AMERICAS NEWS: Clearing the hurdles

There are many hurdles a GP needs to clear in trying to please its investors, but there is one that could be getting even higher – the preferred return given to LPs before a fund sponsor can start sharing in the profits of a fund.

With LPs starting to push back on a variety of fund terms, the preferred return (or pref) has become an issue for some GPs looking to raise their next fund. Traditionally, real estate funds have been structured with an eight percent or nine percent pref, followed by a catch-up for the GP that typically involves a 50/50 distribution of the profits until the GP has reached a previously agreed-upon profit split. That split is often 80/20, although splits of 70/30 were seen in the recent boom.

One vehicle about to start fundraising is being structured with a 12 percent pref and a slower, or delayed, catch-up.

Now, however, one vehicle about to start fundraising is being structured with a 12 percent pref and a slower, or delayed, catch-up. According to people familiar with the vehicle, the GP in question will receive 25 percent of the distributions to a 15 percent net return, followed by 35 percent of carried interest until the GP reaches a 20 percent net return.

The vehicle has raised several eyebrows in the industry, not least of all owing to the higher pref. After having suffered large write-downs in much of their value-added and opportunistic real estate portfolios, many LPs have argued that GPs should get close to, or even hit, the targeted returns for their vehicles before being allowed to compensate themselves.

Peter Lewis, senior investment officer managing direct and indirect, domestic and global real estate investments for the Liberty Mutual Group, said the 20 percent profit split was not the issue if a manager delivered what they originally promised. Instead, the debate related to the appropriate threshold when GPs should start getting their share. “Managers should earn their share when they hit their targeted returns and not before,” he said. Lewis’ concern is shared by many investors who take issue with the compensation structure when a manager has failed to generate their “previously stated return objectives”.

However, one of the fears of ever-rising prefs is that managers could adopt higher risk profiles in order to reach the preferred return hurdle more quickly, thereby catapulting themselves into the promote.

Managers should earn their share when they hit their targeted returns and not before.

Peter Lewis, senior investment officer, Liberty Mutual Group

Russ Bates, head of the Americas at Aviva Investors’ multi-manager group, said it was critical to ensure the incentive structure didn’t encourage managers to always aim for a home run. “Instead of taking safe singles or doubles, you might inadvertently be incentivising your fund manager to swing for the fences every time he does a deal,” he said. “A manager can’t do that consistently.”

Some market participants even questioned whether prefs should be decreasing with interest rates so low. “At the end of the day, you are arguing between a nine, 10, 11 or 12 pref,” said one source. “It’s a fool’s errand if you as a manager are confident in your strategy.”

The current balancing act taking place between LPs and GPs over fund terms and structures has prompted both sides to explore a wide variety of alternative fees, prefs, catch-ups and promotes, according to Joshua Sternoff, partner at New York-based law firm Paul Hastings. “We have clearly seen an upward direction in the pref over the last the two years. It’s a similar story with catch-ups,” he said. “LPs don’t want any catch-up, while GPs want a 50/50 structure. It’s all in discussion and is part of the natural movement of economics as the pendulum swings from the GPs to the LPs once again.”