INTELLECTUAL PROPERTY: Raiders of the lost fund

Zoe Hughes

If real estate limited partners were to make any New Year’s resolutions for their fund investments in 2010, it would likely involve health-conscious promises of more workouts and a much healthier diet.

With fund-level and deal recapitalisations and restructurings increasingly common practice, efforts to restore health should be forefront of their minds as they prepare to leave 2009.

However, as LPs look ahead to what is expected to be another challenging year for the real estate asset class, there is another concern they should be mindful of – the health of their general partners.

No, we’re not talking about a troubling disconnect with regard to GP incentives owing to the absence of carry in funds, although that is an issue for some platforms as they look to the future. A more immediate worry is whether your GP can meet its operational obligations.

In the past month alone, PERE has been told of two separate instances where two general partners asked in-house investment staff to become contractors so that their payroll could be expensed against the fund, rather than paid for by the GP management company. In both cases, PERE was told by sources, the in-house staff rejected the request and left the firms. Both requests were made recently.

There are a wide variety of practices among private equity real estate firms as to what is and isn’t billed a fund expense, and therefore met by LP commitments. Every fund document is different, and it’s down to GPs and LPs to negotiate what is appropriate or inappropriate.

Indeed, the issue of expenses, and what should or shouldn’t be paid for by limited partnerships, isn’t a new phenomenon. As the industry grew throughout the 1990s and early 2000s, questions were repeatedly raised by LPs over the outsourcing of various (formerly in-house) functions to groups affiliated to GPs amid concerns managers were more interested in generating fees than targeting returns.

However, the latest instances raise crucial questions over the health of the GPs involved and the need for limited partners to understand more clearly the financial health of their fund sponsor.

One fund formation lawyer said LPs were generally much more focused on “all things related to expenses”, and were drilling down more into what overheads should be met by the fund or the GP. “It’s part of the conversations GPs and LPs are having about funds. It’s about which services are done in-house and which are done externally,” he said.

The latest guidelines for the private equity industry, issued by the Institutional Limited Partners Association (ILPA) and widely touted as a possible standard for future real estate fund investing, urges GPs to provide an annual breakdown of all partnership expenses and for advisory committees to request full disclosure of “costs expensed to the partnership versus [those] absorbed as part of the management fee”.

ILPA said the principle – one of several expounded by the guidelines – was a vital means to “restore and strengthen the basic ‘alignment of interests’ value proposition in private equity” – and we’re sure they’d agree, private equity real estate.
But could conflicts over partnership-level expenses become more prevalent as LPs themselves turn the heat up on their GPs to make concessions over management fees? The industry certainly shouldn’t expect a tidal wave of unrest over the issue. The instances familiar to our sources were just two GPs out of a universe of several hundred.

 What these do illustrate though is the need for LPs to be extremely diligent as they head into 2010, and to recognise that a healthy fund and healthy investments, also requires a healthy manager to operate them.