Fees designed for a seller's market have survived into a buyer's one. So are the old structures still working - and, if they aren't, what are pension funds going to do about it? Shayla Walmsley reports

Some pension funds believe they're paying fund managers too much for too little - or at least too little that's clear. Michael Nielsen, head of ATP Ejendomme, the real estate subsidiary of the €46.9bn Danish supplementary fund, claims that the shift from a market that favoured sellers to one that favours buyers hasn't necessarily led managers to work harder for the business still available. Instead, fee structures introduced for a rising market have carried over into a falling one. In contrast, many fund managers - although reluctant to comment publicly - believe that if they deliver they will be able to attract the same level of fees they did in better times.

According to a recent INREV study of management fees and terms across almost 250 unlisted property funds, annual management fees are almost ubiquitous. Most (61%) charge based on gross asset value (GAV), though other bases include net asset value (NAV), committed capital and drawn capital. Core funds charged an average of 0.59% of GAV, with value-added at 0.65%. Opportunistic funds are most likely to charge a fee based on committed capital, with an average fee of 1.37%.

"In Europe, we invest in special funds [Spezialfonds], which have their own fee structures," says Wilhelm Korfmacher, managing director of WPV, the €1.1bn German pension fund for chartered accountants. "Some special funds include performance-related fees but most focus on fixed fees."

In future, predicts Korfmacher, fixed fees will make up a smaller percentage of the overall, the total expense ratio (TER), an overall cost metric that gives the annual operating costs of the fund as a proportion of the value of its assets. "The future will be smaller fixed fees and a sharper focus on performance-related fees with long-term-oriented high watermarks.

"I'm not saying that fixed fees will be small but they will be smaller than they are now," he adds. "Investors will try to convince companies that it is a good way to work because it aligns their interests. If the fund manager does a good job, investors will be pleased, and they won't have problems paying a performance-related fee. If the fund manager doesn't do a good job, they won't pay it. That's alignment."

This is a new take on an old issue - alignment - and fixed fund management fees don't offer it. In contrast, performance fees measured against hurdle rates over a specified period are more likely to. It's up to investors to do their own negotiating over what these hurdles might look like - in absolute terms, relative terms or both.

The more comfortable investors are with an asset class, the more likely they are to negotiate, according to Stephen Ryan, senior investment consultant at Mercer's Dublin office. "If it's a popular one, they'll pay up but they will negotiate on more established asset classes such as bonds and equities," he says. "Private equity fund managers can maintain their fees."

Similarly, the less expertise a scheme has in a specific region, the less likely it is to baulk at even relatively high fees. WPV recently justified its investment in an Asian fund of funds - despite the higher fees charged by these funds - with reference to the fund managers and expertise in the region.

In any case, the danger, according to Cordea Savills CEO Justin O'Connor, is that performance related fees do not cover running costs. "Base fees need to be sufficient to properly resource the teams required to manage funds," he says. "Performance fees should be there to incentivise fund managers and teams to generate profits and personal carries - not to finance operating costs."

For Ryan, the contours of the new fee structures are "an open-ended question". Whether the emerging model will be a low fixed fee with a slightly higher performance-related fee, for example, will be determined by how dependent the manager is on an average fee.
Some fee types, such as the catch-up fees levied especially by opportunistic funds, can be "nasty and complicated", argues INREV acting CEO Andrea Carpenter. Under this formula, fund managers "catch up" with investors' profits once the latter have achieved a percentage internal rate of return by splitting profits 50-50 until the manager's share reaches, say, 20%. In principle, the formula only works when funds achieve a relatively high annual return.

In any case, Dirk Söhnholz, managing partner at Feri Institutional Advisers, points out that high fees won't necessarily drive outperformance by fund managers. "The major point is alignment of interest, for example with the manager investing a substantial part of his net wealth in the fund on the same terms as the investor," he says.

According to INREV, fund managers' and investors' interests are aligned in the sense that it is of advantage to neither for outdated fee structures to fail to reward fund managers adequately for performance. But the way some fees are currently structured in fact work against the interests of the pension fund, suggests Nielsen. "There is a question whether fees should be based on committed capital or drawn capital.

If you only pay a fee on drawn capital, it will incentivise managers to buy properties," he says. "In the current market, it is important that managers don't buy before they can see the long-term business model of the property. We want to pay a fee on committed capital - though we will look at it case by case. We don't want managers to buy just to get something on the balance sheet."

In contrast, Prudential Real Estate Investors CEO Allen Smith in December told IPE Real Estate that investors will no longer be willing to stump up fees on committed capital, citing it as evidence that investors are upping the ante when it comes to their expectations of fund managers. Committed capital-based fees benefit fund managers because they're relatively high. Yet these fees have the advantage of not putting pressure on the portfolio manager to invest capital at a speed not justified by the quality of available assets.

