Due diligence needed to weigh up fee costs of unlisted real estate
As interest in European unlisted real estate investment funds increases, an increasing amount of investors are facing the challenge of understanding fee structures and being able to compare them across funds. Fee structures in this type of vehicles are composed of different elements (management fees, performance fees, transaction fees etc.) with each of these components being calculated using a great variety of methods depending on the fund and the fund manager in question. This diversity in methods and in the types of fees poses an enormous problem for investors when trying to compare fee structures across funds. Moreover, due to their complexity, there is not sufficient understanding among investors as to the real effects of different fee structures on net returns; not to mention a lack of understanding of the advantages and disadvantages of each structure.
Aberdeen Property Investors Indirect Investment Management (APIIIM), part of Aberdeen Property Investors, created the Fee Tool, a computer-based model based upon detailed cash flow projections for individual funds, and allows a straightforward analysis and comparison of fee structures across funds. These cash flow projections, being dependent upon a large number of variables such as the performance of the underlying investment portfolio or the terms of the fund (life, extension period, leverage, length of investment period, etc.) determine the shape of cash flows as well as the final effect on net returns from a given fee structure. The Fee Tool produces a series of curves that illustrate the impact of a given fee structure on the net returns for each level of gross returns, as well as a sophisticated Monte Carlo analysis that makes it possible to determine the effect of multiple variables on the final effect of a fee structure.
APIIIM’s work in the field of fee structures for property funds resulted in the creation of an extensive study, from which an excerpt paper was published at the IPD/INREV conference held in Vienna in May 2004. APIIIM’s aim was in the first place to contribute to increasing the transparency in the market, and in the second place to create a reference point which investors, fund managers and fund raisers can use to determine where the average fee levels found in the marketplace stand at, as well as in which ways fees are structured.
In this study, APIIIM made use of its internal database of European property funds in order to be able to model fee structures in detail for each individual fund. Of the 161 funds included in its database, 53 funds fulfilled the criteria needed in terms of the level of detail of available information and for which APIIIM received acceptance from fund managers for their use in the study. These funds were divided in three groups according to their risk/return profile: core, core-plus and opportunistic. We performed a descriptive study of the fees found in each of these risk segments. The results of the fee tool are summarised in figure 1, which shows the differential between gross and net IRR with respect to gross IRR for each of the risk/return groups identified. The shape of the curves shown in the chart reflects the nature of the fee structures found in the market, where a management fee contributes to most of the gross/net differential until the hurdle rate is reached and performance fee becomes payable, at which point the gross-net differential increases and the curve becomes steeper.
As expected, opportunistic funds have fee structures which result in a wider differential between gross and net IRR, as the manager is remunerated for a more active investment style. The performance fee is particularly aggressive in opportunistic funds, as evidenced by the steepness of the curve after the hurdle rate is reached. Interestingly enough, on average the core funds in APIIIM’s sample showed a gross/net differential not too far away from that shown by core-plus funds before the performance fee kicks in: making core-plus funds clearly more expensive. This can be partly explained by the fact that of the funds in the sample, core funds in general made more use of additional items such as transaction fees.
Fees is one of the areas where investors focus when comparing different investment alternatives. While no investor is willing to overpay for the services received, corporate governance concerns are the driver behind much of investors’ interest in fee levels and fee structures. So it is not just a question of whether a certain fee level is reasonable but, whether or not the way a fee is structured aligns the interest of investors and the fund manager.
One good example of a misalignment of interests lies in the calculation of management fees based on commitments made by investors. By charging a fee based on commitments, fund managers make sure that they receive revenue proceeds at a time when the fund has not built up its portfolio and therefore other fee structures - such as those based on gross or net asset value - would not yield enough fee revenue. However, fees based on commitments have some major disadvantages; not only do they accentuate the J-curve of the investment but generally there is no compensation or adjustment if the fund manager does not invest all the commitments made by investors. In addition, during the liquidation period the fund manager will be entitled to a fee based on all commitments even if most of them have already been returned to investors, unless there is an adjustment for returned commitments. Of the funds analysed in APIIIM’s study, 38% applied a fee based on commitments during the commitment period while 15% applied the same fee also after the end of the commitment period.
An alternative method used by some funds to compensate fund managers for their work during the investment period is the use of transaction fees. These fees, which in some funds are also applied to disposals, should be carefully analysed in the context of the management fees paid by the fund so as to avoid double charges when the level of management fee does not justify the charge of a transaction fee. The same approach should be used in the case of funds which charge additional fees such as those based on developments and administrative or property management. Investors should exercise care and examine which items are paid by the fund and which are already priced in the management fee.
