Opportunity zone fund operating agreement

by Stites & Harbison, PLLC

Since the enactment of the Opportunity Zone program over a year ago, the focus has been on gaining a better understanding of the workings of the program and its various applications. While the education curve has been demanding, it has not deterred taxpayers from taking advantage of the program. Qualified opportunity zone funds are now springing up everywhere, chasing the reported $6.2 trillion of unrealized gains for investment in one or more of the 8,700 certified opportunity zones. From the perspective of Qualified Opportunity Zone Funds, attracting capital is now their number one priority. Regardless of whether the fund is established to attract large institutional capital or a small group of wealthy local investors, securing capital will depend, in large part, on the legal structure of the fund, as well as navigating the regulatory, tax, and securities requirements of the Opportunity Zone associated with selling securities.

A Qualified Opportunity Zone Fund is “an investment vehicle that is organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property.” A Qualified Opportunity Zone Fund is much like a private equity fund which complies with the provisions of Section 1400Z-2 of the Internal Revenue Code of 1986, as amended (the “Code”). The typical legal structure of a private equity fund enlists the use of a domestic limited partnership or limited liability company formed under local law in order to provide flow-through tax treatment for gains and losses. The players involved in a fund often consist of an investment manager to oversee the fund’s assets, a general partner or manager to manage its day-to-day operations, and limited partners or members as investors. For purposes of certifying a fund as a Qualified Opportunity Zone Fund with the Internal Revenue Service, the fund simply files a Form 8996 in a timely manner, with its initial federal income tax return. While the self-certification process is made to be easy, there are a number of issues and considerations which require attention of a fund in order for it to achieve its status as a Qualified Opportunity Zone Fund. Here’s a look at some of the more important terms of a private equity fund and how they are affected by the rules of the Opportunity Zone program.

FUND PURPOSE. Normally, private equity funds identify themselves by establishing a business strategy—be it a specific industry, a defined market, an individual sector, or a particular region of the country. For a Qualified Opportunity Zone Fund, this is slightly different in that its business strategy is, for the most part, pre-determined by law. Under the law, a Qualified Opportunity Zone Fund must make equity investments directly in Qualified Opportunity Zone Property located in Opportunity Zones with at least 90% of its assets invested in Qualified Opportunity Zone Property. Also, it is clear that an Opportunity Zone Fund cannot invest in another fund.

FUND TERM. Private equity funds are usually set up to operate for a fixed term. A fund’s term is usually 10 years with a five-year investment period. Investors are generally not permitted to make withdrawals or make additional capital contributions during the life of the fund. Qualified Opportunity Zone Funds will likely operate on a 10-year term since its investors receive the ultimate tax benefit by holding their investment in a Qualified Opportunity Zone Fund for at least 10 years. Investors will not likely look to withdraw from the Qualified Opportunity Zone Fund during the term since the tax benefits are aligned with holding their interests for the 10-year period.

FUND INTERESTS. A Qualified Opportunity Zone Fund, much like a private equity fund, must issue equity and not debt to its investors. Consequently, limited partnership interests or membership interests will be the equity interests offered to investors. It may issue preferred equity investment, which includes preferred stock or partnership interests with special allocations. This is in line with most private equity funds which often provide their investors a preferred return on their investment. Typically, preferred returns range from 6% to 12% of the initial capital contribution depending on the type of investment. The preferred returns are accrued and compounded annually and usually distributed in accordance with the distribution provisions upon the occurrence of a capital event

A word of warning: regardless of the size of the fund or the type of investors, the sale of limited partnership or LLC membership interests is usually a securities transaction under federal and state law. This means that the interests are subject to registration with the Securities and Exchange Commissioner (“SEC”) and with the state of each investor’s domicile, unless an exemption is available. A securities offering exemption from registration often relied upon by private equity funds is the Regulation D private placement offering. This non-exclusive safe harbor exemption has minimal regulatory requirements and standards by which it must abide. It is common to see a fund prepare an offering memorandum, investors’ subscription agreements, a partnership or an operating agreement, custodial agreement and due diligence questionnaires, all of which serve to provide investors with the objectives, risks, and terms of an investment on the offering while protecting the sponsor from the liability associated with selling unregistered securities. Finally, a number of Qualified Opportunity Zone Funds will focus their investment strategy on real estate which requires additional attention. Because of the unique nature of real estate investments, there will likely be regulatory issues under the Investment Advisers Act, the Investment Company Act, and similar state laws which should be reviewed.

