While greater control and incentive fees are widely agreed among investors as key components of achieving alignment of interest with general partners, co-investments is an area that is more up for debate.
The California Public Employees Retirement System (CalPERS), the largest US pension plan, has established a formal alignment interest model, essentially a standard partnership model that its adopts with each of its managers when investing in real estate. The key elements of the model include control, such as rights to transfer assets or terminate a partner with or without cause; incentive fees, so that the manager only makes a profit if the pension system makes a profit; a dedicated team; and co-investment by the general partner.
“The entire purpose of the model is to make sure that we have quality control so that the board and senior staff know exactly what's in each partnership agreement that we're executing and there’s transparency and quality control,” said Jim Hurley, senior portfolio manager at CalPERS, speaking during a panel discussion at the PERE Global Investor Forum 2013 in Los Angeles this week.
Like CalPERS, the Los Angeles County Employees Retirement Association (LACERA) favors a separate account structure with real estate investments because of the control provisions that such a vehicle provides. However, John McClelland, principal investment officer of real estate at LACERA, countered that co-investments were not a necessary ingredient in achieving alignment.
In fact, McClelland viewed such an arrangement “as more of a problem than assistance” under the rationale that managers should be entitled to have some rights in an investment if they are investing their own capital. However, allowing a general partner to have such rights would lessen the control the pension system would have over its investments.
Moreover, “if I need their money to give me confidence that they're going to do the right thing for me, then I have the wrong manager,” McClelland said. “Fundamentally, I need to trust the manager. When we lose trust, our relationship's over. I don't need their capital to develop that trust, and I don't need it to maintain that trust. I need that to happen through demonstrated action, and hopefully that gets demonstrated through performance.”
In response, Hurley noted that CalPERS' viewed co-investments as part of a more comprehensive, common sense approach to achieving alignment. “It's not a complete risk mitigation,” he said. “All we're trying to do is give people a little pause when they're having to do a deal that they have some skin in the game.”
Hurley acknowledged that there was a lack of evidence that co-investments actually help with achieving alignment, but he said one reason for that was the significant writedowns that followed the global financial crisis. “There’s so much noise in the numbers, you can’t pull out any one risk mitigation and say, 'That one works'.”
Fred Gortner, a managing partner at Paladin Realty Partners, offered a general partner’s perspective on alignment of interest. “Structure, control and skin in the game can only go so far in aligning interest,” he said. “It's no substitute for competency, and it’s ultimately no substitute for shared values, trust and integrity and having a manager who is transparent and does the right thing.”