COMMENT: Good and bad ways of maximising fee income in volatile times

From PERE’s conversations with two leading private real estate investment management firms this week, it is apparent that current market pressures are provoking various forms of strategic hedging.

Each of the managers we spoke to shared a perspective relating to a strategic hedge. Both made sense, and yet only one of them was conceived with investors’ interests in mind. The other arguably was not.

The first manager revealed how it was introducing an open-ended, core real estate product for its clients for the first time. Of course, there is not much unusual in that. However, this was a traditionally opportunistic manager adding a lower risk and return alternative to its offering, because investors asked it to.

Accepting that low-to-negative interest rates will be a reality for a prolonged period of time, this manager’s argument was that those firms which possess a considerable market presence are nowadays duty-bound to offer clients property products that can generate the 200-basis point margin over government bonds they require. In other words, given the current climate, there are not enough core products to match current capital demand, and so groups that can offer them, should.

For opportunistic managers with the skills and resources to do it, such a strategic addition also serves as a revenue hedge as markets top out and higher yielding strategies become increasingly harder to service. While two and 20-style carried interest is not center stage, core oftentimes means a more reliable source of income, which is crucial for keeping the lights on.

The subject of fee income brings us to the second, debatably less client-friendly manoeuvre that PERE heard about this week.

The manager which described it to us, normally a direct property buyer via joint ventures or clubs, revealed how a meaningful component of its current deal pipeline had little competition for it. Not because the assets in its pipeline were unattractive. On the contrary: they would suit a whole spectrum of buyers, from REITs to sovereign wealth funds, and all the investment management houses in between.

The issue was that the sellers were actively discriminating against many potential suitors by accepting only bids that would allow them to retain lucrative follow-on management agreements. In other words, if accepting the highest bid would mean also the cessation of asset management fees, then it will be rejected in favor of a buyer without management capabilities.

The latter type, which includes the opportunistic manager we spoke to, obviously stand to benefit because the competitive landscape becomes less crowded. But from the point of view of the investors of the current owners, it seems likely that certain fiduciary promises made to them are at risk of being violated.

So, on the one hand, we have managers reacting to future uncertainty by meeting their investors’ demands for assets that are lower down the risk curve. That’s good practice. On the other hand, we have exiting owners of real estate which are turning a blind eye to offers which would require them to give up asset management fees. 

That’s not so good, and arguably short-sighted: when the time comes to raise fresh capital, the clients of these managers may not be inclined to come back in – if indeed they come to realize what has been going on.