It is often said that in real estate investing, most money is made “on the buy.” In fund investing, where most funds at best have only partially identified “seed” assets, it would seem that this would not be the case, at least from the point of view of the investor. They are committing to fund investments that are not yet identified. How do they know what they are going to get and how do they ensure that, over the life of the fund, the sponsor is incentivized and committed to follow through on the numerous promises and assurances that were made during the marketing?
At ABP, having invested close to €5bn in non-listed real estate, we have gone beyond the “trust me” phase and into the “show me” phase. Although we have fortunately avoided some of the more infamous fund investing catastrophes, we have had our share of disappointments and rough spots both in Europe and the United States. We are well aware of the problems and issues afflicting indirect investors.
In our view, most of the value (profits or loss) relative to the opportunity cost for ABP is also created ‘on the buy’ in our committing to a fund. We insist that funds we invest in are sufficiently aligned with our interests; that the sponsor is appropriately mandated, committed and incentivized to give ABP the highest likelihood of meeting the targeted risk adjusted return, after payment of all fees and expenses. It is to this end that we spend a considerable amount of time negotiating the terms and conditions of the fund investment. Of course, during the life of the fund there are other actions that may or should be taken but these are often too little or too late or simply the application of agreements reached when investing in the fund.
The following factors are among the most important in ensuring that the interests of the sponsor and investor are aligned.
Before investing, we require the fund to commit to a defined strategy and answer the following questions, among others.
q What will they invest in?
q Where will they invest?
q How much will they commit to a single investment?
q Is the strategy a core competence of the sponsor?
We have seen numerous funds that seem to be held together by
the premise that an investor can be “sold” on an idea, not that the sponsor is singly qualified to execute a particular strategy or that a strategy is particularly compelling.
Possibly the single greatest factor in alignment of interest is the size of the sponsor’s co-investment, if they have any. We have seen co-investments range from a low of 1% to a high of 30%. Needless to say, if a sponsor has 30% of the capital of the fund, it is more likely that any “profits” arising from fees will not compensate for a risk of loss of capital. However, most sponsors cannot commit to a 30% co-investment, or if they do, very often it is “house money” and not the money of the fund management team. What we typically prefer is a substantial investment, in absolute terms, by the individual fund (deal) team managers and a sizable investment by the sponsor, again in absolute terms, but also relative to the amount of fees that can be generated from the fund and relative to personal net worth.
Establishing appropriate fees is the main struggle for an investor in creating alignment of interest. Some fund sponsors are in the assets-under-management aggregation business, whereby the amount of fees generated from serial fund issuance far outweighs the value of any potential upside of the incremental promote, due to the scalability of the business. In other words, whereas the base management fee charged under the first fund may be breakeven, the profit margins on subsequent funds that may be simultaneously operated could be quite high. If commitments can be drawn down rapidly, capital invested and held through a lengthy investment period, it is possible to have as many as four to six funds going simultaneously. At 1-1.5% management fees, it is easy to see the profit potential.
To this end, we focus on all fees, base management fees as well as incentive fees. As to base management fees, we consider whether they represent a fair and adequate “reimbursement” for the cost of undertaking the fund strategy. This includes reasonable compensation to the fund personnel to source transactions and manage investments. We also scrutinize the amount of fees being collected under current and contemplated funds and take a view whether or not the sponsor and managers are living too comfortably on base management fees alone.
In most cases, especially with respect to value-added, enhanced return or opportunity funds, we believe the bulk of compensation should be back-ended. When we make our money, the sponsor and managers should make their money. This sounds simple, but is complicated in execution. First, one has to address the hurdle rate or return above which any promote (incentive) is earned. We always ask: is it fair and appropriate to the strategy adopted? In other words, does it represent a minimum return for the risks assumed? We have seen cases where the hurdle was actually set underneath the minimum current leveraged return targeted by the fund, not including capital appreciation. In other words, the sponsor in that case was saying they would earn an incentive fee if they did not lose too much money.
To the extent a hurdle rate is set below the anticipated total leveraged return, we include it in our calculation as a “sub-ordinated” management fee. That is unless the funds suffer a loss, this fee will be earned, not through any value-added strategy, but merely through leverage. We build up our hurdle rates through a variety of means, but most frequently we use a factor of historic property-type returns and anticipated leverage to assist in the process.
Once the hurdle is agreed, one then confronts the question of how much of the excess return should the sponsor share. We look at this both as a matter of basis points and in absolute terms. Insofar as the former is concerned, we attempt to look at fees as a percentage of the overall returns. We then look at the ratio of incentive fees to base fees, to ensure the former usually dominates. However, what is the use of assuming high risks if a disproportionate amount of any returns are paid out as incentive fees? It is the capital that took the risk and should be rewarded. The manager’s expertise should be rewarded but not at the complete expense of the investor. Similarly, a low risk, low return strategy cannot bear very high fees, and must be closely scrutinized. So, total fees as a percentage of total returns can be one factor. Also to be considered are the absolute dollars or euros to be earned both by the sponsor and the fund managers themselves. We consider the amount of capital each had at risk and hope that both on a multiple and IRR basis, the incentive fee is sufficiently high to induce the desired behavior.