Pension funds might even be willing to pay relatively high fees based on performance, depending on the type of fund. "In general, we think we should pay a reasonable manager fee," says Nielsen. "To some extent, it depends on whether it is, for example, on a focused or a pan-European fund. But in general we want to know what we get from the fee."

In other words, what is most important to investors might not necessarily be the scale of the fees but the transparency of the fee structures. INREV claims there is a growing appetite to understand fees, terms and costs for different structures, based on an increase in the number of funds providing information on fees.

Yet the authors of the December study on fees, which covered 50% of the unlisted fund universe, acknowledged that unlisted funds still charge fees on various bases, with continuing diversity in definitions and fee items charged. Among its recommendations is that fund managers streamline the number of fee items and improve underlying
definitions in the interests of transparency. The net result of this diversity is to prevent investors comparing funds.

The lack of standardisation often emerges in the same breath as high or opaque fees. At INREV's annual conference in June, chairman Johan Van der Ende identified 80 fee models operated by fund managers.According to Ryan, "fund managers need to tell us what the fee adds up to for the end-user" - for example, via a total cost measure such as the TER. "End-users need to know what they're getting."

The problem, says Söhnholz, is that often pension schemes don't understand the fees they're being asked to pay. "Many investors do not model the full fee impact, including hidden costs and fees," he says. "Investors should rely on internal or external professional and experienced analysis of funds."

But isn't there a responsibility on the part of investors not to negotiate with fund managers with opaque fee structures - or at least to demand to know how much bang they're really getting for their buck? "I've noticed that investors have different views and different ways of approaching the issue," says Nielsen. "Some are more focused on negotiating fees, others take what the manager offers. It will also depend on whether the manager has a track record and whether the investor has a long relationship with the manager. "In general I have the impression that investors are more critical, that they're looking deeper into the terms and conditions."

He adds: "It's a combination of things, mostly driven by a market that has forced investors to be much more careful. They're looking deeper into the skills and terms offered by their managers. Times are changing and it's up to the manager to come up with good products. Fees are part of it but so is alignment and a track record in real estate - not just a financial track record."

In short, the expected shift in fund managers' approach to fees is representative of a broader change in investors' demands. Söhnholz identifies fee structures as just one element that investors need to focus on - with, for example, co-investment and documentation. Too much emphasis gets placed on the fee issue at the expense of the others "because fees are more transparent than the other factors".

If fund managers rethink their fee structures, it isn't necessarily the case that all investors will benefit equally - nor that they should. In fact, the net result of across-the-board reduction of fees could be an increase in some fees.

Once a fund manager offers one investor a better deal on fees, "news gets out among the trustees of other pension funds," says Ryan. "There's an issue around confidentiality. If the manager gives a fee reduction to one client, he needs to be careful about the others."

Ryan points to ‘most-favoured-nation' clauses in the US which legally oblige fund managers to give investors the best going rate. "Transparency is a good thing but the US model is both good and bad. If it becomes the norm, average rates might go up, so you'll see an overall increase."

Either way, there is some evidence that fund managers faced with investors pulling out or replacing them are warming to the idea of flexibility. "When it comes to fees, the pressure is on underperforming managers," says Ryan. "It's coming from trustee boards, and it's about performance-related fees. Up to now there hasn't been that much of it but now we're seeing it happening. Normally, the manager is close to being fired and volunteers a new fee structure."

It isn't just fees that are coming under attack from pension funds more willing to negotiate in belt-tightening times, either. "As you'd expect in a downturn, investors are much more value conscious, not just with fund managers but with professional services and lawyers, too," Ryan adds. But, despite mooted pressure on fund managers to rethink their fee structures in the wake of the market shift from sellers to buyers, few pension funds have yet seen the benefits.

"It's too early to say whether fund managers have changed approach in response to changes in the market," says Theo Offringa, real estate portfolio manager at TKP Investments, established by the Dutch KPN and TNT pension funds. "But I'm not seeing any more flexibility - not least because there are so few new initiatives now. But what I am seeing is fund managers doing their soft marketing at an earlier stage. They're coming to us to talk about strategy." Korfmacher agrees. "I'm not seeing pressure on fund managers to alter fee structures yet," he says.

Yet Nielsen, for one, holds out hope that fund managers will respond to the realities of the market and bow to pension-fund pressure. "Over the past three to four years, managers had the power," he says. "If we asked sensitive questions, they could just go to an investor who didn't. Now we're finding managers are more ready to discuss their terms. We will talk to managers ready to do so."