Q3 | Torys QuarterlySummer 2022

U.S., Europe or Canada: Where should you set up a real estate fund?

Authors

The choice of domicile for a real estate fund will typically depend on the investor base and the geographic location of the investments. There are many ways for investors to access real estate investments around the world, with a variety of possible structures and vehicles.

 
The choice of domicile for a real estate fund will typically depend on the investor base and the geographic location of the investments. There are many ways for investors to access real estate investments around the world, with a variety of possible structures and vehicles.

This article will compare the main legal and regulatory characteristics of Luxembourg (Europe), Canada and the United States1 for real estate funds, highlight the important points for asset managers to note when setting up a real estate fund in these jurisdictions, and touch on key provisions that are commonly negotiated in the private funds space. These include the MFN (“most favoured nation” clause), the differences between the American and European distribution waterfall and the increasingly common availability of—and interest in—co-investments. While this article covers only the basics of these commonly negotiated points and doesn’t speak to any others, those basics illustrate additional considerations from a market standpoint (in addition to legal factors) that should be considered in choosing the correct jurisdiction of the potential fund.

For more on setting up private funds, visit our first-time funds video series.

Luxembourg real estate funds

The Luxembourg fund environment

Luxembourg is by far the most significant fund jurisdiction in Europe. It is also the second-largest investment fund market worldwide after the United States, and the largest cross-border fund distribution market. Luxembourg investment funds attract money from investors around the globe.

Luxembourg’s success as a European fund hub is well-established and is the result of knowledge and expertise developed over many years, combined with a business environment of remarkable flexibility. The country offers everything financial market players need to successfully and efficiently structure and operate their investment funds: political and legal stability, a AAA rating, multilingualism, a convenient location at the heart of Europe, vehicle tax neutrality with a large tax treaty network, and a comprehensive and sophisticated legal toolbox.

Investors can access real estate equity and debt returns through a variety of paths. While the multitude of structures and vehicles adds complexity for real estate investors, this diversity of channels is also a positive feature rather than an obstacle. Based on preferences, investors have the ability to select a structure that optimizes the balance between control, liquidity, diversification, and cost to best suit their needs.
— LaSalle Investment Management Research & Strategy, Accessing the Real Estate Universe in 2021

As illustrated by the 2021 Luxembourg real estate investment fund survey carried out by the Association of the Luxembourg Fund Industry (ALFI), the Luxembourg real estate investment sector has proven highly resilient during the COVID-19 pandemic. The survey reports that assets under management of real estate investment funds in Luxembourg increased by almost 15% over the last 12 months, to a total of EU 104.4 billion.

Real estate fund managers seeking to establish vehicles in the European Union and raise money from EU investors can turn to Luxembourg for a strong and flexible legal, regulatory and tax environment, while benefiting from the AIFMD framework (and especially the marketing passport it grants access to)2, alongside a highly skilled and multilingual workforce.

Luxembourg structuring options for real estate assets

While no investment vehicle devoted exclusively to real estate investments yet exists, Luxembourg offers a wide range of vehicle options well-suited for this type of investment. The appropriate choice of vehicle will vary depending on investor profiles, tax considerations, and investment types.

As there is no specific vehicle meant for domestic investment, a single vehicle may be used for both domestic and foreign investments.

Luxembourg investment vehicles may be open-ended or closed-ended; regulated, unregulated, or indirectly regulated; and may take different legal forms (contractual or corporate) depending on the specific circumstances and the needs of the particular investors. Based on the regulatory regime chosen, the vehicle may be a standalone fund or a multi-compartment platform.

Real estate managers will usually also set up special purpose vehicles (SPVs) underneath a fund to structure that fund investments. Such SPVs often take the form of Luxembourg private limited companies (sociétés à responsabilité limitée).

Regulated investment vehicles

The different regulated investment fund types are described below. They are all supervised by the CSSF, the supervisory authority for the Luxembourg financial sector, and require its authorization prior to launch.

