Fringe benefits for US pensions looking to consolidate holdings

The recently reported strategy of a public pension fund to consolidate and refocus its core real estate holdings from multiple separate accounts to larger real estate fund investments reveals yet another interesting example of the potential advantages that tax exempt sellers hold in the market.

As competition to deploy capital in core asset classes in the US persists, Sacramento County Employees’ Retirement System (SCERS) apparently went out to the market with a package deal – six of its own core real estate single managed accounts in exchange for entry into a similarly valued single position in an open-end core real estate fund. While its particular motivation for the proposed swap – reportedly to consolidate separate account managers and to reduce fees and commissions – may have driven the portfolio offering, the recent prevalence of portfolio rollover transactions is, at least anecdotally, not unique. What is distinctive, however, is the benefit that tax exempt sellers may be able to offer the potential ‘swap’ targets that tax-sensitive owners cannot.

State and local governmental pension plans, which typically view themselves as immune from federal income taxation, may be able to wield a bit of a competitive edge in potential swap transactions due to their tax profile. So-called ‘super’ tax exempts claim exemption from all federal income tax, including exemption from the ‘unrelated business income tax’ (or UBIT) that applies to private pensions and other tax-exempt investors. As a result, such sellers are generally indifferent to the federal income tax consequences of a straight asset sale.

State and local governmental pension plans, which typically view themselves as immune from federal income taxation, may be able to wield a bit of a competitive edge in potential swap transactions due to their tax profile

In contrast, structuring rollovers of in-kind assets for partnership or fund equity on behalf of tax sensitive counterparts often entails more complex structuring to achieve a partial or complete, tax deferred result for such taxable sellers. Buyers, on the other hand, may seek tax benefits associated with stepped up basis transactions, such as depreciation based on appreciated values, which is generally precluded if the assets are rolled over in a tax-deferred manner. In addition, core real estate funds with institutional investors are often structured to accommodate UBIT sensitive tax-exempt investors and non-US investors such as sovereign wealth funds.

Accordingly, such funds may already have complications to navigate within their own structures, which may include REIT subsidiaries or leveraged corporate investment vehicles, before considering the challenge of how to accommodate rollover investors. Although the details of the SCERS transaction have not been disclosed, it may be that similarly situated super tax exempts will pursue portfolio rollups in order to streamline their investments.

There may also be an additional benefit to super tax exempts that convert ownership of real estate to the UBIT friendly environment of a core real estate fund if the house proposal to subject governmental plans to the same tax treatment as private tax exempt organizations under the UBIT regime prevails. But tax reform, and the ability to leverage any advantage in the tight market today, remain to be seen in concrete terms.