Recently there has been an increasing appetite for European private equity real estate strategies, partly driven by limited partners (LPs) based in North America.
This isn’t surprising in itself, given the relative value on offer in Europe, despite the economic headwinds currently being faced in the region. What has been surprising, however, is LPs’ apparent indifference to the wide range of fee structures offered by these funds.
We place a reasonable emphasis on fees when researching investment managers, as fee structures are more certain than prospective returns. We are not against apparent high fees per se. We believe that apparent high fees charged for genuine value creation are justified, whereas overpaying relative to market standards and relative to expected genuine value creation is not.
Performance fees in European private equity real estate funds typically accrue to a manager after a preferred return, say 9 percent, until a target a 20 percent overall profit share is met. To allow it to move from the 0 percent to 20 percent profit share, the manager’s profit share accelerates or ‘catches-up’ after the preferred return has been reached. These catch-up rates typically range from 0 percent to 80 percent for European private equity real estate funds – but can be as high at 100 percent.
The premise here is that, from a manager’s perspective, it is justified to earn a profit share on all profits after a minimum return threshold has been reached and so the profit share should catch up.
However, from an investor’s perspective this is misaligned with the ultimate aim of incentivizing managers for true value creation as measured, for example, by the amount by which returns exceed those of a less leveraged core strategy, which typically charges much lower fees.
So, in our view, a much more logical and better aligned fee structure would exclude a catch-up, making the preferred return structure one which has a genuine ‘hard hurdle’.
This is not a theoretical exercise ignoring the commercial realities of running an investment management business. Our assertion is that no catch-ups are already market standard for European private equity real estate funds today.
Since the financial crisis, and after much LP and consultant engagement, we’ve seen catch-up structures removed from several high profile and well respected European private equity real estate fund raises. Therefore the market standard has changed.
It is important to acknowledge that some investment managers have removed their 50 percent catch-up clause in return for a reduced preferred return. In these cases, the removal of the catch-up saves the LP around 30 percent in expected performance fees payable. In several cases, we have seen catch-ups removed and preferred returns remaining unchanged, saving LPs around 40 percent to 50 percent in the expected performance fee payable.
Importantly, the removal of catch-ups hasn’t been offered only by those investment managers with poor track records or those with asset gathering tendencies. In fact, we see no link between investment managers with smaller fund sizes or stronger historic performance charging higher catch-ups.
So why do LPs continue to invest in those European private equity real estate funds with higher expected fee structures when there are compelling alternatives?
It may come down to a lack of clarity and information on peer funds or overseas LPs judging European funds relative to standards in their local market rather than European peer funds – sadly, 50 percent catch-ups are still common in North American and Asian private equity real estate funds.
As noted earlier, we are not against apparent high fees per se, but we are against over paying relative to market standards and relative to the expected true value creation. The skill of the manager will remain a critical factor in manager selection, but this needs to be put in the context of the expected net-of-fee proposition being offered.
We believe the market standard for European private equity real estate funds involves a carry structure that has no catch-up. Not only is this a more logical and fairer performance fee structure, but it is one that has been adopted by many respected European private equity real estate managers already.
In an effort build a better proposition for the end saver, LPs should be aware of this when engaging with managers on fees.
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