A closed-end fund is one of the most common private equity real estate investment vehicles today. This fund structure has a finite life, with the fundraising period typically spanning one or two years. That means investors can join the fund at different times. And that leads to one of the most frequently asked questions we receive: Is there an advantage in investing earlier as opposed to waiting until the end of the fundraising period, when more assets have been identified?
The short answer is yes, and it involves a process called equalization. As an early investor, you get paid a premium for your willingness to join a fund earlier in the process. To understand why, it’s important to first explain the mechanics of fundraising and capital deployment inside a closed-end private real estate fund.
How Does Investment in a Closed-End Fund Work?
Closed-end private real estate funds typically start out with no assets when the fundraising period begins. Accordingly, those who commit capital earlier in the fundraising period of a closed-end fund are often investing in a “blind” or semi-blind portfolio. That means it’s possible that only a few, if any, properties have been identified or acquired.
When an investor makes a capital commitment, a percentage of their commitment is drawn down, or “called,” each time the fund manager identifies new assets to acquire. A fund’s first close represents the first time that committed investors are admitted into the fund. Investors who make capital commitments between the start of the fundraising period and the date of the first close all receive their first capital call at the date of the first close.
Regardless of when investors commit capital during the fundraising period, all investors are treated as if they had committed at the same time. In other words, each investor is purchasing a pro rata, or proportionate interest, in every asset the fund acquires when they join the fund. The process of “truing up” investors involves equalization.
Equalization Solves the Imbalance of Risk Among Investors
With these mechanics in mind, it’s clear that earlier investors in a closed-end fund take on additional risks in terms of asset identification and selection compared with later investors. That’s because, in most cases, the fund manager has not yet acquired any portfolio assets at the time the fundraising period begins. In order to solve this imbalance of risk among investors, closed-end funds employ equalization to compensate earlier investors at the fund’s stated rate of preferred return. Equalization ensures that each investor is treated as though they had joined the fund at the same time.
How Equalization Works in a Fund
To see how this process works, take a hypothetical fund with four investors. In this example, three investors—Brady, Alice and Chris—make commitments totaling $4 million between the start of the fundraising period and the fund’s first closing. On March 31, the fund manager identifies the first asset to invest in. The first close is held to admit the three investors and draw down a total of $500,000, equal to 12.5% of total investor commitments. Since this is the first close, each investor’s capital contribution is based on their pro rata ownership interest.
The fundraising period continues, and on June 30, the second close occurs. During that period, the fund has received one new investor, Jason, who has committed $1 million. The fund now has four investors with capital commitments totaling $5 million.
Let’s say the fund manager issues a capital call totaling $2 million, equal to 40% of the total investor commitments, for the fund’s second close. At this point, Brady, Alice and Chris have had 12.5% of their commitments drawn down, but Jason has had 0% drawn down.
This is where investor equalization becomes important. Jason needs to get caught up, or equalized, with the rest of the investor pool. This ensures that after the capital call is complete, all four investors will have had the same percentage of their respective commitments drawn down.
In the chart above, the “capital call 2” column reflects each investor’s pro rata share of the $2 million capital call. At this point, each investor is contributing 40% of their total commitment. Since Jason did not participate in the first close, he needs to catch up and pay his pro rata share from the first closing (equalization). The “catch-up from draw 1” column represents what Brady, Alice and Chris are owed from Jason.
The three early investors essentially funded Jason’s portion of the first capital call, which allowed the closed-end fund to acquire its first project. Jason’s $100,000 is used to pay them back their pro rata shares of the overfunded amount.
How the Preferred Return True-Up Works
The “preferred return true-up” column represents how much Brady, Alice and Chris receive from Jason—the advantage, in real numbers, of investing in a fund by the first close. That money is compensation for taking the additional risk, and it is calculated at the fund’s stated rate of preferred return. (In this example, the preferred return is calculated at 8.0% over three months: $100,000 x 8 x 3/12 = $2,000).
At this point, all four investors have been equalized. In the chart above, the “net amount due on 6/30” column, which is the net dollar amount due at the second close, shows the earlier investors funding an amount lower than their pro rata shares of the $2 million capital call. That reflects Jason’s true-up from the first capital call.
Being an early investor in a private real estate fund essentially means that you are betting on the fund manager’s ability to execute the underlying business plan. Acknowledging—and rewarding—those early investors through the preferred return true-up ensures that all investors are treated equally in terms of the risk they take, no matter when they commit capital to a fund.