Governance issues and the investor/manager relationship occupied centre stage at this year's PREA Annual Plan Sponsor Real Estate Conference in Beverly Hills, as Martin Hurst reports.
Managers have often been criticised for poor governance, especially during the crisis, but there is also a clear recognition that investors and managers must work together for a closer and more constructive relationship.
This was apparent during the discussions at the PREA conference. On the subject of fees, conversations reflected sentiment in Europe about the need to create a more sustainable fee structure.
"Fees should reflect the fund strategy; we need a form of tiered compensation so that if managers don't reach the performance goal they can still earn something," one manager noted. "Investors must understand that even when the markets are in decline managers still need to live."
Another added: "LPs must recognise GPs have to have to pay good talent in order to retain it."
There was also criticism of fees based on assets under management. This is now less common than it was as fee structures come under increasing scrutiny. "As assets under management (AUM) grow the costs do not increase proportionately," one manager said. "They do not encourage managers to be entrepreneurial."
An adviser agreed that adding that "asset management fees just encourages managers to increase AUM. They encourage managers to make bigger bets, which increase the risk of bigger losses."
An investor spoke of his experiences trying to reform the fee structure, and described it as "frustrating at times", adding: "Some managers just say no - which is not the way to keep investor business in the future."
Co-investment is increasingly used as a means to align interests, but the detail is critical. One manager noted: "The important question to ask is ‘where does the co-investment come from?' We must make sure it really is the money of the managers responsible for the fund - that it is part of their net worth."
However, this was dismissed by another investor who noted: "I don't see much correlation between co-investment and performance; it's more about people and trust."
Rebuilding trust has been a central theme and much of the blame for the losses suffered by investors has been directed at managers although increasingly investors are being brought to account. As one former investor noted: "LPs gave up governance issues that they had before and this has now created tension between the GPs and LPs."
A manager added: "They should know what to look for and also know when to say no - otherwise it creates a poor dynamic and alignment."
Another stressed the importance of investor engagement. "This is an important part of fiduciary responsibility. LPs must be prepared to dig down and discuss with managers how they got to where they are today and see what they can do to help out."
Investors should vote, "after all they are paying for the meetings," was the opinion of another manager. "They should also have meetings among themselves to discuss issues without waiting for the annual meeting with the manager."
An adviser went further: "If LPs have negotiated for rights in the documentation they should use them assertively. Otherwise they are breaching their fiduciary responsibility. It is amazing - some GPs don't get it that LPs need to meet. If they don't allow this they will lose confidence of LPs."
The overall trend is that investors are becoming more interested and engaged, and conversations at the conference bore this out. "For a long time investors requested reports from their GPs on an annual basis and didn't ask questions," one manager noted. "Now LPs have started to ask questions - and need more timely and regular reporting. Some of this is growing pains; once both sides have come up to speed the tenor of the conversation will be very solid."
As part of the engagement process, the onus is also on investors to "be more commercial," as one manager put it. He said: "Investors must try to understand what the GP is trying to achieve."
Another added that "when LPs understand the portfolio then GPs can be authorised to manage. LPs hired GPs to what they can't do so it is a question of trust. Of course, GPs must first establish that trust."
But for LPs the road to achieving a good understanding may be a long one. One manager noted that "many investors do not even have a real estate background; some of the state funds have staffing issues. There is a lack of accumulated experience on the LP side. They need to ask much more difficult questions of GPs." An investor agreed, adding: "The ultimate responsibility is with the investors so their staff so have to wise up."
One manager stressed "LPs should focus on picking the right person with a fiduciary mindset", adding: "Don't place too much reliance on an the documentation."
Fiduciary responsibility was called into question again when one manager said: "LPs need to read the agreement rather than just signing it. GPs need to do the same - their lawyers have drafted the documents but many GPs haven't themselves read their agreements properly."
Where several investors are involved in a fund, communication must be carefully managed. As one manager noted "there is a critical mass of investors. If some are selected as representatives discuss issues with managers we will get things done but if all investors take part there will be mayhem".
As the balance of power has shifted more in favour of investors, managers must be prepared to be accommodating. "GPs for their part must be flexible and be prepared to go beyond what the contract says as circumstances change, otherwise they will upset their investor clients," one manager noted. "There should be flexibility in the documentation so managers can do the right thing for the fund."
Another take-out from the discussions with delegates was the suggestion that investors and managers should be more forward-thinking as they draw up their contracts. "We have to be better at anticipating possible problems using the lessons we have learned in the past," said one manager. "The documentation should address the ‘what ifs'. Take refinancing risks: none of us has had to worry about that for years, but now the risks are with us again. We must have the vision to think though what those financing structures could be."
On the subject of financing, there was agreement that one key lesson for all to learn concerns leverage. As one manager noted: "We are so heavily levered it is paralyzing. If we bring this down and accept that real estate can produce results within certain ranges we will have more options to deal with problems. Leverage takes away lots of options."
The investor structure of the fund is increasingly seen as critical in the relationship dynamic. For some years investor clubs have been growing in popularity, as ‘like-minded' investors have tried to align themselves to achieve more control and a better deal generally with the manager. However, there are drawbacks, especially during the current challenging times. "The club magnifies the problem if something goes wrong with one investor," said one fund of fund manager.
Over time "investor interests may diverge," noted one fund manager. "The issue of how to deal with issues that may arise in year five rather than year one is rarely considered. The result may be paralysis. Investors in separate accounts don't have this problem."
"The structures must work for everyone by recognising the strengths and weaknesses of both parties," said another.
A client who wants to sack the manager "should get good legal and investment advice," according to one investor. "They should not work out their own deal. They need someone they can trust, and if they don't trust their GP they should use the adviser to re-establish that trust. GPs should embrace the adviser."
As the markets remain uncertain, caution and discipline are today's investment watchwords. "We've seen managers in a strategy drift," noted one investor. "It's important to stay with core competence. Prudence on the part of the manager demonstrates confidence in your investors."
A manager agreed, adding: "The opportunity set is long-term and opportunities will arise; don't jump in too soon. Discipline will be rewarded. Be patient - stick to your strategy."
A fund of fund manager suggested: "Managers should not be frightened to ask the LPs for an extension of the investment period to give them more time to invest and get good opportunities."
Summing up, one investor noted that although there was a session with a specific focus on governance issues, governance also dominated other discussions. "This shows we're stuck."
So the need to rebuild trust in the US is as urgent as it is in Europe.