pfm: You’ve told us that real estate managers, unlike other private fund models like private equity, charge fees on their co-investment vehicles. What gives?
Hass: It’s important to note that historically private equity funds have generated frequent co-investment opportunities, so many private equity fund investors have become accustomed to, and are interested in taking advantage of, these opportunities. In the real estate space, particularly with respect to closed-end funds, co-investment opportunities have historically been much less common and most real estate fund investors are simply much less ready, willing and able to take advantage of those co-investment opportunities when they do arise. It’s becoming more common now than it has been in the past, but still not nearly as common as it has been in private equity funds.
We’ve seen this same trend play out in private equity too though (i.e., strong demand for co-investment rights but little uptake on offers), is there something unique about a real estate deal exacerbating the trend?
Somewhat, yes. The reason is that a real estate investment involves not only an important decision on the front end about whether to acquire the investment, but also involves continuing extensive and intensive investment management while the investment is held. Most co-investments arise in investments that have opportunistic or value-added strategies, which require the investment manager to be heavily involved in decision making at the property operation level relating to day-to-day management of the property, as well as critical detailed decision on property development, redevelopment and positioning in the market. By comparison, private equity funds invest in portfolio companies with management teams to manage the business of these companies. For private equity funds and their co-investors, the investment manager plays an oversight role, leaving management of the portfolio companies to the management teams of these companies. For real estate funds and their co-investors, the property is the “business” and management of the property business is typically hands-on for the investment manager rather than just oversight.
For that reason, the manager has a continuing intensive management obligation throughout the entire investment holding period, so they are compensated in a like manner, the same way they are compensated at the fund level.
Do investors generally accept these fees as the norm? Or have your clients experienced pushback in the past?
Occasionally, real estate fund investors who are interested in co-investment opportunities try to negotiate for no fees, but in our experience no-fee co-investments are very rare. With greater frequency, however, real estate fund sponsors will agree to a reduced fee or reduced carried interest either in a side letter or deal-by-deal.
Investors think about fee reduction as a way of enhancing their overall economics, but they really don’t debate the fact that some fees ought to be paid for the management effort that goes with co-investments. For example, if an investor has a $100 million investment in a fund for which it is paying management fees of 1.5 percent annually, if the investor can make co-investments for another $100 million and pay fees of only 1 percent, its overall management fee is reduced to 1.25 percent.
One of the issues that typically arises in this context is: should the amount received by the manager in fees and carry go to the fund or go to the manager? That debate is ongoing in the industry.