We have all been there. In a conversation with someone new at a neighborhood party or some similar conversation the question of “what do you do?” inevitably comes up. My reflexive answer is something to the tune of “oh, well, I am in real estate finance.” If I am feeling frisky, maybe I will mention tax equity or tax credit investments. If the poor soul has not run for the hills yet, once in awhile he or she will wonder, well, how do those tax credit investments work? At that point, they have entered the labyrinthe world of federal tax credit investments. In the ensuing couple minutes, that person may very well wish they had never asked the question. However, some hardy folks still persist. At that point, I feel like I have to pull out a structure chart just to continue intelligently. A lawyer wielding a structure chart is not hits at parties. So I do my best to give the ten cent tour as it were. I already have one strike against me for being a real estate lawyer. So I try to use the limited social capital I have wisely. With all bad jokes hopefully now out of the way, I will try to give a better answer than I give my fellow partygoers. If you come this far, you probably already know that a large chunk of my practice involves representing “upper tier” investors in low-income housing tax credit transactions (“LIHTC” for short). But what constitutes the “upper tier” part of the structure? And what is meant by a “proprietary” upper tier fund within that structure? Since answering that basically requires us to turn the figurative pages of a fairly complex partnership arrangement, it made sense to break this up into shorter, digestible parts. Over the course of the series, I hope you, dear reader, come away with some useful insights into the real issues in this part of the investment structure that those of us in the industry deal with on a daily basis when putting these types of vehicles together for our clients.
Thanks for reading Lake Side View! Subscribe for free to receive new posts and support my work.After tackling some basics of fund structure and what proprietary funds are (and what they are not), we will take a look at the typical investment selection and approval process. Then we will cover the management of fund assets using the life cycle of a typical asset from acquisition, construction, stabilization, operation to investor exit. We will wrap up with regulatory considerations as well as the economic and tax aspects of a typical proprietary fund. Don’t say you haven’t been warned . . .
Like almost all other types of institutional real estate investments, low income housing tax credit equity investments are structured as partnerships under federal tax law to allow for the flow-through of certain tax benefits in the form of income tax credits available under Section 42 of the Internal Revenue Code (and other tax and economic attributes) from the project (the “lower tier partnership” or “operating partnership”) up to the limited partner in the project (the “upper tier partnership”) through to the ultimate taxpayer who can use them (the “investor”). Without getting into the weeds too far, the credits are calculated by taking the operating partnership’s “qualified basis” in the acquisition and construction or rehabilitation of a “qualified low-income building.” The operating partnership’s “qualified basis” is, for our purposes, depreciable tax basis with a few adjustments multiplied by the “applicable fraction” for the project (i.e. the ratio of the number of “low-income units” in the project leased to tenants at or below certain income and rent levels to the total number of units in the project). Then, depending on whether a certain percentage of the project is financed by tax-exempt bonds, the qualified basis is multiplied by a credit rate of either a 4% or 9% is applied to the qualified basis to generate an annual credit amount that is available to the operating partnership over 10 years. This is a vast oversimplification of Section 42 in general, but will suffice for our purposes here. 1 Since a picture is worth a thousand words, I guess I should break out that dreaded structure chart after all (call it the accountant’s revenge):
( courtesy of Novogradac & Company LLP ) The typical end-investor at the top of the stack is a bank, an insurance company or certain other large, publicly held corporations that have significant U.S. tax liability. The key characteristic of tax equity investors is that they are almost always widely held C-corporations so as to be able to use the credits and not run afoul of a certain set of arcane tax rules known as the passive loss/at-risk rules. The typical “sponsor/syndicator” noted above is just as that term sounds. Note, I use these terms interchangably here. It is an entity (or a subsidiary of an entity) that develops long-term relationships with LIHTC project developers, the general partners of the lower tier, to invest equity in various project that will generate the credits, which investments are in turn “syndicated” to the investor through the upper tier partnership. For the syndication to the investor, the sponsor is paid an array of fees and participates in some share of the operating cash flow and capital proceeds generated by the fund’s investments. As the industry got off its feet after the 1986 tax reform legislation that created the credit, syndicators were traditionally closely held, private entities together with a handful of non-profit entities. However, in recent years many private, for-profit syndication firms have been acquired by large financial institutions given the capital-intensive nature of the syndication business model. Some banks have developed their own syndication platforms as well. Some may wonder why the two-tier structure? The simple answer for that is that the upper tier fund is essentially a programmatic joint venture structure between the investor and the syndicator/sponsor set up to invest in a variety of projects across geographies, assets, operational strategies and developers, giving the investor control over what assets are acquired by the fund. There are usually some general parameters around what investments will be approved (which may or may not be observed in the breach). But the total capital deployed in most funds is somewhere between $50,000,000 and $200,000,000 depending on investor requirements. The lower tier operating partnership, on the the other hand, is a “true” joint venture. The fund brings the capital. The developer brings the sweat equity. And a single, discrete project is brought to life. Certain investors actually prefer to invest directly with the developer in the operating partnership. But generally, direct investment has traditionally been a smaller slice of the market as compared to syndicated investments. Only a handful of investors have the internal platform required to source, underwrite and close direct investments on a consistent basis. The two-tier structure also allows a syndicator the flexibility to bridge the end-investor’s capital contribution by “warehousing” investments 2 in individual projects by drawing on a revolving line to fund the upper tier fund’s initial lower tier capital contribution in the project at the time of financial closing (i.e. closing of all project-level debt and equity sources). Lower tier financial closing frequently takes place prior to the end-investor being ready to formally commit to the investment, a process that that takes time with most large financial institutions that may be juggling a pipeline of projects across multiple syndicators.