We would be remiss if we did not address the single most vexing element in many fee proposals we encounter: the catch-up. Simply put, this is the sponsor’s statement that after meeting the hurdle rate return (which is often substantially below risks assumed) it is entitled to take the lion’s share, if not all, of the next cash flows until they have obtained 20% of all profits in the venture. We always ask “why?” We have never obtained a principled answer, only the response that this is “market”. We have seen instances where the existence of a catch-up has engendered adverse behavior in managers. If a certain absolute amount of a fee is required, a similar result can be achieved by changing the share above the hurdle. We believe that simple is better, but have entered in two tiered arrangements as well, with higher sharing above higher levels of return.
As the private real estate fund business grows and matures, we find ourselves faced with a growing problem: continuity of business risk. Business continuity risk takes many forms. Most commonly, critical employees of funds, whether or not denominated as “key men” are increasingly mobile, voluntarily and involuntarily. New funds and new managers try to lure away talented people. Employees grow disenchanted with sub-par performance and seek higher pay, perhaps starting elsewhere with a “blank slate”. In addition, fund sponsors are increasingly being bought and sold, which brings challenges, sometimes the least of which is employee turnover.
A fund investor knows that this is part of the life cycle of real estate investing and fund investing, but what can they do to help insure that this risk is minimized? Most critical is the incentivization of the fund management team, not only to make good investments but to stay the course through liquidation of the fund. This very complicated topic can be reduced to a combination of elements, the precise mix of which, as always, depends on the circumstances. The base management fee has to be large enough to provide a living wage to the fund management team and the sponsor has to agree to compensate them from this fee at appropriate levels. In most cases, we require that the fund management team receive a stipulated percentage of any incentive fee, which we look at on a relative and absolute basis: is it enough to keep them interested? Lastly, we often require a vesting period, with a sizeable percentage not vesting until fund liquidation. If someone leaves, there is hopefully enough compensation left to distribute to compensate their successor disproportionately.
The potential for conflict in real estate fund investing is not widely discussed: it should be. In addition to the more obvious areas of potential conflict, for example related party transactions, other conflicts may arise if a fund sponsor has fund or fund strategies or has other competing investment relationships, such as separate accounts or joint venture partners who may compete for investment product with the fund. Of course, related party transactions give rise to potential conflicts, but in some cases the whole purpose of investing with a particular fund sponsor is to take advantage of their operating platform and the services that can be rendered to the fund from related parties, notably management and leasing subsidiaries. It is not enough for fund documents to disclose the potential for conflicts and permit advisory committees to resolve or waive them. This puts the problem off for another day. These potential conflicts need to be disclosed adequately in fund documentation and, more importantly, be addressed prior to fund investing. Are the related parties qualified? What exactly are the fees? Are they “fair and reasonable”?
Exclusivity is more problematic and less evident. We try to avoid funds where the sponsor has competing relationships or strategies. It is fine for a sponsor to say that they have a process in place or that there has never been a problem. However, we would not like to read in a newspaper that one of these competing vehicles got a deal that we would have thought perfect for our fund. Fund sponsors need to be above suspicion. They need to create focus and exclusivity to avoid questions of impropriety.
Although there is a small, but growing number of funds where the investors actually participate in management of the business, approving acquisitions and dispositions among other things, most funds are still largely discretionary. Even in these funds, continuing investor governance rights must be addressed.
Most funds permit removal of a manager with cause. This is a high burden of proof and not much of a right. In response to investor demand, many funds are now permitting the removal of the manager with or without cause, especially after the investment period expires. Although this sounds like a powerful right, it is likely only to be exercised if the investors are severely disgruntled; they would have to find replacement management and investment performance could further deteriorate as a result. Still, it is a fair right to be requested and granted. After all, what sponsor wants to retain management in the face of an investor revolt – probably only the one you wouldn’t want as a sponsor in the first place.
Many funds now provide that investor approval is required for actions that the sponsor may wish to undertake. In large part this is in recognition of two factors. First, investors are increasingly only granting sponsors “discretion in a box”. They are required to define their strategy (asset type, geography, size, diversification, etc.). As discussed above, this helps ensure that investors’ expectations are met. Needless to say, exceptions always come up that may be attractive and that the sponsor still wants to undertake. Secondly, in such cases, unless the documents provide for a mechanism to “break out of the box”, it is likely that a single investor could veto; thus the need for pre-determined voting rights. Other actions that might require investor approval would include changes to compensation, extension of the investment period or maturity date of the fund, or replacement of a “key-man”.
Investors are well advised to retain legal counsel with specific experience in fund investing (very often not even real estate attorneys). Also they should consider joining investor-oriented associations such as INREV. Perhaps most importantly, though, they need to speak to other investors on a continuing basis. Fund investing, unlike direct real estate investing, is not a zero-sum game.
Barden Gale is Co-CIO Global Real Estate and head of US real estate, and Michiel Olland is head of European and Asia Pacific real estate at ABP Investments