  • Specialized investment funds (SIFs) governed by the amended law of 13 February 2007: There are no restrictions on the asset classes in which SIFs can invest, but they must comply with a risk-spreading rule dictating that no more than 30% of their assets or commitments may be invested in securities of the same type issued by the same issuer. An analogous restriction applies for real estate funds and investment concentration in any particular property. An SIF can be structured either under a corporate legal form, or as a contractual arrangement (co-ownership of assets as a fonds commun de placement, or FCP).
  • Investment companies in risk capital (SICARs) governed by the amended law of 15 June 2004: SICARs can only invest in risk capital (assets contributed directly or indirectly to entities to facilitate their launch, development or listing on a stock exchange), and must take a corporate legal form (public limited company, corporate partnership limited by shares, common limited partnership, special limited partnership, or private limited company). This type of vehicle is most suitable for private equity strategies, although it is possible for a SICAR to invest indirectly in real estate through entities that it holds, and to invest directly in real estate assets with risk capital characteristics.
  • Undertakings for collective investment (Part II funds) under Part II of the amended law of 17 December 2010: Part II funds can take a corporate or a contractual form, and can be publicly offered to retail investors. Because of this, they are highly regulated, with a more stringent CSSF approval process to be completed before they can be created. They are well-suited for real estate investments, with only limited investment restrictions when retail-based money is targeted.
Unregulated investment vehicles

Unregulated vehicles are generally set up as corporations or partnerships subject to the Luxembourg law of 10 August 1915 on commercial companies.

Among the available unregulated vehicles, common limited partnerships (CLPs) and special limited partnerships (SLPs) may often be a suitable alternative when a tax-transparent vehicle is needed. The main difference between the two is that an SLP does not have a legal personality distinct from that of its limited partners. Both CLPs and SLPs may qualify as alternative investment funds (AIFs) when relevant conditions are met.

The Luxembourg legislation on partnerships is characterized by contractual flexibility, low formalism, high confidentiality, flexible governance, and legal certainty. CLPs and SLPs are set up by means of limited partnership agreements. The document used to establish such an agreement may be signed by the parties privately, without the assistance of a notary, or formalized in a notarial deed. It must be publicly disclosed only in excerpt. Statutory default rules apply only to those situations for which the limited partnership agreement lacks certain provisions considered indispensable for investor protection. The parties are free to determine most of the terms of the agreement, including those on corporate governance, the voting rights of the limited partners, the deployment of capital, profit and loss allocation, and restrictions on transfer. CLPs and SLPs are not subject to any investment restrictions or limitations, risk-spreading requirements, or investor requirements (unless they qualify as AIFs and are fully in scope of the AIFMD), and they do not have to be authorized or supervised by the CSSF. Accounting obligations for CLPs and SLPs are also simplified. Finally, note that CLPs and SLPs can only be set up as standalone vehicles, and cannot be structured as umbrella funds.

Hybrid vehicles

It is also possible to create certain indirectly regulated structures under which the fund is neither authorized nor supervised by the CSSF, but to do so, it must appoint an alternative investment fund manager (AIFM) in accordance with the amended law of 12 July 2013 (here, the AIFM Law) that implemented Directive 2011/61/EU on Alternative Investment Fund Managers (the AIFMD) into Luxembourg law. The AIFM is subject to the supervision of the EU authority of its country of establishment.

This is the case for reserved alternative investment funds (RAIFs), which are governed by the amended law of 23 July 2016, as well as for any unregulated vehicle that qualifies as an AIF under the AIFM Law and that must appoint an AIFM.

A RAIF may be given either a corporate legal form or the contractual form of an FCP. It may invest in any asset class and apply any investment strategy. RAIFs must spread the risks of their investments in the same manner as SIFs. However, an exception applies to RAIFs investing exclusively in risk capital, according to which their constitutive documents are not subject to a risk-spreading requirement.

The impact of EU legislation on Luxembourg real estate funds

Due to Luxembourg being an EU member state, Luxembourg funds are subject to EU directives and regulations; major legislation of relevance here includes the AIFMD, the AML Directive and ESG-related texts.

The Alternative Investment Fund Managers Directive

Where a real estate vehicle qualifies as an alternative investment fund under the AIFMD, it must appoint a separate, supervised entity to manage it, which will serve as the AIFM. Authorized AIFMs benefit from the so-called AIFMD passport, allowing them to offer their services (management and marketing) anywhere in the EU.