There are two commonly used upper tier fund structures 3 , a “proprietary” fund and a “multi-investor” fund. The term “proprietary fund” is just a fancy way of saying the almost all of the partnership or membership interests in the fund belongs to a single investor. And a multi-investor fund is just as it sounds (I know, lawyers are so creative!). So we are going to focus on what a single investor will spend time on when negotiating the fund agreement with the sponsor. But before we leave multi-investor funds for now 4 I should point out the key differences between the two options. Structurally it boils down to this. A multi-investor fund is generally set up for the sponsor to manage the economics of the fund to try to achieve a specific IRR or yield. So its investment selection will reflect a broad diversification across developers, markets and types of projects in order to balance out the economics. In exchange for this economic deal, the sponsor will have quite a bit of control over management of the fund, selection of assets, the underwriting and closing of investments and other operational aspects of the fund, including how the lower tier operating partnership is acquired, managed and possibly sold. The investors have some say say in some major decisions and some veto power over certain investments depending on the specifics of the fund. And investors frequently enter into side agreements with the sponsor that modify the sponsor’s rights and responsibilities under the fund documents as well as how certain specified investments are treated. But, multi-investor funds are a much more passive form of investment for the investor. In a proprietary fund, the investor controls the investment approval process and parameters, in exchange for taking on basically all of the economic risk. There are a couple of key reasons an investor would choose a proprietary fund structure over investing in a multi-investor fund. First, most bank investors also make LIHTC investments for Community Reinvestment Act (“CRA”) compliance purposes. Given the importance of compliance with this extensive regulatory regime, many banks prefer to have a considerable amount of control over key investments for which they are claiming CRA credit. The sticks and carrots of CRA compliance are inordinately byzantine and well beyond our scope here. 5 But we can just acknowledge that, at the very minimum, banks want to stay on the good side of the various federal regulatory agencies who are charged with CRA review and enforcement for strategic reasons. Second, proprietary investments are usually (but not always) designed to make investments that produce a higher economic return over a larger investment size. Multi-investor funds will usually have maximum deal sizes and developer allocations, either explicitly in the fund documents or imposed via side agreements by significant investors, to avoid over-concentration of the total fund size in any one investment, development team or market. There are no such limits in a proprietary arrangement. So proprietary funds are the best vehicle for an investor to make large, serial investments in important CRA-oriented projects, which can be more difficult to do on a consistent basis making multi-investor fund investments.
As I mentioned above we will break up the excitement here into multiple parts since I do not want to completely scare people off. I know, you can probably barely contain yourself to hear about to regulatory and tax issues. Remain patient! We will pick up with the investment selection and approval process in the next post.
Thanks for making it this far!
This article assumes the readers has some basic familiarity with the LIHTC program and how it works at the operational level. If not, as a starting point, the introduction to the credit in IRS audit guide (c.f. Pages 10-13) will give the reader the basics of how the credit is calculated, who can use its, what kinds of projects are eligible and how the project is required to be operated by the owner to be maintain eligibility.
Warehouse line structures can get a bit complicated, including adding an additional “middle” tier entity between the fund and the operating partnership. These are frequently driven by the needs and concerns of the warehouse line lender, which essentially holds a mezzanine position in the operating partnership limited partner until the end-investor makes it initial capital contribution at the upper tier which is used by the syndicator to pay down the draw on the warehouse line of credit used for that particular lower tier investment.
There are also what are known as “guaranteed” funds, where investors receive a certain guaranteed level of return on a certain percentage of their investment. However, although these funds present some unique tax structuring issues, guaranteed funds are really a subspecies of either a proprietary fund or a multi-investor fund as they may take both forms.
Multi-investor funds (or “multi-funds” as they are commonly known) and some concepts unique to this type of investment fund could be the topic of any entirely separate article. And may be? Stay tuned in the future.
The CRA sets forth a rubric of evaluations that banks undergo in relation to the geographic areas where they operate and the products that they offer. These evaluations look at both lending and equity investments. At the end of an evaluation period by the applicable regulatory agency, the examination yields a written examination report accompanied by a rating. Most banks that have at least a regional footprint are very focused on maintaining excellent CRA ratings. Again, the ins and outs of the CRA could be its own separate treatise article.
