Investors increasingly seek fund managers that can demonstrate an alignment of interest. But achieving effective alignment can be a challenge, especially as lower return prospects spell implications for incentive fees. Richard Lowe reports

Fundamentally speaking, a pension scheme invests in a real estate fund for the same reason a general partner manages it - to make money. The critical difference is that the former, or limited partner, is looking for a return on the committed capital and is exposed to both upside and downside risk, whereas the latter will collect management fees no matter what.Admittedly, this is a crude picture, but it does highlight that an alignment of interest between investor and manager is unlikely to exist naturally. Engineering an effective level of alignment is one of the most challenging aspects of investment for investors and fund managers alike, and given the uncertain outlook for real estate markets, the issue is perhaps more pressing than ever."Alignment of interest is really important," says Steven Grahame, senior investment consultant at Watson Wyatt. "It means your interests are the same as mine - we are working towards the same goal. There is never going to be a perfect marriage between the limited partner and the general partner, because the investor will want the fund manager to achieve the best returns he can for a sensible level of risk.

The fund manager is running a business and that means he might have an interest in making a lot of money relative to risk, but would also seek to transfer as much of the operating risk of the firm on to his investors. What you really want to do is concentrate the investment manager on the particular product you are invested in and the life of that investment and not necessarily see new products and legacy investments drawing on the business or the general partner's time."Kiran Patel, global head of research, strategy and business development at AXA Real Estate Investment Managers (REIM), likens the practice of establishing an alignment of interest as a balancing act where there is no easily defined one-size-fits-all solution."Alignment between manager and investor has always been seen as a critical issue over the years," he says. "The important thing in each case is there is no right or wrong answer. At the end of the day it is a balance."

However, some investors may feel that the extremely bullish market environment of recent years has caused this balance to tip in favour of managers. Michael Nielsen, head of real estate at giant Danish pension fund ATP, certainly falls into this camp and he made such an observation at the IPE Real Estate Investor Forum in Berlin last May.
Fund managers across the board have done very well in the recent bull market, possibly regardless of whether they are particularly good at actively managing assets or simply rely on positive yield shift and high levels of gearing. Either way, they were in a better position then to dictate terms because of the high demand they enjoyed from investors.
This applies very much to performance fees, which today are a well-established means of creating alignment. "We continue to see some very aggressive incentive fee packages," says Nielsen. "We hope that in the future the new situation in the real estate market will bring the incentive fees back to a more balanced level. We have no problems paying incentive fees, but they have to be on a fair basis."Grahame explains how the establishment of track records can help fund managers justify bigger and bigger performance fees, which are "incredibly lucrative" to the industry. "The manager, if he becomes very successful, is going to create more and more aggressive performance fees and products," he says. "This is why you really need to do your research before you commit to funds. The risk is on you, because you have a simple decision to invest or not. Others who are track record-sensitive are likely to buy the track record, leaving the astute investor unable to negotiate on key terms."

This scenario could well change now that there is less of a scramble from investors to gain access to real estate funds and they are happy to sit on their hands while the global economic picture becomes clearer. The tables may have turned somewhat.
"Investors are probably more cautious with their money than they were at the beginning of last year," says Luca Giangolini, joint head of corporate finance at Cushman & Wakefield. "There is certainly still money out there, but the capital raising environment is more challenging. At the beginning of 2007, when managers were launching funds they were over-subscribed, so it was easier to secure more aggressive fee structures than it is now. There has been a shift in the demand and supply equation for capital and therefore investors are starting from a stronger negotiating position on fees."But Nielsen is concerned that there has yet to be a visible shift of power back in favour of investors. "We haven't seen any clear evidence, but it will take some time," he says. "There are many investors all over the world looking for real estate exposure. The manager can just go to the next investor and if he is ready to accept the terms then why should the manager then discuss with investors like us?"Performance-related fees have become increasingly popular, especially for closed-ended funds (they are less so for open-ended vehicles, where it becomes more of a challenge to implement). They are not universally welcomed, with some investors concerned they put pressure on managers to take more risks, but the general consensus is that they are a positive feature.

Watson Wyatt published a research note earlier this year on fees entitled A fairer deal on fees, (applicable across all asset classes including real estate). It found that pension funds around the world are paying on average 50% more in fees than they were five years ago. Paul Deane-Williams, senior investment consultant at Watson Wyatt explains that performance fees are welcomed at his firm because they can be an effective way of creating alignment - but, importantly, only if they are properly structured."Left to their own devices, the performance fee will only ever favour the manager," he says. "There is no way that all the upside should be given to the manager and none of the downside, because if you are looking at a real alignment of interest you are going to share both. There has been too little of performance fees being structured in such a way that they do align interests across the board. It is difficult to do, but possible."Watson Wyatt has sought to work with fund managers to push for the inclusion of a number of important - albeit somewhat jargonistic - provisions: ghost years, claw backs and high water marks. "Good investment managers want to maintain the relationship with their clients and they want to build their businesses, so they are quite prepared to have those discussions," says Grahame.Invesco Real Estate, for example, collects performance fees on some of its closed-ended funds and these work on a rolling two or three-year timeframe with a "phased payment" mechanism. Fund manager Rory Morrison explains this is a positive feature for the investors, because a manager will not receive a large fee for the performance in a particularly good year if this is immediately followed by a year of comparable underperformance."It is over a three-year period, which smooths out spikes," he says. "There is always going to be a risk with a performance fee that it encourages short-termism rather than long-termism if your performance fee timetable is over a short period. This is why we tend to have a three-year rolling programme."
It is not just the performance fees that need to be scrutinised, but also management fees. Watson Wyatt identifies the practice of calculating base fees as a percentage of total assets under management as one of a number of flaws in common fee structures, because this can encourage the asset gathering.

