FEATURE: Double fee trouble

Limited partners are hot on the issue of fees associated with a fund and its affiliated operating partner. These arrangements could come under even greater scrutiny now that returns are coming under pressure.

Some of the largest funds own asset management companies, such as Goldman Sachs and its 100 percent owned property asset management company, Archon Group. In this case, Archon is asset managing and advising on deals and assets and charging for its trouble. Yet Goldman Sachs is also charging investors in its fund as well.

To some, this model is seen as being a fund within a fund. But Goldman Sachs isn't alone in having captive advisors. There are many more firms who also execute the same model.

The genesis of the in-house asset management model was born out of necessity. In Japan in the 1990s, for example, large firms found there were no external operating partners who could manage non-performing loans. Instead, the firms had little choice but to go out and create their own operating platform. By internalising such functions, it was also possible to save on fees and promote. It was a model that was extended to other countries.

Today, however, questions are often raised over whether such affiliates are an additional “profit centre” for funds.

“If you become as big as some of the funds became, my guess would be the size of the GP overhead did not swell proportionally, but I'll bet the affiliate hired a lot more people,” one US-based advisor tells PERE. “In theory, you could shift the GP overhead to the affiliate at a cost, but the fund pays for it. The cost of the asset management is effectively passed through to investors through the investment. The gross return from that investment will be less,” the advisor says.

The issue is clearly an important one for investors. Fund managers state that funds would have to pay unaffiliated external operating partners anyway for work on investments, but where the issue is clearly most sensitive is in relation to value-added asset management. That is, expertise the GP is already being renumerated for.

Elizabeth Malloy, assistant director of Ernst & Young's London real estate finance group, says LPs do not expect to see terms in fund documentation about the choice of operating partner unless the firm has an affiliated asset management company. In that case, investors need reassurances that funds are paying “going market rates” to the asset manager.

Paul Schwartz, a partner at US law firm Goodwin Procter, adds: “What investors are all over is the question of whether the fund sponsor gets additional fees or compensation from the portfolio companies. It is not uncommon for investors to raise the question and have the documentation address whether the fund sponsor or its affiliates can get fees from a joint venture between the fund and operating partners.”

He says fund sponsors which are “vertically integrated” with internal real estate service companies, such as property managers or mortgage brokers, have a potential conflict of interest – something investors are very focused on. “It is very typical for the funds to talk about the circumstances in which the fund sponsor and its affiliates can receive compensation,” he says.

There is, however, one key selling point to having an inhouse asset management or related services group: there is usually only one promote, according to Schwartz. In contrast, where a non-affiliated operating partner is used there are traditionally two.