Investors increasingly want to make sure their managers' interests are aligned with their own, and they have the power to do so. Christine Senior looks at how
Falling markets have given investors greater power to ensure alignment of interests between themselves and their fund managers. If they are suffering, they want the pain to be shared, not as an end in itself but as a means of pushing managers to do better. If managers want to attract new money they have to be prepared to make concessions to their investors. For new vintages of funds negotiations are likely to focus on these issues.
The European Association for Investors in Non-listed Real Estate Funds (INREV) has recognised the level of concern around alignment and is currently producing a study into the subject.
The two most important tools at the disposal of investors to ensure their interests are protected are ensuring significant co-investment from the managers themselves and secondly through a favourable fee structure.
For more opportunistic funds, investors are clear that managers' willingness to put ‘skin in the game' is concrete proof of their commitment to work hard for the success of their fund. While investment can come from both the fund sponsor, such as a bank, or the managers themselves, clearly cash coming out of the pockets of those who are managing the fund on a day-to-day basis gives greater comfort that they will make huge efforts to ensure success.
Douglas Crawshaw, senior investment consultant at Towers Watson, regards this as "hurt" money, so the manager suffers too if something should go wrong. He says that investment terms should be exactly the same for both investors and managers: "Managers should become investors like other investors, so they sign up to the same documents as all other investors, including being responsible for paying their share of management fees."
Mn Services, which manages money for a number of Dutch pension funds, has over 100 partnership arrangements in more opportunistic investment funds. Richard van Ovost, the firm's director of international real estate, also emphasises the importance of the fund manager having a significant proportion of his personal money at stake in the fund. Van Ovost seeks a complete picture of the financial situation of the fund manager himself.
"I try to look at what their financial background is," he says. "I want to be sure the money they invest together with me is substantial for them. Sometimes they try to make a smokescreen over the fact that they are financing their co-investment via a bank or via future fees or other means, but we dig very deep into their private circumstances to see what they can contribute to the fund. Sometimes some have gone as far as to take an extra mortgage on their house."
If money is coming from the corporate sponsor, that too should be meaningful. Much depends on who the sponsor is. Five million pounds might be a modest amount to a large investment bank, but to a small start-up or boutique manager it could be substantial.
Charles Graham, co-founder and principal of real estate management business Europa Capital, underlines this: "If we go along and say we are a few individuals and the money is coming out of our pockets, investors would rather see something in the region of 1% or 2% of capital committed actually coming out of the individuals' pockets rather than 10% coming out of a bank. It doesn't get you up at 5am in the morning if banks put in 10% of the money; it does get you up at 5am in the morning if you have gone to your bank and taken it out."
The other way to bring managers into line using the fee structure involves a complex set of variables. Fees for unlisted real estate funds often follow the private equity model, but this may not be ideal for real estate funds. Discussions on fees centre on both the base management fee and the level of performance-related rewards for managers.
Fees levied on gross asset values are particularly out of favour with investors, based on the view that this encourages higher gearing and more reckless deployment of funds. INREV's recent report on management fees and terms highlighted that investors are less willing to accept fees based on gross asset values.
"Where the market is now you don't want to force fund managers to make investments to increase GAV, when they should wait," says Lonneke Löwik, INREV's director of research and market information. Nor do you want to encourage managers to increase gearing, which could be another consequence.
Crawshaw says: "The manager will argue that by taking on the maximum amount of gearing they are able to increase the amount of money to invest and therefore improve the diversification of the fund by buying more buildings. That is correct. But with an increase in debt comes an increase in risk."
If fees based on GAV are increasingly rejected by investors, fees based on NAV are not ideal either. The value of an asset is going to vary not only because of the manager's efforts but also because of market performance. Investors question why they should pay for that.
Ideally Crawshaw prefers fees based on capital invested, though he accepts this is not always reasonable for some opportunity funds in the early stages of their life, where managers need cash not only to buy buildings, but also to pay their skilled staff.
"We would accept fees on committed capital for a period of time then switch to invested capital after the investment period has expired," he says. "We don't want to encourage people to draw down money faster than they would otherwise want to do to generate performance."
Anthony Frammartino, a principal at the Townsend Group, says the industry is moving away from the model of fees based on committed capital.
"In the past in real estate we had moved to more of a private equity model, where you had fees on committed capital," he says. "Those fees on opportunistic strategies were anywhere from 1.25bps to 2bps in some cases, but the convention was more like a 1.5bps from day one on committed capital. The acceptance of fees on committed capital for most purposes is no longer accepted or favoured."
The ideal is for the management fees to reflect the true costs of running the fund by the manager. Though that is not always simple to discover, it is what investors are increasingly attempting to do.