Over the years, Luxembourg has positioned itself as a competitive cross-border distribution hub with a robust and widely recognized legal, regulatory, and tax framework. Luxembourg’s attractiveness is evident from the ever-increasing number of real estate investment funds in the country: By the end of September 2021, it had a total of 518 regulated investment funds investing in real estate, including 88 manager-regulated AIFs, 134 RAIFs, 9 SICARs and 76 unregulated vehicles3.

The European AML directives

The fight against money laundering and terrorist financing (AML/CFT) at the EU level is pursued by the periodic issuance of directives in this area, which member states must implement into their domestic laws.

Luxembourg systematically implements such directives into its law by the relevant deadlines.

As presented in the ALFI guidelines of May 2021, AML/CFT rules impact real estate funds slightly differently than other types of asset class.

Because investments in real estate assets may entail higher risks, if the relevant risk-based assessment reveals the need, enhanced due diligence must be applied to this type of asset by those responsible for AML/CFT for the fund4.

The SFDR: Regulation (EU) 2019/2088 on Sustainability-Related Disclosures in the Financial Services Sector

The EU is implementing a regulatory reform to ensure that the transition to a more sustainable economy is supported by the investment management industry. The new rules apply to many financial market participants, including investment fund managers, which are subject to new obligations to give regulators and investors greater transparency on how the risks caused by climate or social change and failures in governance will be incorporated into their management processes.

Investors everywhere are turning to this developing framework to guide their approach to sustainable investing, and using it as a tool that allows them to compare potential investee funds with one another, no matter where the funds may be located or what asset class they invest in.

Canadian and U.S. real estate funds

Limited partnerships as preferred vehicle

The preferred vehicle in Canada and the United States for structuring and investing in either open-ended or closed-end real estate funds is the limited partnership. From a tax standpoint, this type of vehicle is advantageous because it gives investors access to flow through shares. Limited partnerships also allow for limited investors liability. The general partner is charged with managing day-to-day affairs on behalf of the fund.

Securities regulation

In terms of securities regulation, Canada has a closed system, in that it requires any person or company wishing to trade in securities to first file a preliminary prospectus with the relevant provincial securities commission, unless a prospectus exemption applies. In the United States, no such filing is required, and most funds are offered in accordance with the private placement regime. For private equity funds focused on real estate investments, the most commonly utilized prospectus exemption is to offer the interest in the fund on a private placement basis. This means that the limited partnership units are issued to “accredited investors”, in reliance on another exemption such as the friends, family and close business associates. It is important to note that, in order to be eligible as a private placement offering, such a fund must have fewer than 50 investors.

Where to form funds in Canada and U.S.

In terms of jurisdiction of formation, in Canada, because both securities law and limited partnership law in Canada are regulated at the provincial level as opposed to the federal level, there are certain advantages and disadvantages to forming the fund in a particular province. In the United States, the vast majority of limited partnerships are formed in Delaware (where there is extensive and sophisticated case law and courts as well as advantageous and protective limited liability laws), in addition to a Form D filing at the federal level as blue sky filings in the various states in which securities are offered are common. Most funds are offered to accredited investors and qualified purchasers, in order to have a valid private placement as well as in connection with an exemption to avoid becoming an “investment company” in the United States.

In the United States, REITs play a key role in fund and deal structuring.
Tax considerations

While tax considerations are generally outside of the scope of this article, it is important to point out that if a partnership has even one partner or investor not resident in Canada, this could cause the entire partnership to be deemed a non-resident entity, triggering Canadian withholding tax on Canadian-source income. Naturally, this is an issue that tax-exempt investors such as pension funds are particularly sensitive to. In these circumstances, non-Canadian investors often use a Canadian corporation to hold their limited partnership interest in the private equity fund. For example, U.S. investors looking to invest in a Canadian real estate fund will typically use a holding corporation (commonly known as an unlimited liability company) to allow for tax flow to its U.S. entities. Structures with international investors may be set up as two or more separate limited partnerships operating in parallel with one for Canadian investors (or American investors as the case may be) and others for non-resident investors.

