In a post-Lehman Brothers and post-Bernard Madoff world, transparency has come crashing into the spotlight of private equity real estate fund operations. From increased LP reporting to politically-driven regulations, greater disclosure is now a key issue for all concerned.
Yet this push for greater openness comes at a challenging time for GPs and LPs alike, many of whom are still dealing with legacy assets in need of refinancing as well as trying to invest capital in markets where deals are more complex than ever before.
Operating a private equity real estate fund and platform today, therefore, is not only more arduous and time-consuming, but – owing to regulatory and investor pressures – also more expensive.
In the September fund administration supplement, PERE will explore the challenges and opportunities facing GPs, LPs and fund administration professionals as they manage private equity real estate vehicles and firms post-2008. One thing is clear to see though, as John Noell, fund and transaction partner at Chicago-based law firm Mayer Brown, explains, increased LP reporting combined with heightened regulation of the industry and downward pressure on fees means “players are getting squeezed at both ends”. Such pressures, he adds, mean “the barriers to entry are only set to increase”.
LP reporting
Perhaps the biggest issue currently facing fund professionals and investors is the level of LP reporting required today compared to just two years ago. In addition to the usual quarterly reports and annual investor meetings, GPs have seen an expediential rise in the number of ad-hoc questions being asked of them as investors try to evaluate their own portfolios, and managing the risks within them. Edgar Alvarado, Allstate Investments’ head of real estate equity Robert Teel, vice president of Yardi Systems’ global solutions group
It’s not just a question of volume, though. With no industry-wide guidelines on reporting standards, there is a growing debate as to the type of data GPs should proactively disclose in quarterly reports.
According to Edgar Alvarado, Allstate Investments’ head of real estate equity, and Joseph Stecher, chief investment officer of Morgan Stanley AIP Real Estate, the ability of an LP to personally evaluate a GP’s assumptions and assess potential risks is crucial to being a good fiduciary. “If we don’t know what risks we are taking, how can we manage those risks,” says Alvarado. 
If we don’t know what risks we are taking, how can we manage those risks.
But in order to do that, GPs need to provide comprehensive portfolio and asset-level information, particularly about the concentration of risks and debt schedules. “Getting the information below the portfolio level is an evolutionary process and many GPs are now getting ahead of things,” says Alvarado.
Robert Teel, vice president of Yardi Systems’ global solutions group, adds the impetus is increasingly on GPs to put information in the hands of their investors. “It’s about opening up the books more and allowing LPs to come to their own conclusions on the portfolio and assets.” Teel, though, raises a question on most GPs’ minds in inviting limited partners to “delve” into the portfolio: “How filtered a view do you as a GP allow?”
“There is a battle going on at the minute,” Teel explains. “Fund managers want to ensure LPs don’t come to inaccurate conclusions when they dig deeper into portfolio and asset data but investors clearly want and need more information.” Fund managers want to ensure LPs don’t come to inaccurate conclusions when they dig deeper into portfolio and asset data but investors clearly want and need more information.
Fund managers are opening up, but Teel asks, in being more transparent, are GPs creating more work for themselves and LPs? LPs don’t have large pools of investment officials to help them aggregate and analyse asset and fund information, yet in providing even more data fund sponsors are faced with the dilemma of potentially generating even more questions in return.
“Fund managers didn’t go into business to spend all their time operating an investment vehicle but rather to create value for their investors,” adds Michael Sala, executive director at JPMorgan’s private equity real estate services. “The time spent in managing that operation is an opportunity cost for the GP.”
Technological progress
Of course, in deciding to open up their books in more detail, GPs are faced with the challenge of how they deliver that information to LPs. James Hutter, managing director of JPMorgan’s private equity real estate services
In an age where information can penetrate all corners of the globe in seconds, and where data can be accessed from the palm of your hand, GPs have a plethora of technological choices at hand. However, for many fund sponsors, quarterly reports and updates are still delivered to LPs on PDFs and Excel spreadsheets via password-protected investor portals.
The portals are certainly a major improvement on the technology of just a few years ago, allowing LPs to access reports, and receive drawdown notices, and fund and asset updates, instantly. But in a world where the ability to interact rules technological evolution, LPs are beginning to push for greater manipulation over the presentation of data. LPs are looking for the ability to electronically import a GP’s data, aggregate and view that GP’s data in different ways to assess different risks and, ultimately, compare GPs with similar strategies.
Rather than manually uploading individual fund reports into their own systems – all with their own templates and reporting standards – LPs are looking for the ability to electronically import a GP’s data, aggregate and view that GP’s data in different ways to assess different risks and, ultimately, compare GPs with similar strategies.
The Blackstone Group is pushing such LP interactivity, having spent the past year developing a proprietary system that allows investors to view their exposure to the firm across the real estate, private equity and hedge fund asset classes and funds, with the ability to drill down into specific funds, geographies, sectors and investments. Called BXAccess – and currently being piloted by a group of Blackstone LPs – the on-demand database will also have a multi-manager function, giving LPs the opportunity to upload data from other GP managers for easier comparison. Senior managing director Edwin Conway says on p. 16 the portal grew out of trying to give LPs and Blackstone staff more granular information in a “dynamic and interactive” way.
Of course, not all fund managers have the resources, financial and personnel, to develop new interactive portals like Blackstone. Indeed, many smaller and newer platforms often have to rely on living in an Excel environment.
“In-house data systems are a big ticket item you are asking GPs to underwrite and develop and only the largest are able to do that,” explains James Hutter, managing director of JPMorgan’s private equity real estate services. In-house data systems are a big ticket item you are asking GPs to underwrite and develop and only the largest are able to do that.
According to Yardi Systems’ Teel, in a post-Madoff world, many institutional investors are looking for fund sponsors to track investments and funds in something other than an “Excel spreadsheet built by analysts out of business school. Investors want accurate, repeatable distribution and collection of data”.
