COMMENT: Keeper of the keys

Of all of the risks that private equity real estate investors face with their managers, key person moves rank among the biggest. So it’s no surprise that some institutions want to have more of a say in key person decisions regarding their investment partners. Still, on the surface at least, it’s not always apparent why this level of scrutiny is warranted. 

The Oregon Public Employees Retirement Fund, for example, last week disclosed that Dan Dubrowski, the co-founder of one of its real estate partners, Lionstone Partners, was planning to leave portfolio management over the coming years. In its commitment documents, the pension plan indicated that it had approval rights on Dubrowski’s successor. It also said, when the time comes, that a moratorium would be placed on new investments until a suitable replacement was found.

Such stipulations aren’t necessarily unique to Oregon or other plan sponsors. Still, they’re much more likely to be requested, and granted, when: one, the investor is an institution that can write sizable checks and, two, when the manager is a smaller organization that is more thinly staffed and doesn’t have a significant number of other institutional investors. Indeed, it’s hard to imagine the opposite scenario – with small investors dictating terms to large managers – being as common.

It is understandable why investors want to help make decisions on key personnel. In the case of Oregon, the pension plan accounts for 99 percent of the capital in its newly formed joint venture with Lionstone. In exchange for shouldering the vast majority of the risk in the partnership, it sought to control some of that risk by being able to determine if it would be comfortable with the portfolio manager in the venture.

The thing is, Dubrowski isn’t the portfolio manager for just the Oregon partnership but for all of the firm’s investments, so the pension plan’s involvement in choosing his future successor has implications that extend beyond its own mandate with the firm. That could be a sticking point for other investors affected by the stipulations of one large investor.

Then again, it’s unlikely an investor would pledge large amounts of capital to a firm unless they received some kind of advantage in exchange. Also, we’d argue that when an institution requests a general partner to be more transparent about successors, or a variety of other matters, the firm’s other investors also benefit.

What we are questioning, however, is why such LP involvement in key person decisions is more characteristic of real estate than mainstream asset classes. In an email to PERE, Anthony Breault, senior real estate investment officer at Oregon State Treasury, helped to shed some light: “The key person risk is pervasive in our industry and one of the focal points for any GP due diligence. To that end, Oregon takes a rather active role on this facet as it is our investment belief that GP selection is one of the most critical factors in determining portfolio outperformance in the private markets.”

To be more specific, it’s not necessarily the GP itself but its key people that are critical to portfolio outperformance in real estate and other private asset classes. In addition, it’s more common with such strategies that investors could be partnering with managers, particularly smaller managers where it is just one or two people that are driving the success of the entire platform.

Illiquidity aside, this is definitely one of the lesser-publicized, but no less significant, potential risks for institutional investors in property and other private asset classes. Given the alpha opportunities that these alternatives currently are offering institutional portfolios, it’s clearly not a risk that investors are shying away from.