Operational Real Estate: OpCo Ownership Considerations

Introduction

The growth of the operational real estate (OpRE) sector is one of the most significant recent trends in global real estate markets. OpRE is relevant to a wide range of real estate asset classes and subsectors, but all OpRE investments have one thing in common: The returns on such investments are directly and deliberately linked to the revenues and profits of the business conducted on or from the real estate assets.

OpRE assets all involve some level of operational need beyond the mere collection of rent, ranging from simple caretaking to branding, on-site specialist services (e.g., hospitals, senior care, life sciences), food and beverage, and wider experiential offerings. Given the operationally intensive nature of OpRE assets, investors need to think carefully about how the operations of the businesses that use the underlying real estate asset are managed. A variety of approaches are commonplace, ranging from investors appointing a third-party specialist operator to investors taking on some or all of the role in managing operations.

A diverse range of investors are active in the OpRE sector, including private equity and real estate funds, listed REITs, family offices, and sovereign wealth funds. In this report, we will look at key considerations relating to the ownership of operating companies (OpCos) in common investment structures used by closed-ended funds to access OpRE. In particular, many fund investment managers will be mindful of closed-ended-fund lifespans, which will need to be weighed against the need to preserve operational continuity for any OpRE businesses owned by a fund.

Part 1: Typical OpCo Structures

Promote: Typically, promote will be payable by the joint venture (JV) partnership group to the operating partner either by way of distribution on a promote share (or other equity interest) or payment of a promote fee under the management agreement, subject to tax structuring.

Promote: Depending on the commercial agreement, promote may be payable by the property companies (PropCos) to the investment manager, typically by way of payment of a promote fee to the OpCo under the management agreement.

Promote: Depending on the commercial agreement, promote may be payable by the JV partnership group to the OpCo partnership either by way of distribution on a promote share (or other equity interest) or payment of a promote fee under the management agreement, subject to tax structuring. Split of promote between the investment manager and the operating partner is to be agreed commercially.

Promote: Depending on the commercial agreement, promote may be payable by the JV partnership group to the OpCo partnership, either by way of distribution on a promote share (or other equity interest) or payment of a promote fee under the management agreement, subject to tax structuring. Split of promote between the fund and the operating partner is to be agreed commercially.

Part 2: Key Considerations

Third-Party Operating Partner
This is a traditional and well-understood model, wherein a third-party operating partner owns the OpCo, which houses all relevant employees, intellectual property (IP)/branding, etc., and provides operational services to the PropCo/operational business pursuant to a management agreement. Key considerations:

1. Economics:
   
   1. The operating partner will be remunerated and offered incentives by way of payment of management fees (to the OpCo) and promote (to the operating partner and/or OpCo).
   2. The fund and/or investment manager do not participate in any OpCo upside (management fees and promote).
2. Separation:
   
   1. This structure allows for a clean removal of the operating partner in for-cause or no-fault scenarios.
   2. In for-cause (i.e., bad acts) scenarios, any promote interest will typically be forfeited or discounted and the operating partner’s co-investment interest can be acquired often at a discount to value.
   3. Depending on the negotiating positions of the parties, an operating partner may insist upon material termination/penalty fees and crystallization of any promote interest in a no-fault removal scenario. 
3. Exit:
   
   1. Typically, when a third-party operating partner owns the OpCo, an exit would involve only the sale of the PropCo.
   2. Flexibility should be included in management agreements to cater to each intended exit scenario. For example, determining the scenarios in which the operating partner is retained or may be terminated or resign in the case of a sale of PropCo should take account of valuation impact, competitor concerns, and other factors.
   3. Do certain key operational functions need to be retained by/transferred to the PropCo on exit to protect asset value? If so, an orderly internalization of the business operations (including employees, service contracts, IP/branding, etc.) will be required and should be catered to in the management agreement.
4. Other considerations: The investment manager will need to ensure that management agreement terms include adequate protections with respect to exclusivity and noncompete; operating partner key persons and time dedication; IP/know-how being held for the benefit of the fund; and ownership of personal data (e.g., contact details) of customers/clients.