CAPITAL CONTRIBUTIONS. Private equity funds enter into subscription agreements with investors committing them, by contract, to contribute a certain sum (a capital commitment) when called for by the fund (a capital call). This capital commitment concept will not likely work with a Qualified Opportunity Zone Fund since investors must transfer cash from their unrealized capital gains into a Qualified Opportunity Zone Fund within 180 days after the close of the transaction that gave rise to the capital gain. Consequently, neither the investors nor the Fund have the time or the luxury of making a call on capital when a new investment is identified and a portion of the investors’ committed capital is required to acquire it. Moreover, the requirement that all cash is collected upfront, rather than when needed, can create problems for the Qualified Opportunity Zone Fund. As previously noted, a Qualified Opportunity Zone Fund must maintain 90% of its assets in the form of Qualified Opportunity Zone Property. Cash is not included in the definition of Qualified Opportunity Zone Property. Therefore if a Qualified Opportunity Zone Fund is not able to convert its cash into one or more Qualified Opportunity Zone Property assets to satisfy the 90% rule, it will face monetary penalties.

DISTRIBUTIONS. Capital distributions made by a private equity fund to its investors are controlled by the occurrence of capital events, which can include the sale of a portfolio company, a refinancing, or a change of control transaction. Cash distributions are allocated between limited partners/members and the general partner/manager in accordance with what is called the “distribution waterfall.” The distribution waterfall can be viewed as a set of separate accounts which operate as follows; once the first account is satisfied in full, the distribution proceeds move to fill the next account, and so on. While distribution waterfalls are individualized for each fund, they typically contain the following four tiers:

Preferred Return. 100% of the distribution first goes to the investors until their preferred return is satisfied.
Recovery of Capital Contribution. Next, 100% of further distributions go to investors until they recover their capital contributions.
Catch-Up. After the preferred return and capital contributions are recovered by investors, the remaining distributions are split between the investors (typically 80%) and the general partner/manager, in the form of carried interest (typically 20%). However, since the limited partners have already received substantial distributions, the general partner receives allocations at the catch-up rate until the carried interest allocations are caught up. The catch-up tranche is structured so 100% of the distributions go to the sponsor of the fund until it receives a certain percentage of profits. The fourth tier is structured so the sponsor receives a stated percentage of distributions as carried interest.
Carried Interest. Following the catch-up phase, the general partner or manager will then receive 20% of the distributed amount, while the limited partners will receive 80%. The carried interest is generally 20% of the fund’s net capital appreciation and fees.

MANAGEMENT AND CONFLICT OF INTEREST. The sponsor, in its capacity as the general partner of a limited partnership or manager of a limited liability company, will maintain full management and control and accept full personal responsibility for partnership liabilities which include the right to decide the investments that compose the fund as well as establish compliance, risk, and valuation guidelines for the fund. Limited partners or members, on the other hand, will have no personal liability beyond their investment; but, in exchange, will not participate in, or consent to, the acquisition of fund assets. As a result of this division of responsibility, general partners or managers, as the case may be, will be raising capital from investors, investing in portfolio companies, or divesting its assets, which can result in conflicts of interest issues. Since general partners and managers are in the business of providing asset management services, they often manage various aspects of the fund by contracting with affiliates giving rise to questions on whether the sponsor is fulfilling its fiduciary duty to act in the best interest of the fund and its investors.

GENERAL PARTNER/MANAGER COMPENSATION. A private equity fund sponsor’s compensation customarily includes a 2% management fee per year of assets under management as well as a 20% carried interest. Funds often pay the sponsor additional compensation in the form of the investment management, property management, financing, and administrative fees, the amounts of which depend on the fund’s negotiating position with investors. Management fees are typically paid to the investment manager while carried interests are allocated to the general partner.

INVESTOR RESTRICTIONS. Investors investing in qualified Opportunity Zone Funds will be subject to certain notable restrictions imposed by the marketplace and the Opportunity Zone rules. First, investors are generally not permitted to withdraw from the fund or transfer their interests during its life. Second, investors, due to their legal status are not allowed to participate in the management of the fund and, as a result, are not provided with veto rights over individual investment decisions. Third, investors can only invest capital gains, which must be invested in a relatively short period of time and are required to maintain their investment in the fund for the 10-year hold period.

Qualified Opportunity Zone Funds are being formed all across the country at a rapid pace even though there remains much to unlock about the Opportunity Zone program. Enticed by the estimated $6.2 trillion dollars of unrealized gain available for investment and the expiring timeline for investors to receive the full tax benefits of the Opportunity Zone Program, those Qualified Opportunity Zone Funds which address the elements discussed above will be in a better position to fully capitalize on this new program.