Fundamentals of Structuring Upper Tier Partnerships for LIHTC Investments: Part 3
Managing Fund Investments
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The fund agreement is signed up, the CCCA executed, the wire initiated and the fund now owns an interest in the project. It is the beginning of a beautiful friendship. The hard work has been done. Or has it? In this installment, we will take a look at how the investor will expect the sponsor manage the day-to-day operations of the fund.
Ongoing Capital Calls
The CCCA will map out the expected dates of the lower tier capital contributions for an approved investment that are expected to be made after initial closing. But these are usually just projected dates, not specific events. Quick review, the major benchmarks in the lower tier partnership agreement for subsequent capital contributions are usually some combination of (i) construction completion, (ii) conversion of project debt to its permanent form, (iii) stabilization of the property based upon certain economic and occupancy hurdles being met and (iv) receipt the final tax credit allocation documents from the state allocating agency. Some deals may include construction-period installments tied to a certain percentage of the project being completed. In practice, when the sponsor determines that all of the conditions to a particular project-level installment have been or will be met shortly, it will make a formal capital call to the investor for the amount of capital set forth in the CCCA for that installment, subject to any adjustments that the sponsor thinks are applicable pursuant to the particular lower tier partnership agreement (more below). As part of the capital call, the sponsor will deliver a certificate from itself that all conditions to the specific installment have been met, a similar certificate from the lower tier general partner to the same effect (or any exceptions) and all all supporting diligence showing the satisfaction of each condition of the installment.
In a proprietary fund, the investor will generally have the final say over whether the capital contribution conditions have been met to its satisfaction. What will satisfy certain conditions is subject to quite a bit of negotiation in the lower tier partnership agreement. So the upper tier agreement will simply “look down” to the lower tier partnership agreement in that respect. But, there are usually some key documents at each step of the construction and lease-up process that the end-investor wants to see. For a construction completion installment, it will be the documents necessary to establish that the project has been placed in service such as certificates of occupancy and an architect’s or general contractor’s certificate of completion as well as the the expected total costs of the projects in the form or a preliminary cost certification prepared by the operating partnership’s accountants. For a conversion or stabilization installment, it will be some demonstrable level of lease-up or occupancy by qualified tenants as well as meeting some debt service coverage test as calculated by the general partner or the project’s accountants. And for the final credit allocation, the investor will want to see a final Form 8609 showing the qualified basis of the project and the resulting LIHTC allocable to the partners.
Some sponsors may try to negotiate to retain the right to reasonably determine whether the capital contribution conditions at the lower tier have been met or even will be met within some certain period of time. The usual rationale will be that the sponsor has the expertise and resources to evaluate the risks. And from a business perspective, the sponsor will want to maintain good relationships with its developer partners and not hold up capital unnecessarily. However, unless an investor has no experience in LIHTC investments and is completely dependent on the sponsor’s judgment (which would be rare in a proprietary fund), the investor should insist on approving all capital contributions by the fund to the lower tier before they are made.
Adjustments To Expected Contributions
The lower tier partnership agreement will contain a number of capital adjustment provisions that are based on the total amount of LIHTCs generated (versus what what projected) and the timing of credit realization in the first year or two of operations (versus what was projected). As a result, the investment fund’s capital contribution to the lower tier may increase or decrease.
In a proprietary fund, lower tier capital adjustments are fairly straightforward. Any downward adjustments received by the fund will be passed through completely to the investor. Likewise, an upward adjustment to capital for either accelerated credit delivery or increased qualified basis will mean the investor will have to put in more capital than originally anticipated. The fund agreement and the CCCA will usually restrict the investor’s liability for upward adjuster for any specific deal to somewhere between 5% to 10% of the originally projected total capital contribution for such deal. Some sponsors may ask for a dilution right to fund upward adjustment amounts over the cap to protect the fund’s interest in the lower tier. However, investors usually disfavor this approach at the fund level because of its potential effect on the economics of other investments. Instead, it is typical for the fund to agree to a dilution right in favor of the project general partner in the lower tier partnership agreement.
