Limited partners in real estate funds still may not be fully aware of all the fees that general partners are charging them, delegates at the PERE Forum in New York heard last week.
“I think that is a real problem that is going to continue to evolve,” said Jarrod Rapalje, senior consultant at Cleveland, Ohio-based advisory firm Courtland Partners, reacting to how the US Securities and Exchange Commission (SEC) already was investigating areas in mainstream private equity to do with fees and consultants.
“If it were to turn out that the real estate manager was charging additional affiliate fees that no one was aware of, it could become a big problem,” added Rapalje.
Fellow panelists Paul Mehlman, partner at Landmark Partners; Joanne Douvas, former partner at LGT Clerestory; Michael Dombai of Cortland Capital Market Services; and Preston Sargent, executive vice president of Bailard, debated various areas where transparency was less than ideal.
Though none suggested fund managers were liberally engaging in non-transparent practices, they focused on managers potentially pushing off the costs of personnel onto affiliates so that the fund would bear those costs and thus make the management fee more profitable. Linked to this, they asked how investors would know if the manager was doing this. Delegates also heard that, even if it was present in fund documentation that a general partner was allowed to charge for property management, leasing and other costs, it should nevertheless be quantified and reported.
The majority of the time, managers using affiliates disclose that they have in-house leasing, development and other services receiving fees from the fund. In these cases, panelists said it was important to understand the manager was charging the fund market rates for the services provided to that fund. Good managers provided limited partners with clear disclosures of current market rates for these services, the participants agreed.
Highlighting other controversial issues, Rapalje revealed one instance where a firm was about to close on a fund where the leverage calculation was “quite loose.” It took a larger investor rather than a smaller investor who first noticed it to engineer a change after pointing out it could potentially understate the leverage. “Some of the time, fees are not clearly disclosed,” he added.
Panelists said the reasons for various controversial fee issues going unchallenged included: investors sometimes failing to notice; investors not wanting to challenge a manager or not wanting to be shut out of the next fund; and not wishing to establish a bad relationship with the manager.
The debate over transparency in real estate comes as the spotlight continues to shine on mainstream private equity.
In September, the SEC charged a New York investment advisory firm with breaching its fiduciary duty to a pair of private equity funds by sharing expenses between a company in one’s portfolio and a company in the other’s portfolio “in a manner that improperly benefited one fund over the other.”
An SEC investigation found that, while Lincolnshire Management integrated the two portfolio companies and managed them as one, the funds were separately advised and had distinct sets of investors. Despite developing an expense allocation policy as part of the integration, it was not followed on some occasions, resulting in the portfolio company owned by one fund paying more than its fair share of joint expenses that benefited the companies of both funds.
It also comes in the wake of comments by Andrew Bowden, director in the Office of Compliance Inspections and Examinations at the SEC, during a forum held by PERE’s sister title, Private Equity International, in May. “Lack of transparency and limited investor rights have been the norm in private equity for a very long time,” he said at the time. “By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50 percent of the time.”
Bowden added: “Some of the most common deficiencies we see in private equity in the area of fees and expenses occur in firm’s use of consultants, also known as ‘operating partners’, whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not independently afford. The operating partner model is a fairly new construct in private equity and has arisen out of the need for private equity advisers to generate value through operational improvements. Many limited partners view the existence of operating partners as a crucial part of their investment thesis when they allocate to private equity funds, largely because the operating partner model has proven to be effective. Many of these operating partners, however, are paid directly by portfolio companies or the funds without sufficient disclosure to investors.”