Big may not necessarily be beautiful but being bigger in the world of private equity real estate certainly helps when it comes to offering concessions to limited partners.

Zoe Hughes

As GPs globally pound the streets in search of hard-to-come-by capital commitments, one large fund manager has promised investors it will cut its management fees to zero on unfunded commitments in an effort to help LPs' liquidity issues.

The fund, which is currently in market raising several billion dollars, argued that in today's volatile real estate markets it might not deploy its dry powder for another 18 to 24 months. “We have told investors we will not charge you [during that time lag],” the fund sponsor said.

The move, revealed at the GRI conference in New York last month, has been greeted with disquiet by many industry professionals. The issue comes down to size and tenure in the market.

LPs pay an annual fee to general partners to manage private equity real estate funds. Fees can range from 1 percent to 3 percent, but are typically in the region of 1.5 percent. Those fees are used to keep the fund – and its team – afloat as it sources deals, performs due diligence and executes on its strategy. As one participant told PERE: “Who's going to pay the wages, the office overheads, how will you source deals with no management fee?”

Few GPs can afford to forgo management fees while they wait for the opportune moment to invest their dry powder – particularly if that opportune moment isn't expected for at least another year or two. Firms with multi-billion dollar funds already under their belts, though, do have that luxury.

Few GPs can afford to forgo management fees while they wait for the opportune moment to invest their dry powder. Firms with multi-billion dollar funds already under their belts, though, do have that luxury.

LPs, already wary of increasing their cash drag, will likely find attractive a fund managed by seasoned pros who nevertheless will not start charging fees until the capital is “in the ground”.

There are reasons to worry about the incentives created by this structure. By moving to 0 percent management fees on unfunded capital commitments you merely encourage a “rush to invest” mentality, it might be argued. And in today's property markets, no LP wants their fund manager rushing to invest when opportunities could be even more attractive further down the line.

By slashing management fees, a fund without a robust existing management fee stream could be forced to cut its expenses and even its staff. Speak to any LP and the preservation of personnel is among the top of their concerns as private equity real estate firms navigate the current downturn.

In any event, many smaller funds simply do not have the institutional heft to take a break from management fees charged on committed capital. However, smaller GPs tend to make up a much larger percentage of the committed capital of the fund, and at least one group has used this to its advantage in attracting LPs.

According to one funds of funds manager I spoke with, a real estate GP group whose capital commitment to a new fund equals between 20 percent and 25 percent of the total has agreed to essentially be treated as a second-class citizen within its own fund.

Not only will LPs benefit from preferred return and catch-up provisions granted to limited partners and borne by the fund manager, but within the fund itself, the capital committed by the GP is subordinated to capital committed by external LPs.

The $130 million Granite Bay Lands Fund 2008 has adopted such a tiered repayment strategy as well. However, the Granite Bay Development-sponsored fund has also set in place a 5 percent management fee – that is only payable on revenue earned by the partnership. The fund, according to documents seen by PERE, is targeting discounted raw land and finished lots in Sacramento and Reno with the intention of “holding” the assets until property markets return.

That means much of Granite's acquisitions will not be revenuegenerating for the foreseeable future. Instead Granite asks that LPs pay annual management fee “advances”, capped at 1 percent of total commitments a year for the first four years. And just like advances in the book publishing world, the advances are offset against future revenue-based management fees.

Only the largest real estate fund managers can afford to operate with zero management fees on uninvested capital, however – as Granite is proving – the small guys are prepared to cut deals that they hope LPs will find reasonable and attractive.