INTELLECTUAL PROPERTY: Show them your skin

Limited partners are looking for ways to improve the alignment of interests in real estate funds. May I suggest an instructive analogy: The Titanic.

 It has been observed that the strong alignment of interests between Captain Edward Smith and his passengers failed to keep the ship from sinking. However, Smith went down with his ship. When a real estate fund hits an iceberg, the GPs may or may not go down with their ship depending on how much of their personal wealth is tied up with the fund. And the case can be made that the GPs are a lot less likely to hit the iceberg when doing so would result in severe personal economic pain.

 As such, the critical issue of GP co-investment in a partnership is getting keen attention today.
When members of a general partnership commit capital to a fund, it ideally should be a “meaningful” portion of their own personal net worth sat alongside that of their investors’ money. It’s the proverbial skin in the game.

However, as the industry has evolved and some GPs have become quite wealthy, concerns have risen that some GPs aren’t exactly betting the farm with each successive fund.

Thanks to a fund formation mechanism that converts the management fee stream into a GP commitment, some GPs have managed to turn other people’s skin in the game into their own skin in the game.
 The European Association for Investors in Non-Listed Real Estate Vehicle also added to the debate, after a study of fund documents from the past three years found a third of managers had the right to transfer (aka sell) GP co-investment in a fund without penalty.

In calling for GPs to put their money where their mouths are we hit a major roadblock. How, exactly, do you define “meaningful”.

A GP trading out of his own fund? When LPs seek an alignment of interest with their manager, this is certainly not what they have in mind.

But in calling for GPs to put their money where their mouths are we hit a major roadblock. How, exactly, do you define “meaningful”. A 5 percent co-investment for one GP could be a team’s entire liquid wealth, whereas a 50 percent co-investment could be a drop in the ocean for another GP. As one advisor said: “A simple percentage won’t cut it.”

Instead LPs – and their advisors – could start demanding the disclosure of personal financial information of fund managers to prove, once and for all, how meaningful a stake a GP is taking in a fund. After all, nothing focuses the mind on performance more than the threat of personal loss – and LPs want to ensure if they feel the pain next time, so does the GP.

It’s something many GPs and their team will inevitably fight against. Who after all wants to disclose their net worth? GPs with personal fortunes won’t want to demonstrate to LPs that their commitment to a fund represents, merely, a comfortable diversification of assets. LPs should be shown that the GP team believes

Nothing focuses the mind on performance more than the threat of personal loss – and LPs want to ensure if they feel the pain next time, so does the GP.

the activities of the fund will be the single best home for their own money over the next 10 years. On the flip side, some GPs might not want to show their entire liquid savings are invested in a fund, with no room for manoeuvre if the unexpected happens.

For limited partners though, demanding the disclosure of a GP’s “personal balance sheet” could provide a more crucial insight into the operations of a fund sponsor besides just determining how meaningful is meaningful.

In reviewing the personal finances of members of a GP, LPs will also be able to draw their own conclusions about the sustainability of the platform and whether the GP’s business plan will weather the realities of the market. Given events of the past two years, that’s information LPs should be asking for. It’s information, though, that GPs will not be happy to provide.