LOS ANGELES-Necessity being the mother of invention, the market turmoil of the past few years gave birth to many creative solutions to the problem of illiquidity in a down real estate market. One of those solutions was the sale to opportunity investors of preferred equity interests in entities holding real estate.
By nature, opportunity investors typically want to reap their outsize returns within a relatively short time—usually just a few years, and the cost of these investments to the sponsor are usually sufficiently painful to incentivize the sponsor to retire or replace them as soon as possible. As the real estate economy continues its slow but steady recovery, we are now seeing the maturity of these investments, and thus the need or ability for sponsors to either buy them out or find more sustainably-priced capital to replace them.
These transactions raise several issues that both sponsors and new investors in these entities need to keep in mind.
Sponsors retiring the opportunity investment need to be sure to confirm that the opportunity investor is still the sole owner of the interest, and has not sold or pledged all or part of it to others, by requiring the outgoing investor to make representations to that effect, running a UCC search, and, if the interest is certificated, by requiring delivery of the original certificate.
New investors coming in to replace the opportunity investor need to remember to diligence those matters that always need to be diligenced on entry into an existing company, but with perhaps greater scrutiny given the stress of the economic downturn and the additional stresses that may have been imposed on the company by the outgoing investment itself.
Those diligence items include the liabilities and contingent liabilities of the company, of course, with particular attention to potential income and other tax liabilities. Incoming new investors should also diligence, and look for representations covering, the same matters they would if buying the real property owned by the company (such as environmental issues, no litigation, no notices of code violations, status of property-level debt, rent rolls, etc.).
The new investor buying in to an existing real estate entity should also look for representations regarding the company itself and its balance sheet, including comfort that the company has not engaged in other businesses or owned other assets that may have created liabilities.
Particularly coming out of a period of economic stress, the new investor may well also want representations from the remaining venturers confirming that they have not pledged their interests and are not themselves on the verge of bankruptcy. The financial health of the other partners is an important consideration in determining how much comfort to take in the representations that are given.
Finally, as always, the incoming partner needs to carefully consider the proposed amended joint venture agreement, which may carry artifacts of the replaced deal that no longer make sense. In particular, it will be important to review carefully the control provisions, distribution provisions and exit provisions for clarity as well as consistency with the negotiated deal.
Tom Muller is co-chair of the land use and real estate practice group at Manatt, Phelps & Phillips LLP. The views expressed in this column are the author's own.
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