STATESIDE: Performance enhancer

By the end of next month, Boston-based private equity real estate firm TA Associates Realty is expected to complete fundraising on its latest value-added fund, Realty Associates Fund X, near or at its hard cap of $1.575 billion. One notable feature of this vehicle is its sliding fee structure, which is different from sliding schedules that are usually based on the amount of capital committed by an investor.

The fee structure for Fund X is said to be unique in the industry for being based on a particular year in the fund’s life. Management fees for the vehicle begin at 0.5 percent in Year 1 and rise to a peak of 1.25 percent in Year 5, before descending back down to 0.6 percent for Years 8-10, according to a presentation made by TA Realty to the Fresno County Employees’ Retirement Association. Although TA Realty’s fee structure may be unusual, it does reflect a larger trend at hand – the growing pressure for managers to deploy fund capital more quickly.

For the most part, the sliding scale for management fees appears to be driven by TA Realty’s limited partners. After all, investors have been making a harder push for managers to make fee concessions. In the case of Fund X, all of the fees are lower than the average management fee of 1.5 percent to 2 percent.

In fact, the vast majority of management fees fall in the range of 1.5 percent to 1.74 percent, according to a recent KPMG report. In the report, this range accounted for 47 percent of vintage 2009-2010 funds and 44 percent of vintage 2011-2012 funds and funds currently in market.

The lower fees offered in Fund X are expected to save limited partners a bundle of capital. According to one LP who invested in Fund IX, which had a similar fee arrangement to that of Fund X, management fees for the predecessor fund have indeed been lower in the aggregate. However, investors are less concerned with the fees themselves than what they hope the fees will help to do – drive fund performance.

Many investors, after all, have been pushing back on having to pay a 1.5 percent to 2 percent management fee on committed capital from their first day in the fund – typically a time when managers generally are thought to be less active in investing capital. With a sliding schedule, fees for both Fund IX and Fund X likely would more closely correspond with TA Realty’s level of active investment activity for the fund. As the workload for the fund increases, so do the management fees that the firm collects. As the assets in the fund are sold off and the workload load declines, the fees likewise decrease.

In exchange for lower management fees, a manager potentially can begin to collect performance fees at a lower hurdle rate and increase that participation as they generate higher returns for investors. In this way, manager compensation for the fund is more performance-based than with other funds. According to the Fund IX investor, however, it’s still too early to evaluate performance fees for the vehicle, as TA Realty has only made a few dispositions to date on behalf of that fund.

The lower fee structure for Fund X also may give TA Realty an edge over competitors with similar offerings in the market. More cynical industry observers pointed out that a complicated fee structure potentially could put the firm in a better negotiating position, since a manager will understand its own fee structure better than any investor would.

It isn’t likely that TA Realty’s sliding fee structure is going to catch on with many other fund managers, which continue to favor a simpler flat-fee approach. Still, managers are responding to the greater emphasis on performance in other ways. In fact, one general partner that spoke with PERE noted an emerging trend for managers to shorten the investment period of their funds – typically spanning four years plus the fundraising period – by as much as a year.

It’s completely understandable why LPs would want to see their capital put to work more quickly, as they have their own targets and obligations to meet. A more performance-focused push, however, requires a delicate balancing act, since it may potentially incentivize a manager to put out money too quickly, which could result in ill-timed investments.

One also has to question the feasibility of deploying capital at a faster pace at a time when many fund managers have had to extend both the fundraising and investment periods for their vehicles. It’s an idea that has its merits, but it may not be the most opportune time to put it to the test.