Key role of REITs in U.S. funds

In the United States, real estate investment trusts (REITs) play a key role in fund and deal structuring. Foreign investors in U.S. funds will often prefer REITs, to ensure that they are granted negative control rights without running afoul of their investment restrictions.

REITs are also preferential from a U.S. tax standpoint, particularly because U.S. REITs are generally not subject to U.S. income tax if certain criteria are met—meaning that a well-managed REIT can avoid some of the U.S. tax reporting requirements for foreign investors. A U.S. REIT is one of the most tax-efficient vehicles for foreign investments, because a REIT that distributes all of its current operating income pays no tax at the entity level, and insulates a foreign investor from having to file a U.S. tax return with respect to this distributed income. Shares of a domestically controlled REIT are also exempt form FIRPTA tax (i.e., Foreign Investment in U.S. Real Property Tax Act) on exit, provided the exit transaction is structured as a sale of REIT shares. For foreign pension plans organized in a jurisdiction that has a beneficial tax treaty with the United States, or which qualify as foreign “governmental” investors, distributions of operating income can be wholly exempt from U.S. tax, provided the investor owns less than 50 percent of the REIT. Gains realized from a sale of shares of a REIT that a foreign governmental investor does not control are also exempt form FIRPTA tax even if the REIT is not domestically controlled.

The American AML directives

U.S. regulatory authorities are increasingly focusing on anti-money laundering and financial crimes compliance, as they try to modernize and upgrade existing AML requirements, and fund sponsors should be prepared for increased scrutiny, compliance and disclosure requirements. Proposed regulatory changes highlight the need for fund sponsors to prepare for the new requirements and financial reporting obligations under the Bank Secrecy Act.

In late 2021, the Financial Crimes Enforcement Network issued an Advance Notice of Proposed Rulemaking (ANPRM) to allow for public comment and input into the new potential requirements to be implemented in this respect. There is also recently introduced legislation in respect of AML, risk and compliance measures, particularly in the real estate sector. This legislation is intended to build on previously enacted legislation requiring, for example, disclosure by private companies of the beneficial owners of real estate to a nationally maintained registry (prior to which such requirement only applied to residential real estate and only within certain U.S. jurisdictions). Also of similar note, the Securities and Exchange Commission (SEC) proposed new and amended rules for private fund advisors focused on disclosure and sponsor practices.

Sustainability

Similar to Luxembourg, ESG (environmental, social and governance) considerations are also a key driver of change and modernization in the North American funds space. While private equity funds are not yet formally regulated in North America as they are in Europe, investors are increasingly focused on ensuring that the sponsors of funds they are investing in have robust ESG policies in place in relation to proposed investments and the ongoing management of those investments.

In addition, U.S. regulators have been hinting at following the lead of the Europeans (at least in some fashion), and North American sponsors should be prepared for future regulatory changes in this area. These will be important for sponsors not only to stay compliant but also to position themselves to attract capital and meet the ESG requirements of their domestic and foreign investors. In addition to ESG considerations, climate change and diversity and inclusion (D&I) are also key focuses for investors in the United States and Canada. In addition to increased reporting and transparency generally by funds (including by reference to the ILPA5 Diversity Metrics Template, first related in 2018) in relation to these matters, investors are also keenly engaged in preparing measurable standards for sponsors to consider and comply with.

Market similarities and differences in real estate funds

Most favoured nation clause

The “most favoured nation” clause (MFN) is widely used in Canadian, U.S. and Luxembourg real estate funds for investors of sufficient size. Such clauses allow these investors to be informed of any preferential side letter entitlements to be granted in favour of other investors in the fund and, under certain circumstances, they also allow such investors with rights under a side letter to exercise or be granted similar preferential rights with respect to their investment in the fund. It is worth noting that the AIFMD requires that AIFMs treat all investors fairly. Preferential arrangements may be offered provided that they are disclosed to all investors.

MFN rights must often be negotiated at length, and it is important that both sponsors and investors have retained the appropriate counsel to guide them in this process.

MFN rights are typically granted to the largest investors, the first close investors or repeat investors. Sponsors will typically try to negotiate some carve-outs to investors’ MFN rights and their ability to elect to use such rights, such as those relating to tiering (based on the size of the investor), LPAC/investor committee representation and fee discounts.