Another key point of negotiation over the effect of adjusters is whether and how much of the load will be correspondingly adjusted, particularly if there is a downward adjuster. Most investors decline to pay additional load for upward adjusters. But downward adjusters usually do lead to a clawback of a corresponding amount of the load. This is to compensate the investor for the shortfall on its expected economic return as well as to incentivize the sponsor to select investments that have the best chances to deliver the expected credits and overall economic return.
Disputes Over Capital Contributions
What happens if the sponsor thinks the conditions to the capital installment have been met and the investor disagrees? There are a few different approaches to this issue. Some investors will only agree to the obligation to be reasonable in determining whether a certain condition has been met. And if the investor determines that it has not been met, the sponsor and the investor have to continue work together in good faith to resolve the dispute. But some sponsors will insist on more definite dispute resolution mechanism. If the investor conceptually agrees to this, it will likely require an objective determination that the disputed condition has been met and the investor is in default, usually in the form of a dispositive court order. At that point, there may be a spectrum of possible consequences, including:
Suspension of the investor’s economic and tax benefits as well as any approval and voting rights;
A binding arbitration right in favor of the sponsor to compel payment of outstanding capital by the investor; or
The sponsor obtaining a springing security interest in the investor’s interest in the partnership perfected by a UCC filing that the sponsor may then foreclose if the investor’s breach continues.
Most investors will agree to suspension of their benefits and rights if they are actually found in default. However, arbitration is not favored as a dispute resolution mechanism as to whether capital contribution conditions have been satisfied. Hence, the usual insistence that a court declare that the condition has been satisfied before arbitration even commences. In that scenario, the sponsor gains little from a separate arbitration right. An investor agreeing to grant a security interest in its interest in the fund is uncommon currently as this is a drastic remedy at the fund level to deal with what is likely a deal-specific dispute. The market has moved away from this over recent years. Some financial institutions are prohibited from granting security interests in property altogether. However, with the banking sector upheaval that occurred in 2023 (and may not be over yet), we may see more sponsors insist on tougher default remedies going forward.
Sponsor Powers And Restrictions on Authority
To comply with most states’ limited partnership formation statutes, the general partner will be in charge of the day-to-day control of the business of the fund for the investor to maintain its status as a limited partner. The same is true for a fund that is set up as a limited liability company, even though most limited liability company statutes do not have the same prohibitions on non-managing member involvement in the regular operations of the company. The sponsor will also be specifically authorized to do certain things on behalf of the fund, such as:
find suitable investments for the fund consistent with the acquisition guidelines;
subject to the fund agreement, give or withhold consent to matters requiring limited partner consent under the lower tier partnership documents;
subject to the fund agreement, consummate approved investments on the terms set forth in the CCCA;
engage a variety of professionals to help manage certain aspects of fund operations;
invest fund assets in permitted investments (more on this in the next installment); and
employ and/or contract with sponsor affiliates on reasonable, arms-length terms.
These powers will then be circumscribed by a broad list of restrictions on the sponsor’s authority and powers to take certain actions without investor consent that are fairly typical across the industry. These include things like acquiring or selling interests in lower tier partnerships, borrowing or lending money, admitting new partners, making certain tax elections, changing fund partnership documents, giving or withholding consent as the limited partner in the lower tier partnership, agreeing to additional fees at the project level or consenting to project refinancings.
As with approvals of capital contributions by the fund, the scope of investor consent rights in general may be subject to some negotiation. Some sponsors will seek sole control over being able to consent to certain lower tier matters, such as minor changes to project-related documents or to certain aspects of the scope and cost of the project. Sometimes a sponsor may even ask for sole control over consenting to anything that does not adversely affect the investor’s projected return and ability to receive all of the projected credits subject to some sort of materiality standard. Whether an investor agrees to any sort of compromise on sponsor’s consent rights depends on a couple things. One, what are the investor own internal capabilities (or desire) to handle all of the consent requests? Two, what sort of internal asset management capabilities does the sponsor itself have? Some investors insist on being quite hands-on when it comes to what is going on at the project level, and often have sensitivities around certain issues where they will not agree to relinquish control in any case even if they do agree to compromise on consent rights. Who has the final say over changes to the scope and/or cost of the project, for example, are frequently part of this sort of conversation.