This is an area of concern for Nielsen who observes an increasing trend towards managers increasing the size of their funds significantly without adjusting the level of management fee. A fund that doubles in size automatically doubles the management fee, but this can in turn reduce the effectiveness of additional incentive fees.
"We want to pay a fair and reasonable management fee to cover the manager's cost. We don't want him to become rich off just the management fee," Nielsen says. "We have seen many funds where the balance between the performance fee and the fixed fee is unreasonable and we can't see why managers would go for the incentive fee at all, because they are earning money on the management fee."Meanwhile, Mikko Räsänen, portfolio manager at Finnish multi-employer pension fund Ilmarinen, is concerned about what he sees as "one of the key issues going forward" - funds being unable to retain staff."Nowadays I see a lot of employee turnover in fund initiatives and that is not a good phenomenon for investors," he says. "At the end of the day we are buying the brains and the deal flow of the fund managers. That is a negative phenomenon at the moment. It is crucial to us that the fund managers and the key employees, asset managers, portfolio managers in those teams are very motivated and incentivised and they receive a big portion of the carry."

However, it is possible that staff turnover could become more of a problem in the current market environment, with many fund managers seeking to incentivise their staff members by offering them a share of a performance fee. If return expectations are moderating, this could cease to be an effective method."If returns are going to be lower in the next two years than they have been in the last four years, an employee who has a share of the performance fee is probably less optimistic now," Grahame says. "I am not certain performance fees are always going to mean people will stay with a fund and we might start to see some staff turnover. That said, you could argue the climate and uncertainty could equally make a fund manager stay if opportunities are not evident elsewhere, whatever the performance fee. But the point is there are some implicit assumptions made with performance fees that need to be questioned."

In the face of lower return expectations it is likely that hurdle rates for new fund offerings will moderate accordingly. However, funds that were written close to the end of the bull run may have hurdle rates that look far more aggressive today than they did when they were originally set. Investors will naturally want to keep managers to their initial promises, but a hurdle rate that is deemed unrealistic in the eyes of fund staff is likely to render a performance fee ineffective as an incentive."There are a lot of funds written two or three years ago, which now would look like very aggressive hurdle rates. But the world has changed," says Patel. It is debatable whether real estate should follow the lead of equities and bonds and allow hurdle rates to be revised if market conditions change. Patel admits this a difficult topic, but AXA REIM has started to discuss the issue with investors."These are very difficult and hard discussions, but the key here is keeping the right balance of incentivisation," Patel says."We have one or two funds where we think the hurdle should come down, but in reality it is not our decision. Some of these things we should talk about, because it happens in other asset classes. Today there may be several funds [not specifically AXA funds, that is] that may not be perfectly aligned because the market is so different."

AXA REIM also offers alignment in its funds through co-investment on a number of levels. This can be in the form of one of the AXA group companies investing capital in the fund (this is at the discretion of the company's chief investment officer and is on a pari passu basis, whereby they receive the same terms as other investors in the fund). There is also the opportunity for individual managers to invest in the fund and some AXA REIM funds employ a carried interest scheme where individuals who work for the fund (whether full-time, part-time or indirectly) are able to invest their own money and receive a return if the fund outperforms."There are other models out there where the carry will only go to the top five or six senior people and they could stand to earn millions," says Patel. "We don't have that approach. We have much more of a team collegial approach."
ING Real Estate has been publicly championing co-investment recently, and Peter Macpherson, head of investor relations at ING Real Estate, says the firm is open to both corporate co-investment and what he describes as personal alignment - staff putting their own money into the fund."We have clients, globally, who now will not invest in a product unless there is a personal co-alignment," he says. "They do expect an element of corporate co-investment, but some investors are more focused on the personal alignment of the managers rather than the corporate alignment."

However, some asset managers like to promote their independence. Invesco Real Estate is one example (although the company does sometimes offer co-investment in more niche products)."Traditionally at Invesco we have set ourselves up and promoted ourselves in the investors' eyes as a wholly independent fund manager," says Morrison. "We are not aligned with a bank or an insurance company or a pension fund. We don't have a balance sheet that we use to make significant investments in products and then market what is left of the product to the institutional investment market. We produce funds where we tend not to invest, because a lot of investors find that more attractive, because they feel there are no conflicts of interest. So, it does go both ways."
Co-investment is seen as an attractive way of creating alignment at the Universities Superannuation Scheme in UK. However, Graham Burnett, head of property, does not see it as a prerequisite. "It is not that funds cannot work without it," he says. "But it is an attraction, particularly when it is meaningful."ATP, meanwhile, has increased its focus on the issue and is demanding higher co-investments from both managers and their teams. "Many managers have doubled the size of their funds, but maintained the same nominal amount of co-investment," Nielsen says. "This is not acceptable for investors. We will in all our future investments demand higher co-investments from managers and the key persons."