Terms of endurance

As private equity real estate firms around the world expand and evolve, economics sharing and questions of succession will continue to be at the forefront in shaping general partnership agreements. By Eva Poon

Private equity real estate firms are beginning to look a lot like other corporate entities in one respect: retaining human capital. As the industry expands and competition becomes fierce among both institutionally sponsored funds and privately sponsored funds, general partnership agreements are becoming more complex. With top GPs needing to be properly incentivized and their interests aligned within the firm, agreements have to be much more carefully spelled out. Go-getter GPs that decide to take their track records elsewhere or kick-start their own funds are often seeking more than just economic gain – they want to have a say in the structural growth of the firm.

The sharing of carried interest and surplus management fees, veto rights among partners, and succession provisions are all issues GPs can look forward to hammering out and amending in long sessions with legal counsel.

The primary issue is the economics, according to Josh Sternoff, a partner in the New York office of law firm Paul Hastings, who says it is one of the biggest questions facing GPs. “Who is deciding what different percentages of the carry different individuals within the firm are going to take?”

Any such discussion should take into account differences between institutionally sponsored funds and privately sponsored funds, he argues. A general partner sponsor attached to a large global financial institution may not necessarily spread the carry in the same way as a real estate fund sponsor, which consists of a small group of partners running their own shop.

In the case of a real estate fund sponsor, it's typically one, two or three key people who are making all the decisions, says Sternoff. A performance committee or a compensation committee may also help to make those decisions. Larger financial institutions have an added layer of decision-making – often a combination of HR or other personnel up the chain – in conjunction with the particular group that is sharing in the carried interest.

For an institutional sponsor “the house is involved,” says Steven Lichtenfeld, co-chair of the real estate capital markets group in the New York office of Proskauer Rose. “They've created the brand. The brand brings significant value in terms of either deal flow, infrastructure or credibility. In effect, the house shares in the profit and the investment team will have a piece of the carry that is separate from that. For privately sponsored funds the splits will depend on the dynamic between the founders or partners and the investment team.”

Spreading the carry
How a firm structures the carry is an important question, says Sternoff. “Regardless of how your waterfall works at the fund level, whether or not you have a deal-by-deal waterfall with your investors where you get paid the carry based on the success of a particular deal in isolation or, as is more typical these days, you get a portfolio-wide return based on the return of the overall fund – either way the general partner needs to make decisions about how to share that carry around its own members.”

The carried interest is generally paid out on a total portfolio basis, according to Peter Fass, a partner in Proskauer Rose's New York office and co-chair of its real estate capital markets group. But there are deal-by-deal payouts with clawbacks. “When it's an overall fund payment you have to wait to the end and you have a lot of people who are building up tremendous value but not getting paid a lot of money upfront. Sometimes you have to figure out a way to get them some money in advance against their carry.”

Who does, in fact, get to share in the carry is circumstancespecific. Typically the carried interest is limited to a relatively small group of people who are actively involved in the portfolio investment decisions, says Sternoff. But that's not always the case. Some institutions “spread it around a little bit more in which case you'd be more likely to see smaller slices reflecting the fact that maybe you have some relatively more junior people getting a piece,” adds Sternoff.

Somewhere between 40 to 60 percent of the carry will be taken up by the investment team, according to Lichtenfeld, with maybe less flexibility in an institutionally-sponsored fund and more flexibility in a privately sponsored fund. It's also partly a function of how active the founders or partners remain in the fund. “If the founders remain very involved and the investment team is young and in essence the founders are really out there doing substantively all the work, they'll get a bigger piece of the carry.”

Some agreements between partners and employees at a private equity real estate firm may also allow employees to share in the carried interest. There are two different ways that can work. “Employees can become ‘partners’ simply for purposes of receiving the carried interest but they're still employees at the firm,” says Sternoff. “Another way to do it is kind of a ‘shadow’ carry program where in effect you're giving employees bonuses and setting aside a bonus pool out of the carried interest that's paid in the form of bonuses to employees.” It provides a means to “share the carry a little bit further down the chain of employees without making everybody a member or partner of the firm.”

For the most part, the carry and surplus management fees are not shared equitably among partners at a firm. “A lot depends upon the seniority of the various players,” says Jason Glover, a partner in the London office of law firm Clifford Chance. “If you go back five years you'll certainly find that the vast majority of the carry was given to the most senior partners, with a relatively small proportion to the middle ranking or the junior partner base. Increasingly, and particularly with potential succession issues, firms are recognizing that they need to secure the services of some of their junior or mid-rank partners for the long-term. These partners are being allocated larger shares of the carry than what they historically got.”

Questions of succession
Much like corporate entities – and perhaps even more so – private equity real estate firms are facing questions of succession. Indeed sometimes the real challenge is achieving consensus among the partners.

Inevitably control issues may arise among partners over such decisions of the firm including setting up new fund lines, or decisions to hire senior executives, among many others. A lot depends on the size of the firm, says Glover. Firms with three or four partners tend to have a consensus basis – everyone has to agree to the decision. Larger firms with perhaps fifteen or twenty partners, according to Glover, what often happens is either a group of senior partners acts as the management committee or, the management committee is an elected group of partners, elected by the partners as a whole. That committee will then make the decisions.

The partners may also have veto rights in bringing in a future partner, which can have implications in structuring the firm for future growth. “Often an ability to bring people in as partners is something that existing partners have a veto right over,” says Glover. “Such a veto right can be quite dangerous as just one person can block a hire which may be key to the future growth of the business, so it's a bit tricky.”

In the situation where a founder or partner leaves the firm, either retiring or joining another firm, they'll often have some value in the business. The question, says Glover, is how that is going to be paid out. Is it something paid out by other shareholders or is it paid out by the partnership? “Normally what you have is some sort of ‘redemption’ mechanism so that the person who is leaving will be paid out from future cash flows of the partnership with payments staggered over a period of time of say three to five years,” he says.

The provisions are generally controlled by the partnership agreement, adds Fass – another reason terms should be spelled out as diligently as possible at the start. Most likely there may be forfeiture. In other cases he may be able to keep his carry, but with penalties – it all depends on what was originally negotiated. “There's no hard and fast rule,” says Fass. “On an institutional side, you'll see more of a vesting schedule and a penalty depending whether they work for a competitor or start their own funds or other situations.”

Another key issue involves how the carried interest is “vested” – that is, how a firm rewards its partners but keeps them incentivized for the long run. Different kinds of vesting schedules exist, but as Sternoff says what most firms adopt is a “multi-year period” such as 25 percent of the partners' allotted carry a year for the first three years of a fund and “then the last 25 percent perhaps vesting at the end when the fund makes its last distribution to make sure you've got people incented to stick around until the end, and not just leave after four years.”

For privately sponsored funds though, succession issues are even more relevant as the firms continue to grow and expand – and key members are groomed to take over leading roles. “As the fund sponsor founders or partners mature naturally there will probably be some lieutenants that are groomed to ultimately run the business,” says Lichtenfeld.

“As the funds grow in stature and certain members of the investment team become instrumental to the success of the fund they'll be granted equity stakes, they'll have a bigger piece of the carry, and ultimately they will be the ones that the LPs will be looking to to manage the fund and be viewed as the driving forcing behind the fund.”