The MFN clause is typically documented in a side letter. There is some criticism within the industry that side letters have become too common and have diluted protections and entitlements that were previously only available to a selection of the largest and most prominent investors. Evidently, the implications of such side letter rights for GPs or sponsors include the cost and administrative burden of complying and monitoring compliance with length, detailed and onerous side letter provisions.

It is important for both sponsors and investors to be clear in their side letters as to how the provisions are to be relied upon (i.e., the investor, in writing, and within a specified number of business days). MFN rights must often be negotiated at length, and it is important that both sponsors and investors have retained the appropriate counsel to guide them in this process and lend an understanding of the current market norms with respect to each provision under negotiation.

Waterfall: U.S. vs. Europe

Under the European model of waterfall, the GP does not receive its carried interest until all of the limited partners’ capital contributions (including unrealized investments) have been recovered and their preferred rate of return has been reached, which is paid to the GP at the very end of the fund’s lifecycle. Under the North American model, sponsors more commonly receive carried interest from individual investments before the investors are made entirely whole (this is often referred to as the “deal-by-deal” model; however, in recent years, it has become more mixed, with some funds taking a more “European”-style approach to the waterfall). In the case of a real estate development fund, for example, the deal-by-deal model means that the GP is paid carried interest as each real estate investment achieves stabilization and is sold, rather than waiting until the very last real estate asset is stabilized and sold, as would be the case with the European model). For obvious reasons, investors typically prefer the European-style waterfall, while GP sponsors prefer the North American model. The waterfall is typically governed by the jurisdiction of the fund and is not a matter for negotiation between the investors and the sponsors.

A clawback will often be included, particularly in the North American-style waterfall. This constitutes an important protective feature negotiated on behalf of investors, pursuant to which there is a requirement to return excess carry both on an interim basis, as well as at the end of the term of the Fund. In addition, this may be coupled with the requirement to pay a portion of the carry into an escrow account such that a certain amount is withheld from distribution to the GP sponsor until such time as the limited partners are made whole on a net of tax basis. This ensures that if the sponsor is overpaid its carried interest, a mechanism is in place that will force the sponsor to pay back the relevant amount on a net of tax basis. In North American deals, a certain negotiated amount may be held back in an escrow account to ensure that any funds to be clawed back are easily accessible and will not be spent by the sponsor, particularly first-time sponsors or those lacking a strong balance sheet—even more commonly in the North American context, the carry recipients or a creditworthy entity on behalf of the GP will provide a guarantee of the clawback amount in order to backstop the GP clawback provisions. Clawbacks are also used in European funds, but typically only kick in upon fund liquidation with a portion of the distribution proceeds being held in escrow until that process has been completed.

Co-investments

Co-investments are becoming increasingly popular, sought-after rights in real estate funds. Co-investment rights allow one or more investors to participate alongside the fund in individual investment opportunities or more passively in vehicles managed by the sponsor for the purpose of making a particular investment alongside the main real estate fund. The management and performance fees charged by the sponsor on individual co-investments are usually lower than those charged to investors under the main fund (or there are none). As previously alluded to, regulatory oversight of fund managers and sponsors is increasing in relation to the fees charged, including those applicable to co-investments, with the goal of ensuring that conflicts of interest are fully and adequately disclosed to investors.

Conclusion

The jurisdiction you select for your next real estate fund or real estate fund investment is one of the most important decisions in your investment strategy. From structuring the fund to securities law to tax, decisions made at the beginning bear critical implications throughout the life of the fund. As a result, it is best to consider the advantages and disadvantages of Canada, the United States, and Europe (in Luxembourg) early in the consideration process.


  1. Note that tax considerations fall outside the scope of this article other than a very cursory mention.
  2. Alternative Investment Fund Managers Directive.
  3. ALFI Luxembourg Real Estate Survey 2021.
  4. Additional information can be found in the “Reviewed practices and recommendations aimed at reducing the risk of money laundering and terrorist financing in the Luxembourg Fund Industry” issued by ALFI in May 2021.
  5. “ILPA” stands for the Institutional Limited Partners Association.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

© 2022 by Torys LLP.

All rights reserved.
 

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