Asset Management Fees
The sponsor will also receive an annual asset management fee for its day-to-day administration of the fund’s investments. The fund agreement will usually spell out a list of asset management services the sponsor will perform. Tasks such as inspect projects, regular review of project operations and performance, maintaining a “watch list” for troubled properties, consulting with the investor on replacing accountants, property managers or local general partners, monitoring compliance with all regulatory requirements and agency requests, generating or obtaining all financial or tax reports or documents necessary for the investor to claim the credits and keeping the investor informed of all material developments and events affecting any fund investment. The fee may be structured as a flat amount each year agreed to at the time the investment is approved or as a certain percentage of overall cash receipts of the fund from all projects. Most investors prefer the former as it helps make deal-specific returns more predictable. However, there may also still be negotiation over whether the fund’s expenses related to the sponsor’s performance of the asset management tasks are paid for out of the asset management fee (which will affect the total fee) or are separate expenses billed to either the fund or the investor. Both the sponsor and investor will want to clarify how the fee and the expenses are to be paid.
Extraordinary Events
Occasionally, a project will run into some sort of serious trouble. It may be as simple as a material casualty loss caused by some sort of natural disaster or fire. A local general partner or its property manager may not be performing as needed to keep the project viable. Or has engaged in some sort of bad act. Or a project may be so far underwater economically that it cannot service its debt, and loan default or even a foreclosure may be imminent. Or the problem may be so severe that the investor will want to put the fund’s interest in the project back to the developer through what is known as a repurchase provision.
Naturally, the investor will have approval rights over the resolution of these significant events that are outside the regular asset management duties of the sponsor. But these are not necessarily simple “go/no-go” decisions. They usually require a detailed review of legal, financial and tax issues, and a joint formulation by the investor and sponsor of a strategy to pursue an acceptable conclusion that balances a number of disparate interests. And the solutions will likely be expensive and time-consuming. So frequently investors will want to see a plan, a timeline and a proposed budget for these types of extraordinary expenses for which the investor may ultimately be responsible for.
Sponsor Default and Remedies
What happens if the sponsor itself does not behave as promised? In that case, much like at the project level, the investor can remove the sponsor as general partner of the fund. The traditional list of material defaults giving rise to this investor right are for things like fraud, breach of fiduciary duty, breaches of the fund agreement that materially impact the investor or the fund itself, blowing the partnership status of the fund for tax purposes, significant securities law violations and bankruptcy of the sponsor. Because the remedy is so severe, the sponsor will generally have fairly lenient cure rights (60 to 90 days and sometimes longer) to preserve its interest for most defaults that can be cured. The one removal trigger that does receive some attention is the threshold of credits that that sponsor has to deliver across the fund. That usually winds up being somewhere between 70% to 80% of the total credits expected from all lower tier partnerships.
If the sponsor is removed, there will also be the issue of what it should receive as compensation, if any, for its interest. Most investors will insist on nominal compensation for removal for true “bad boy” acts on the basis that the sponsor should not be able to profit from its own wrongdoing. But again, the credit delivery threshold trigger and the consequences of that sort of default may require some compromise as the sponsor has likely delivered some value to the investor in that scenario. In that case, an investor may be willing to pay some measure of fair market value for the sponsor’s interest if it elects to remove the sponsor for that particular default. Likewise, courts would be likely to avoid a draconian forfeiture of the sponsor’s interest in any action to enforce that removal provision.
In reality, removal situations at the fund level are exceedingly rare. In fact, short of an outright bankruptcy by the sponsor, I do not know that I have ever heard of an investor exercising this type of right at the fund level. It is definitely a remedy of last resort.
Onward . . .
Well, we are three-quarters of the way through this page turner (pun intended). The last installment will focus on the key tax, economic and regulatory aspects of a typical fund. The really fun stuff. Be on the look out for that next month some time.
As a general note to readers, and in an effort to stick with the twice a month publishing schedule, one post will probably focus on a more technical topic. And the second piece will be a little lighter fare with a more open format. Sometimes it will be a news aggregation, depending on what is happening in the industry. Some months, I may take a step back and look at some broader professional theme in my travels. Other months, I may do a case study or possibly an interview with another industry denizen. As always, open to any and all other ideas as well.
Until then, may the four winds blow you safely home!