Realty fee realities

Real estate opportunity funds sport higher fees than other property vehicles to justify the process of searching for high-return investments. Limited partners can use a variety of tools to ensure their GPs are earning those fees. By Aaron Lovell

Target IRR before and after management fees by fund strategy (%)

Target IRR before 11.4 14.7 21.6 15.9
Target IRR after 9.8 12.4 17.7 13.4
Differential 1.6 2.3 3.9 2.4

Lee says that the current market has allowed savvy opportunity funds to find core investments and rework the financing or use leverage to try to hit a 20 percent return. ?Rather than picking up the glimmer in someone's eyes and really taking a risk for the big return, some investors have argued that GPs are buying trophy assets, levering them up and financially engineering higher returns,? says Lee. ?They have observed that in some instances, if the asset doesn't hit a 20 percent return, after the carried interest and the 1.5 percent management fee is paid, the net return to the investor looks more like a value-added or core plus return. These investors are asking, ?Why was that asset an opportunistic play?? All it did was make money for the sponsor.?

Still, as Lee points out, not all of the data suggests that stable, class-A properties are being passed off as opportunistic investments and, more importantly, the market continues to support the current fee structure. Any sort of fee reform will most likely have trouble gaining traction until some of the largest investors begin to balk, but, then again, sizeable investors are often able to tweak the terms to their benefit, including management fees.

?Until [funds] have problems raising money based on the terms they're putting to market, those terms aren't going to change,? Lee says, adding that first-time funds looking to establish their track records might have to show more flexibility in their fee structures.

?It's going to take several lead investors, $250 million and up, to convince any large, global opportunity fund, who has been out to market and is now on their fourth, fifth, sixth or seventh fund, that their fee structure needs modification,? he adds.

Even if an LP isn't a nationally recognized name with hundreds of billions in assets, it still has the power to exert some level of control over private equity real estate commitments. Investors can push to increase the transparency of a general partner through detailed reports, password-secured websites or advisory boards, as well as utilizing more active controls like ?key man?provisions, increasing the alignment of interests with the fund's dedicated team and carefully choosing the preferred rate of return. By getting involved, investors can make sure their GPs are finding and executing an opportunistic strategy ? and earning their fees.

But it is also important to utilize these controls sparingly, as too much oversight can handicap GPs. Lee says that more stringent investment guidelines can chip away at the flexibility and discretion LPs are paying their fund managers to exercise. ?It's an expensive service,? he says. ?If an LP wants to go out there and make their own investment decisions on an asset-by-asset basis, then they are over-compensating the sponsor. But they're also in the wrong vehicle.?

Braxton suggests one way GPs can demonstrate that they're earning their money is through comprehensive and clear reporting. ?We have found that sponsors who do an exceptional job of reporting and communication with their LPs seem to have the true alignment of interests,? he says. ?Reporting is critical.?

Braxton adds that LPs are beginning to focus on making the LP/GP relationship as transparent as possible, with the help of better reports and up-to-date information. ?Years ago, it wasn't common to have these protected Internet sites where you could log-in to your account with a sponsor and take a look at all the reports that are on the system, all the historical data. Those are very valuable tools.?

Lee suggests that advisory boards are another way to increase a fund's transparency, providing a framework where information can flow to investors, conflicts of interest can be settled and ongoing dialog can be maintained between investors and sponsors.

When moving higher on the risk/reward continuum, talent becomes increasingly important, so LPs might want to review their relationship with their dedicated teams. Braxton points to ?key man? provisions as useful tools. This often allows the LP to pull out their unfunded commitments if the fund's GP (or team of GPs) is no longer managing the fund.

Also, making sure the fund's dedicated team is cut in on the profits helps keep the interests of the LP and GP aligned, as well as ensuring that the rest of the investment professionals don't jump ship because they're not getting a piece of the pie. LPs should inquire as to how much of the promote the fund's dedicated team will receive, as well as how much capital the dedicated team is investing into the fund.

Both Lee and Braxton suggest that the preferred return rate can also be used to control how opportunistic a strategy the GPs will pursue. For example, a higher preferred rate, perhaps with a ?catch-up,? will lead GPs, who, in an opportunity fund structure are already working towards a 20 percent return, to execute riskier deals with a higher upside. With a lower preferred rate, LPs will usually see more moderate returns, less risky investments and a shorter timeframe on their investments.

But in the end, making sure a fund is pursuing the agreed upon high-return opportunity strategies – and thereby earning those higher fees ? comes down to communication between investor and sponsor.

Braxton says, ?The biggest carrots are the promotes and the fee structures, but, as in any other business, a successful relationship is ultimately based on trust and communication.?