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December 28, 2020

Stroock Client Alert

By: Richard G. Madris, André B. Nance, David C. Olstein, Eric Requenez

2020 has been a challenging year for many real asset funds, particularly in the core real estate sector. In addition to asset level challenges related to office, retail, hospitality and other properties, many open-end funds have faced investor redemptions at a higher rate than pre-pandemic. A number of real estate investment managers have had to suspend redemptions or institute gates and queues to deal with the requests.  In addition to the liquidity issues related to redemptions, managers also face additional issues with respect to institutional investors subject to ERISA who have submitted redemption requests for some or all of their commitments.  As fund managers consider how to respond to investor redemption requests submitted for year-end or the next redemption date (or an existing queue), they should consider how to address the issues described below.

Many real asset funds permit participation by “benefit plan investors” (generally, ERISA plans, IRAs and certain collective investment vehicles that are deemed to hold assets of such plans and accounts). In order to avoid subjecting themselves and their funds’ investment activities to regulation under ERISA, managers typically rely on one of two exemptions – (1) limiting participation by benefit plan investors to less than 25% of the value of each class of equity interest issued by the fund (the so-called “25% Test”), or (2) operating the fund as a venture capital operating company (VCOC) or real estate operating company (REOC).

Funds relying on the 25% Test must monitor compliance on an ongoing basis, including in connection with any acquisition or redemption of interests in the fund.  While the impact of investments in the fund by benefit plan investors is generally well-monitored by fund managers (and benefit plan investors), sometimes less attention is paid to the impact of redemptions.  Redemptions by non-benefit plan investors (other than investors affiliated with the fund manager, whose interests are disregarded for purposes of calculations under the 25% Test) will have the effect of increasing the relative ownership percentage of benefit plan investors. Therefore, the potential impact on compliance with the 25% Test should be reviewed each time a redemption request is received or accepted, with pro forma calculations run on ownership percentages prior to and following each redemption.  If a redemption would result in benefit plan investor participation exceeding the limit established under the 25% Test, fund managers are generally able to take actions to reject or delay such redemption or to redeem interests held by benefit plan investors in order to maintain compliance with the 25% Test.  

Funds that operate as VCOCs or REOCs will often rely on the 25% Test as a backup, if that option is available to them based on the ownership percentages of benefit plan investors. Such funds should also take care to monitor the effect of redemptions on compliance with the 25% Test as described above.

As long as the fund is in compliance with the 25% Test, the underlying assets of the fund will not be treated as assets of participating benefit plan investors for purposes of ERISA and the Internal Revenue Code, and the fund and its manager will not be subject to the fiduciary requirements and prohibited transaction rules thereunder.

Redemptions of interests in open-end funds may raise additional issues under ERISA, including issues relating to the valuation of redeemed interests and the administration of redemption queues.  For questions on these and other issues related to redemption requests, please contact any of the Stroock attorneys below.

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For More Information:

Richard Madris

André B. Nance

David C. Olstein

Eric Requenez

This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. This Stroock publication may contain attorney advertising. Prior results do not guarantee a similar outcome