Choosing the right general partners is one of the most important decisions limited partners will make. Every LP has a responsibility to ask a prospective GP the following nine questions, according to Joseph Stecher
The real estate industry has experienced a tough few years. While the challenges are likely to continue, both general partners (GPs) and limited partners (LPs) can benefit from a thorough review and analysis of the private equity real estate model. That is one of the duties of a fiduciary.
Following are nine key questions that the LPs should ask when evaluating a GP with which they are considering investing. The relative weighting of importance of these criteria is highly dependent on the individual sponsor's platform, scale, available resources and strategy. In addition, the criteria are relative and not absolute in application and we do not expect managers to score a nine out of nine.
1. Does a fund offer LPs ‘true full pooling' prior to paying carried interest to the GP?
In simple terms, this means that if an LP invests €100 in a GP's fund, the GP receives a carry only after the LP receives €100, plus fees and expenses if they are ‘outside' the €100, plus a compounded preferred return. No deal by deal, no escrows, no tests.
2. Is the management team economically aligned with the LPs?
A key consideration is whether the GP is investing alongside the LPs - and in amounts that are significant to each of them. The absolute amount of the investment is less important than how meaningful it is to the person writing the cheque. Sharing of the carry among the members of the GP should reflect expected contribution to the success of the fund.
3. Does the manager give the fund sufficient focus?
Ideally, a fund's strategy should be the management team's only strategy. Large firms may have multiple strategies, but each investment management team should focus on only one. A GP should not seek carve-outs to launch a debt fund and a core fund and an emerging markets fund and a speculative construction fund, or other distinctly different strategies. Multiple strategies by a limited team increased the risk that the investment team will be distracted from the fund's main strategy.
4. What are the responsibilities of the advisory board and how are members chosen?
It is our observation that few GPs have threaded the needle of empowering LPs while also shielding them from liability, as well as from the possible consequences of conflicts between the interests of the other LPs and those of their own beneficiaries. Perhaps because of this regulatory impasse, some advisory boards are little more than ‘luxury skyboxes' (exclusive seats handed out as rewards to big clients) with little expectation that recipients will ‘get into the game'.
There are many issues that advisory boards could review and assess, or review and assess more effectively, including valuations, leverage ratios and aggregate risks across the fund (interest rate, debt maturity, lease rollover or vacancy, political); sufficiency of uncalled capital to finish the fund's investment programme; and potential conflicts embedded in the manager's disposition strategy and in the property-level fees paid to the manager (see question 8).
These duties do not constitute ‘micro-managing', nor are they beyond most LPs' resources and capabilities. However, if these boards are going to act more like corporate boards (should), then LPs in good conscience may have to accept some restrictions, too.
Perhaps the individuals who are employed by LPs must accept limits on the number of advisory boards on which they can effectively serve (six? eight? 10?), or short of that, perhaps advisory boards should have sub-committees that dig into certain matters to leverage the strengths of the entire board.
Another option is for auditors and other professionals, or professional board members, to serve as a resource for advisory boards at the fund's expense.
5. What was the size of the prior fund relative to the new fund?
Increasingly, large successor funds relative to recent prior funds (of any absolute size) raise the suspicion that at some point the management fee could become a profit centre. We suggest managers consider launching smaller funds with more co-investment opportunities offered to LPs at discounted fees - which would give investors a chance to average down their cost as they commit more, while retaining discretion over an increasing portion of their programme with a GP. This arrangement gives the GP needed scale to close larger deals (or more deals), while minimising the fixed management fee.
Alternatively, GPs could offer a main fund/'sidecar' format, where the investor firmly commits to both funds in a proportion negotiated with the GP, but the main fund charges on committed capital and the sidecar charges only on invested capital.
Transactions go first to the main fund, with a portion allocated to the sidecar according to a formula agreeable to LPs and GPs (anything from GP discretion to investments over a certain size), with the understanding that the main fund will likely be fully drawn (but at higher cost to LPs because of fees on committed capital versus invested), and that the sidecar, while charging lower fees, may never be fully drawn.
6. Are the people that the LP believes to be key persons also ‘key persons' according to the fund documents?
This is especially important when investing with smaller, entrepreneurial real estate managers. Ensure that the fund documents clearly impose real consequences if key persons abandon a fund.
7. Does the LP understand each way that the manager is making money from a fund?
For example, if the manager is ‘vertically integrated', how is he or she compensated for providing leasing, management, development and redevelopment services to the fund? At market? By a pre-negotiated fee schedule? Is there GP disclosure of these fees, as well as LP oversight? If the manager is more of a corporate-style investor, who keeps the fees that the underlying fund investments pay to the GP for various advisory and board services? The GP? The LPs? A sharing between the two?
8. What are the investment limitations?
Are the investment limitations of the fund consistent with a GP's resources? Do they account for risk - and not just concentrations by geography and property type - while still giving the GP a certain amount of latitude to branch out beyond the types of transactions that comprise the track record?
This section generally runs to two or three pages in most partnership agreements because of the carve-outs that some GPs impose (leverage limits can be similarly watered down). Like an auditor's statement, if this portion of an agreement runs to more than half a page, the qualifiers could be telling you that something is wrong.
9. How transparent is the GP's reporting?
Obtain sample reports, and ask how often a GP communicates with its LPs, both formally and informally. GP reporting should provide investors with the key data to value his or her position with a reasonable application of time and expertise, given the time an investor has available for each investment in his or her portfolio. And GPs should encourage and enable dialogue among their LPs, through an investor-only portion of an annual meeting, for example.
Joseph Stecher is CIO of Morgan Stanley AIP Real Estate