicts framework:

• identify related parties and anticipated conflicts before launching the fund;
• determine whether related-party acquisitions or dispositions are permitted under the governing documents;
• clearly disclose material affiliate fees and other compensation;
• establish procedures for allocating investment opportunities among competing vehicles;
• adopt appropriate valuation procedures for illiquid real estate assets;
• determine whether an LPAC or other contractual approval mechanism is appropriate;
• where the OM exemption is used, determine whether the issuer is engaged in “real estate activities” for purposes of NI 45-106;
• where the OM exemption is used, complete the applicable Schedule 1 disclosure under Form 45-106F2, as applicable;
• where the OM exemption is used, determine whether an independent appraisal is required under NI 45-106 for a proposed real estate transaction;
• consider NI 31-103 conflict requirements where a registered firm is involved;
• ensure that the LPA, management agreement, offering documents and actual practices are consistent; and
• maintain records demonstrating how material conflicts and related-party transactions were considered and approved.

Conclusion & Next Steps

Conflicts of interest are a normal feature of many private real estate fund structures. Sponsors commonly control several entities, provide services to the fund through affiliates, manage competing investment vehicles and participate economically in transactions beyond their ownership interest in the fund. The legal and governance framework should reflect that reality from the outset.

For Ontario private real estate funds, effective conflict management generally begins with clear authority in the governing documents, specific offering disclosure and documented procedures for material related-party transactions. Depending on the structure, independent valuations, LPAC approval or other safeguards may also be appropriate.

Sponsors using the offering memorandum exemption should pay particular attention to the additional regime applicable to issuers engaged in real estate activities. NI 45-106 and Form 45-106F2 can impose enhanced real estate disclosure requirements and, in prescribed circumstances, an independent appraisal requirement. These requirements operate separately from any voluntary LPAC or other advisory committee established under the fund documents.

Where a registrant is involved, NI 31-103 adds a further layer of conflict-of-interest obligations.

Addressing these issues during fund formation allows the sponsor to align its LPA, management arrangements, offering disclosure and operating procedures before capital is raised and related-party transactions occur.

Book a Consultation

If you are forming, restructuring or operating a private real estate fund, or preparing an offering memorandum for a real estate capital raise, contact us to schedule an initial consultation with Nick Wright.