In a difficult capital-raising environment, negotiating power has shifted to institutional investors, who are demanding – and receiving – more favourable deal terms and more transparent reporting from fund managers, according to a new report issued today by accounting and consulting firm Ernst & Young.
Deal terms that were typical prior to the financial crisis have been revised, in some cases significantly, as a result of investor pressure. Historically, many of the largest private equity real estate funds have charged investors several types of fees, including those for fund management, acquisition, disposition and asset management. But as many investors have seen poor returns or lost capital in their real estate portfolios, they are now putting fund managers under greater scrutiny and successfully challenging the amount of fees and the types of fees that managers are charging.
Management fees, or at least the calculation methods for those fees, have been modified in favour of LPs. Such fees are now based on actual costs incurred by the general partner on a cumulative basis and are capped, generally at 0.5 percent on committed capital and 1.35 to 1.75 percent on invested capital, according to the Trends in real estate private equity report. Previously, management fees averaged 1.5 percent of the committed capital during the investment period and the invested capital after the investment period.
Managers also are agreeing to other concessions, including changes in the carry structure, according to LPs surveyed for the report. Carried interest continues to have a typical structure of 80/20, but with a 60/40 or 70/30 distribution in favour of limited partners during GPs' “catch-up” period, compared to a 50/50 distribution in previous funds. Carry, moreover, is now being reviewed by auditors prior to payment.
Additionally, E&Y noted an increasing trend in 2011 toward full pooling of returns, as opposed to deal-by-deal returns that characterised funds in 2007. And while the standard for general partner commitments historically had been 1 percent, “LPs are now expecting GP commitments to be meaningful,” Mark Grinis, E&Y’s global real estate funds leader, wrote in the report. “This should be contributed through cash and not through the waiver of management fees.”
Furthermore, the period for clawback provisions should now extend beyond the fund term – including liquidation and any provision for LP giveback of distributions – whereas such provisions generally did not extend beyond the term of the fund prior to the crisis.
Meanwhile, the industry associations that represent LPs – such as the European Association for Investors in Non-listed Real Estate Vehicles (INREV) and the Institutional Limited Partners Association (ILPA) – have clamoured for more frequent and transparent reporting, such as clearer definitions for fee structures in private placement memorandums or prospectuses. “By instituting some level of consistency and a framework around things like capital calls, reporting and the types of data they’re requesting, they’re creating a format their constituents can utilise,” said Grinis.
Changes in investor reporting are expected to continue, especially as new regulations impacting the real estate funds industry – such as the Dodd-Frank Act and Alternative Investment Fund Managers directive – take effect. While most established funds tend to report on a quarterly basis, E&Y predicted additional disclosures on assumptions, fair value criteria and debt analysis, among others.
One challenge is that, while the new regulations will help to put LPs more at ease in terms of how their investments are being managed, they also are concerned that managers will become tied up with compliance and the rising costs of running the fund, which could affect the speed at which capital will be invested and, ultimately, the size of returns.
Investor pressure on fund managers to reduce fees also is spurring another shift in the private equity real estate industry. Private equity real estate firms have been forced to become more efficient, which has led to a growing interest in outsourcing the back-office operations of real estate investment platforms. While the industry previously was poorly equipped to handle outsourcing, an increasing number of organisations are now developing the infrastructure needed to provide private equity real estate firms with this capability, the report noted.