Investment Manager-Owned/Part-Owned OpCo
This is an increasingly used model, wherein the investment manager owns some or all of the OpCo (or the investment manager has its own operational division in-house), which again provides operational services to the PropCo/operational business pursuant to a management agreement. This structure can lead to conflicts of interest and governance issues, given regulatory requirements. Key considerations:

1. Economics:
   
   1. The investment manager will participate in OpCo upside, including receipt of management fees and, depending on the commercial agreement, promote.
   2. The investment manager will be responsible for funding OpCo working capital and increased exposure to operational risk/liabilities.
2. Separation: Typically, the same regime (for-cause and no-fault termination rights) used for the third-party operating partner model will be applied. However, the investment manager will need to be mindful of its fiduciary duties when acting in different capacities (manager of the fund versus OpCo service provider to the fund) and enforcing any rights under the management agreement.
3. Exit:
   
   1. If only the real estate assets are being sold on an exit, there is a risk of conflicts of interest arising in which an investment manager-owned OpCo will continue to service assets under new ownership. Some issues to be considered:
      
      1. Do certain key operational functions need to be retained by or transferred to the PropCo on exit to protect asset value? If so, an orderly internalization of the business operations (including employees, service contracts, IP/branding, etc.) will be required and should be catered to in the management agreement.
      2. Consideration needs to be given to the ability transfer or retain the OpCo management agreement in the event of a change of ownership of the assets separate from the investment manager.
   2. If both PropCo and OpCo are being sold on an exit, detailed consideration needs to be given to the sale terms and allocation of consideration between the PropCo and OpCo interests that are being sold.
4. Fund considerations: The fact that the investment manager has an ownership interest in the OpCo (which provides services to/receives fees from a fund subsidiary) raises a variety of fund-level considerations and the need for regulatory compliance.
   
   1. The fund documents will need to permit the investment manager to charge fees to the fund subsidiary; ensure that any OpCo-related fees and promote are not required to be set off against the fund-level management fee or credited back to the fund; and permit the fund to enter into the management agreement with the OpCo (being an affiliate contract), ideally without investor/advisory committee approval.
   2. Due to the connected party arrangement, the fees payable by the fund to the OpCo will need to be arm’s length and appropriately benchmarked by the investment manager or at the request of the advisory committee.
   3. Other regulatory compliance matters will need to be considered, depending on the applicable investment jurisdiction and regulatory regimes.
5. Other considerations: The investment manager will benefit from ownership and control of the OpCo, allowing for control over exclusivity and potential ability to scale the OpCo to provide services to other operating businesses, and direct ownership of IP/know-how.

Fund-Owned/Part-Owned OpCo
In this model, the fund (rather than the investment manager) owns some or all of the OpCo, which again provides operational services to the PropCo/operational business pursuant to a management agreement. This model can lead to structural complexities, but it allows for investors to participate in any upside in which the PropCo and OpCo are sold together for a premium. Key considerations:

1. Economics:
   
   1. The fund will participate in the OpCo upside, including receipt of management fees. The fund will also benefit from any premium that results from the combined sale of both the PropCo and OpCo.
   2. The fund will have responsibility for funding OpCo working capital and increased exposure to operational risk/liabilities.
   3. This model can be time-intensive for the investment manager asset management team, which will need to oversee/manage the OpCo on behalf of the fund.
2. Separation: Typically, the same regime (For-cause and no-fault termination rights) used for the third-party operating partner model will be applied.
3. Exit:
   
   1. An exit would typically involve the sale of both the PropCo and OpCo by the fund.
   2. Investors should consider whether this could affect liquidity because of a narrower pool of potential purchasers — i.e., PropCo-only purchasers will be excluded from the sales process.
4. Fund considerations:
   
   1. The fund documents will need to be considered to ensure that there are no applicable restrictions regarding the percentage of fund investments that can be made in OpRE assets/operational businesses.
   2. There should be no conflicts of interest due to the fund’s ownership of both PropCo and OpCo, which allows for full alignment.
5. Other considerations: The fund will benefit from ownership control of OpCo, allowing for control over exclusivity and direct ownership of IP/know-how.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.