Hutter agrees, adding that in a world filled with complex transactions, Excel environments are not always suitable. “When you are talking about smaller data requirements, Excel may be fine,” Hutter says. “But when you do a multi-year, large financial investment you are talking about buying up and down the capital stack, investing in the debt and equity, and the work is much more intensive. How you keep track of the hierarchy is much more difficult.”
The bottom line
As GPs face the internal pressure of vastly increased investor relations work, they are also experiencing pressures against their personal and corporate bottom lines, with many LPs calling on managers to lower fees, particularly management fees. Gary Koster, Americas leader of Ernst & Young’s real estate fund services group.
A recent white paper, jointly produced by PERE’s parent company PEI Media and BNY Mellon, reveals that management fees are the partnership terms and conditions subject to most negotiation by LPs.
Indeed, several GPs say they have received operating budget information requests from LPs to ensure that management fees are being efficiently spent. One GP currently raising a first-time fund says such requests may presage LP demands for management fees that closely match operating budgets, rather than charging a flat rate. “We are comfortable taking a smaller management fee just to cover costs, not necessarily a fixed 1 or 2 percent,” he says, referring to a perception among many LPs that a fixed percentage management fee may be arbitrary and not necessarily reflect the costs of running the firm.
Mega funds have come in for particular criticism from LPs for charging management fees that exceed operating budget needs, thereby becoming a perceived profit centre for the firm. Of course, not every GP is building wealth by collecting management fees over and above expenses. In fact, many are keenly aware that in today’s tough fundraising environment, a smaller follow-on fund might bring the flow of management fees very close to, or beneath, current operating expenses.
Smaller fund sizes obviously mean a smaller pool from which to draw management fees, threatening the ability of some GPs to attract and retain the personnel it needs.
But fees are not the only issue impacting GP personnel though. So too are increases, and the threat of increases, to the carried interest tax rate in the US and UK.
In June, on both sides of the Atlantic, GPs watched with apprehension as the British government increased the capital gains tax rate from 18 percent to 28 percent, and as the US House of Representatives passed a bill that would tax 75 percent of carried interest as ordinary income. Taxation of carried interest is top of mind because it impacts not just the owners of the business, but also the senior employees.
GPs in the US were able to breathe a sigh of relief when the Senate voted down the plans by the House of Representatives. However, industry professionals don’t expect the issue to lay dormant for long. With capital gains in the US enjoying a low 15 percent tax rate and ordinary income taxed as high as 39 percent, many politicians see the issue as closing a loophole, according to Gary Koster, Americas leader of Ernst & Young’s real estate fund services group.
“Taxation of carried interest is top of mind because it impacts not just the owners of the business, but also the senior employees,” Koster says. Taxing a greater portion of carried interest at ordinary income tax rates may equate to a “de facto pay cut” for many GP executives, he explains.
Koster notes that the US proposals could also have more far-reaching consequences with calls to also abolish the capital gains treatment for the transfer of individual partnership interest in an investment management business held for more than one year.
“Currently if you want to sell your long established investment management business it would be eligible for capital gains treatment,” Koster says. “Based on legislative proposals, capital gain treatment may not be allowed in the future making an individual’s investment in these businesses less attractive versus other businesses.”
Political will
Increasing the capital gains tax rate in the US is an issue that has rumbled on for years, even decades. In the wake of the credit crisis though, private equity real estate professionals sense higher taxation will come – it’s just a matter of when. Clayton Johnson, chief executive officer, Tribe Consulting Group
But coupled with a push by politicians for greater regulation of the alternatives industry, it is becoming clear the hurdles the industry will have to face going forward.
Two of the biggest regulatory hurdles to emerge to date are Europe’s proposed Alternative Investment Fund Managers’ directive and the US’ recently-passed Dodd-Frank Wall Street Reform and Consumer Protection Act.
Both legislative labours will exact unprecedented levels of disclosure from private equity real estate firms. Under the Dodd-Frank law GPs with $150 million or more in assets will be required to register with the Securities and Exchange Commission, establish formal compliance policies for potential conflicts of interest, as well as designate or hire a compliance officer and face regular inspections by the SEC. Europe’s proposed Alternative Investment Fund Managers’ directive [has been] dubbed by one fund administration professional as “Dodd-Frank on steroids”.
In Europe, AIFM – dubbed by one fund administration professional as “Dodd-Frank on steroids” – could also prove costly for GPs in terms of time and money, bringing with it additional reporting requirements about offering memorandum and assets in which funds are invested, as well as the need for GPs to hire independent valuers.
The directive is meant, in theory, to protect European investors from making overly-risky investments, but, in a move widely criticised by the real estate and private equity industry, it could also potentially restrict some non-European GPs from “marketing” their funds to investors inside the EU without obtaining a passport to do so from one or more regulatory bodies.
At press time, three European legislative bodies were charged with reconciling two versions of the AIFM directive. Like their counterparts in the US, there are plenty of differences on all sides and a lot of lobbying and pushing back and forth is currently taking place. New systems and processes are being put in place. The industry is growing up and evolving, just like other asset classes had to.
What is clear to private equity real estate GPs, LPs and fund administration professionals, however, is that – irrespective of where they might be based – doing business in the future will be harder, and more expensive.
For Clayton Johnson, chief executive officer of Austin-based management consulting firm, Tribe Consulting Group, the changes currently being seen in private equity real estate fund administration could be considered the growing pains of the asset class. “This is a very, very young industry. Real estate has been around for a long time, but institutional real estate investing has not.”
As such, Johnson says, the industry is “starting to figure itself out. New systems and processes are being put in place. The industry is growing up and evolving, just like other asset classes had to.”
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