"Investors are spending a lot of time understanding a manager's true costs, their true overheads, making sure the management fee is what is has always been intended to be, something to cover overhead costs and not to be a profit centre," says Frammartino.
Discussion around fees also means looking at the structure of performance-based fees. Stephen Ryan, senior investment consultant at Mercer, says in the market conditions seen recently performance fees can actually serve to disincentivise managers.
"Some opportunity funds were so geared toward performance-related fees that when the market dropped it seemed to some managers they would never get to the hurdle rate and they almost gave up hope," he says. "You'd think a low base fee plus a huge incentive fee would work to incentivise managers; in a contrary way if managers get depressed they could even walk away."
The US model of catch-up fees where often the bulk of the profits goes to the manager once the investor has received his preferred return is being called into question. These kinds of arrangements have often tended to be heavily weighted in favour of the manager, giving him a disproportionate reward for a lower return with some of the more aggressive profit splits.
Frammartino thinks pressure is moving in favour of investors. "In cases where catch-up fees had been more aggressive than 50/50 they are moving back to 50/50 or lower in some cases," he says. "We do see pressure on them to go away. I don't think they will. I think they will be reworked to be less aggressive than they have been."
Hurdle rates are also under pressure to rise. Where 8% was once common, these are moving up to 9 or 10%, or even reaching 12% in some cases.
The distribution of performance fees among personnel is also a source of concern. Investors prefer to see fee income filter down to all the members of the investment team, incentivising all to work hard for the fund. If the team leader, or worse still the management company, takes the lion's share of fees, more junior colleagues may lose motivation.
"If the firm takes 80% and of the remaining 20% the bulk goes to fund manager and only pennies remain for rest of team, that's not as good as if the team get the bulk of the money," says Crawshaw. "They know if they do well for investors they are going to make money. It is an incredible motivator."
But alignment of interests with managers is not the only kind of alignment sought by investors. A sense of common interest among fellow investors is also important. The rise of joint ventures and so-called club-style investments where like-minded investors join forces to invest in a fund is an indication of this.
Individual investors, as well as ensuring their fellow investors share their values, are also able to access funds at lower investment levels. But in any fund investors are keen to have more information about co-investors. A fund with a large number of retail investors in it carries certain risks, since they tend to have a herd mentality and might want to pull out en masse in a crisis.
"One of the emerging trends for the next vintage of funds will be making sure the manager is deemed to be aligned on the way down as well as on the way up, and also whether investors in a fund have some sense of common purpose and common goal," says Chris Cooper, head of investment management DTZ. "Nobody wants to see asset values being written down heavily because suddenly a run of a few investors want to desert the fund. These closed-ended unlisted funds are meant to be a long-term investment. One of the shortcomings is they could have less liquidity, so you have to be prepared to take a long-term horizon."
The German pension fund for doctors Ärzteversorgung Westfalen-Lippe has investments in 22 indirect real estate vehicles. Marian Berneburg, portfolio manager of real estate investments, says his fund's policy on how to achieve alignment varies according to the type of fund.
"In a core fund to align interests it's probably more appropriate to go all the way down to the asset manager and to the facility manager to have an incentivised fee structure on the level of the project, whereas in a more opportunistic one it's more of an entrepreneurial approach. That's where we want the sponsor to be committed as if it were their own business," Berneburg says.
He takes particular issue with cases where the hurdle rate and the target rate differ:
"If I have a fund come to me saying we have a target rate of 10% but our hurdle rate is at 6%, naturally I ask why the hurdle rate and target rate deviate - otherwise they are obviously not convinced they can reach the target rate. In our view hurdle rate and target rate should be identical and then anything above the target rate should be paid for additionally."
On an ongoing basis Berneburg is keen to keep abreast of what the fund is doing, understanding it and monitoring it: He says: "That doesn't mean I'm trying to do the fund manager's job. But I want to keep an eye on what's happening."
West Midland Pension Fund's approach is also to rely on both fee structure and co-investment to ensure alignment of interests. Co-investment says Mike Hardwick, the fund's investment manager, focuses the manager on deploying capital in a manner that is more likely to be profitable.
"At the same time, because the manager has shared money at stake, they are much more likely to invest in a way that preserves capital on the downside should an investment fail to meet underwriting expectations."
He gives a cautious welcome to tiered performance fees, now becoming more common in some funds:
"In some opportunistic strategy investments we have seen a move toward a tiered carry mechanism whereby carried interest is levied more heavily above certain performance rates," he says. "While we do not want to encourage reckless risk-taking we do see the advantages of such a system in aligning interests."