ILPA: The guidelines heard around the property world

This article originally appeared in the March 2010 Private Equity Manager Monthly, a monthly printer-friendly publication delivered to subscribers to Private Equity Manager.

The investor -friendly terms and conditions guidelines that were drawn up last year by the Institutional Limited Partners Association (ILPA) were originally designed for investors in traditional private equity funds. Private equity GPs have certainly felt the effect of the guidelines’ dissemination: many of them have spent the last several months negotiating with LPs who have started showing up at meetings with the ILPA guidelines in hand. However, the ILPA effect is quickly spreading to other corners of the alternative investment industry as well: GPs in the private equity real estate world are increasingly finding that their prospective and existing investors are asking them to adhere to the ILPA guidelines before agreeing to new commitments.

Though the guidelines were not written with real estate funds in mind, LPs in this space aren’t going to settle for less than what is now widely perceived as “market terms” in the buyout space. PEM spoke with two executives with experience in the real estate field to get their impression of the fundraising market right now, and what impact ILPA is having on it. 

In almost every conference I’ve gone to in the last year in the United States, the ILPA guidelines have been talked about. And what that means is that people are going home to their computers and tracking them down and printing them out and saying “we should all be looking at this and seeing what we missed”. That’s good, because people are talking about what makes sense. The good thing about the ILPA guidelines is that they have put in one place the various categories that people need to be thinking about and given some common sense guidance on terms.

They say for example that the incentive fees should be a portfolio test, rather than a deal-by-deal incentive. Historically real estate funds used to have deal-by-deal incentives. That really benefits the GPs; they get their carry sooner, so they exit the good deals sooner, and they leave the losers in the fund. Real estate moved out of that a long time ago, and there are very few funds we are in that don’t have a portfolio test. I think because the real estate market was so fragmented, the LPs in the real estate market went through hell in the early 1990s. After that, the LPs exerted a lot of pressure. They said they would only commit if they got preferred returns and a portfolio-wide test on the carry.

The private equity business is more concentrated, with some big names that have a lot of power, such as KKR and Blackstone. They have got a lot of power vis-à-vis the LPs I think, and in real estate it has been a little different. Real estate is a much broader, more fragmented market that is more locally oriented. So there are some terms that have benefited LPs in real estate that they don’t always get from the big name private equity firms, such as preferred returns and hurdles. In real estate you virtually always have a preferred return hurdle or something like that.

If you go through the ILPA guidelines, a lot of those terms are already included in almost all real estate funds. They all have a preferred return, and historically they have all had catch ups. But I don’t know that I’ve seen a private equity fund agreement that has every single one of the ILPA terms. That would be the best case for an LP. 

I think the thing we saw changing the most in the last two years is that the catch-ups are slowing down. It’s really rare to see an LP come at you with a proposal for 100 percent catch-up or an 80 percent catch-up to their benefit. Now it’s 50-50 at most. The other thing that is changing is that LPs are pushing for a no-fault divorce in the agreements, and that was not typical earlier. A supermajority vote is required, but there is the nuance of what constitutes a ‘supermajority’. I’ve seen two-thirds, three-fourths and 80 percent qualify as a supermajority for a no-fault divorce clause, and that is relatively new. I’ve seen this kind of interpretation before but rarely, and now in every case people are looking to redefine that term.

We haven’t seen the ILPA guidelines drift into the real estate space too much yet. I think it is coming, but from my meetings with institutional clients I think they are spending their time fighting fires and not worrying about ILPA too much. I am personally surprised by how many managers I talk to that don’t know what I am talking about when I mention the guidelines. Those of us in real estate live in our own little world for now, but I think the impact of the guidelines is coming.

What I call the core concepts of the guidelines – cost, base, management fees – are going to migrate into real estate. I would be surprised if real estate GPs adopt the guidelines word for word, because real estate is a different animal, but I think the basic concepts are going to be adopted. I’ve been surprised by how little the managers seem to be focusing on the changes that are about to happen to them.