Performance fees are one of the main instruments used to align the interests of investors with those of the fund manager. However, most of the funds available in the marketplace show a lower hurdle rate than their target IRR (see figure 2). In fact, this divergence was the largest in the opportunistic funds segment, where the average difference between the target IRR and the hurdle rate was 7.8%. What is more, opportunistic funds in the sample studied by APIIIM had an average hurdle rate of 11%, while the average target IRR for core-plus funds in the same sample was 12.7%.
A great variety of calculation methods are used for performance fees so care should be exercised so that the alignment of interests between investors and the fund manager prevails. For instance, performance fees based on realised cash flows are generally better than those based on unrealised performance; since unrealised returns rarely take into consideration costs related to the liquidation of the assets and the fund. This is the case with many open-ended funds or funds with liquidity mechanisms; if the performance fee method does not take into account the aforementioned costs the final out-performance will fall below the estimated performance and could even result in the investor paying a performance fee even in cases where the final performance of the fund was below the hurdle rate. Investors should exercise care and determine whether a given performance fee structure makes use of clawback mechanisms in order to correct possible inefficiencies.
The Fee Tool developed by APIIIM contains a module that allows the performance of Monte Carlo analyses, where multiple variables (such as the life of the fund, portfolio returns, pace of investment activity, etc.) are assigned ranges and types of probability distribution. This allows the user to perform an analysis where all the possible outcomes are taken into account in order to ascertain how the degree of freedom in the variables defined by the fund’s mandate can influence the impact of a given fee structure. Figure 3 shows an example output from the Monte Carlo module. In this example, the red dots, which form a line, show the multiple differential gross-net IRR for each level of gross IRR obtained when constraining four variables: length and investment pace of the commitment period, length and sale pace of the disposal period, leverage in acquired properties, and asset sales during the life of the fund. The blue dots, in contrast, show the outcomes obtained when these four variables assume random values under a defined probability distribution for each variable. As a result, the band of possible outcomes widens significantly, and the same fee structure can have an impact on net returns that could exceed 1% depending on the conditions under which the fund performed.
This exercise shows how the final impact of a fee structure will ultimately depend on the degree of freedom the fund manager has to manage the fund. For this reason, investors must perform a thorough due diligence placing the fund’s fee structure in the context of the findings from this due diligence work. There are currently numerous funds that do not properly define some parameters that are of key importance. One of these is the timing of disposals: of the 53 funds included in APIIIM’s fee study, only 27 make a reference in their legal documentation as to the timing of the fund’s winding up. Of these 27 funds only 17 state clearly the timing of a decision to liquidate the fund’s portfolio of assets. In the case of a fund that pays a management fee on commitments a longer than desired disposal period would have an adverse effect on net returns, and what is more the interests of the manager are not aligned with investors since a longer disposal period means a longer period under which the manager can continue charging the same management fee.
The ability of a fund manager to take on risk is also an important parameter to take into consideration. This can be used by fund managers in order to increase the risk profile of the fund in order to maximize the performance fee. However, this would be at the cost of investors, who would see the risk profile of their investment rise with the subsequent conflict of interests. Although most funds have clear guidelines and restrictions, these usually do not cover all the aspects that define the risk profile of a fund. For example a fund manager can rely on developments even when not assuming development risk if assets are acquired from developers when they are fully let. This can lead to excessively long commitment periods or to the impossibility of investing all commitments if any of these development deals fails before the fund can identify an alternative investment opportunity prior to the end of the commitment period.
The study performed by APIIIM confirms what most investors already know: there is a wide amount of divergence as to how fees are structured and calculated for unlisted property funds. The results also showed how there is a large divergence as to the levels of fees charged by different funds in the same risk/return category (particularly in the case of core-plus funds), which indicates that some fund managers price their products significantly more aggressively than others.
In addition, the results from this analysis reveal two important conclusions. Firstly, investors should not only focus on the level of fees but more importantly on how these are structured as this will determine whether the interests of the investor and the manager are aligned. Secondly and more importantly, any fee structure can be only analysed in the context of a thorough due diligence work that must explain how the fund’s structural
factors affect the impact of the fee structure as well as whether the fund is a sound investment proposition or not. In this sense, particular attention must be paid in order to make sure that the guidelines and restrictions of the fund do not leave room for the fund manager to increase the risk profile of the fund to an extent that it becomes detrimental to the interests
It is important to highlight that fees are only one more element to take into account when evaluating the soundness of an investment in a given property fund. The focus should therefore not be to minimize fees but to maximise the net IRR, which implies that a great deal of the analysis effort has to concentrate on evaluating the ability of the fund manager to add value throughout the investment process, as well as making sure the structure of the fund is aligned with the interests of investors.
Anders Åström is managing director and Antonio Alvarez a senior associate at Aberdeen Property Investors Indirect Investment Management