The terms that bind

As capital continues to flow into private equity real estate, GPs are gaining the upper hand in negotiating the terms of their fund documents—but that doesn't mean LPs are staying quiet. By Paul Fruchbom

In his book Money and Class in America, the writer Lewis Lapham, editor of Harper's Magazine and equal opportunity social critic, compares money to the element of fire. “Men can employ it as a tool,” he writes, “or they can dance around it as if it were the incarnation of a god.”

Lately, investors worldwide have had little reason to dance. Global equity markets continue to be sluggish. Bond yields remain depressed. Even real estate, which has enjoyed a spectacular run of late, has seen a severe compression in cap rates and a general consensus that the sector is entering a lower-return environment. The reason for all of the above: an overwhelming supply of capital.

In today's financial markets, water, not fire, may be the most apt metaphor—it won't burn you, but you can certainly drown in the flood.

As the deluge of capital pours into the property sector, it's not just influencing overall returns and investment opportunities. It's also seeping into the industry's foundation, exerting pressure on the basic structure underpinning the private equity real estate sector: the limited partnership agreement. Even legal documents, after all, are not immune to the forces of supply and demand. And as the pace of capital flowing into the opportunity fund sector outpaces the number of managers capable of investing that capital, the balance of power between LPs and GPs is shifting—and not in favor of the institutional investor.

“The first comment that I hear more than any other is that there is so much competition for good funds that GPs are not giving on terms,” says Gary Stevens, a partner in the real estate group at secondaries investor Landmark Partners.

Doug Weill, a managing director in the real estate private equity fund group at Credit Suisse, agrees. But he points out that even if sponsors have a newfound advantage, they are not actively using it to press for better terms.

“There is less leverage on the part of investors to negotiate today because of the liquidity in the market,” says Weill. “I think the GPs are taking advantage of that liquidity to push on their terms, but not considerably.”

reason may be that business partnerships are not driven by the same forces that govern large-scale financial markets— relationships matter. And as much as GPs have the upper-hand today, they're more interested in building long-term partners and creating trust than they are in squeezing every penny out of their LPs.

“GPs can't just stick it to investors,” says Gary Koster, a partner in the real estate, hospitality and construction group at Ernst & Young. “They want to be in this business for 15 or 20 years. They're not here to swoop in today and leave tomorrow.”

In fact, one of the most surprising aspects of the current environment is the extent to which LPs have been able to withstand conceding terms to their general partners—and even, in certain cases, winning concessions of their own. Firms of all shapes and sizes (and track records) may be able to raise capital in today's environment, but, in general, that does not mean they have been able to strike a better deal for themselves.

“You really have to bifurcate the universe,” says Koster. “If you take the old-line public and private pension funds that have been investing in private equity real estate for a long time—they're the 600-pound gorillas of the world. They've got Nori Gerardo-Lietz and a whole fleet of consultants that ultimately wield a lot of power because they control a lot of institutional money.”

In reality, some aspects of the limited partnership agreement are so well-established that it's difficult to get any significant movement, regardless of the balance of power. Management fees, for example, are typically set at 1.5 percent of committed capital. Several placement agents note that such fees can reach as high as two percent in certain situations, but this is dictated more by circumstance—a first-time fund or an international vehicle—than any particular negotiating leverage afforded to either party.

Similar precedent holds in the realm of carried interest, where the standard 80/20 split is fairly widespread. Yet some sources note that LPs have been able to negotiate more favorable terms, particularly with emerging managers, where the GP promote is structured as a step-function—the carried interest percentage gradually increases to 20 percent as certain return thresholds are reached.

“New managers are hoping that they can compete for capital against established funds by offering terms more favorable to the investors,” says Stevens. “In particular, higher preferred hurdle rates, lower carried interests and lower or deferred management fees.”

As the above makes clear, it is difficult to make generalizations about the terms governing real estate funds. Regardless of the amount of capital in the market, each firm is different. Terms and structures vary based on a wide variety of factors, including the track record of the sponsor, their experience, geographic focus and investment strategy.

Nevertheless, some broad points can be made. Over the past several years, for example, GPs have been able to negotiate a lower preferred hurdle rate, the return threshold which a fund sponsor needs to surpass before it begins to share in the partnership's profits. That's not to say the debate has been easy. Landmark's Stevens points out that as return expectations are coming down, LPs feel they deserve a higher preferred hurdle while GPs, in order to maintain their incentives even if returns come in below their targets, are pushing for a lower one.

“Generally, I think GPs are winning that argument and prefs are coming down,” says Stevens.

The numbers would appear to back that up. A recent Ernst & Young survey, which covered approximately 179 funds with aggregate capital of $93 billion, showed an average return hurdle of ten percent (see chart on p.31). Credit Suisse's Weill points out that while a preferred return of ten to 11 percent used to be the norm, nine to ten percent is now more common; 11 percent, he said, is atypical. Other industry practitioners argue that an even lower threshold, eight percent, is becoming standard.

While sponsors have been able to negotiate a lower preferred return, investors have pushed back on the GP catch-up, which provides for the fund manager to receive a disproportionate share of the profits after the preferred hurdle has been reached. While the catch-up percentage used to be as high as 80 percent (or even 100 percent in some outliers), that number has trended down for several years—according to most market observers, the average is now approximately 50 percent, a figure that is still too high for some LPs.

“Some investors and consultants don't think there should be any catch-up,” says Stevens. “They think the carried interest should only apply to returns in excess of the target return.”

A more realistic negotiating posture for many investors, however, is not the size of the catch-up, but rather where it actually kicks in. Weill points out that the norm is still a catch-up that begins at the preferred return. But he adds that, in specific cases, LPs have successfully negotiated a more favorable structure.

“The real debate is where the catch-up starts,” he says. “For many first-time funds the catch-up starts at say 15 percent—when the investor has netted an IRR of 12 to 15 percent. Several funds have gone out to the market with that structure or been negotiated down to that.”

Another area where LPs have made gains in recent years is the timing of the GP's carried interest payments. In many of the funds raised in the early 90s, primarily in the US, the promote was paid out on each individual deal rather than at the end of the fund's life, a structure that favored the sponsor. Even though investors are now protected by clawback provisions, as one placement agent put it “it's not easy to go after Joe GP.”

“We see a lot of pressure from LPs to have the promote paid out on the back end—and GPs acquiescing,” says Weill. “Where there is a deal-by-deal payout, LPs are asking for personal guarantees to back up the clawbacks. That is leading more GPs to move to back-end promotes.”

Increasingly, investors have also been scrutinizing the use of subscription lines, revolving credit facilities that use the commitments of the LPs as collateral. GPs typically borrow against these lines to cover transaction costs, acquisition fees and other incremental expenses in order to prevent calling capital at irregular intervals. However, industry practitioners also point out that funds sometimes use this cash to acquire assets, taking advantage of the arbitrage between the cost of debt financing and the LP's preferred return. David Watson, a partner at Goodwin Procter, points out that investors are now very focused on exactly how long these subscription lines can remain outstanding, thereby limiting their usefulness in acquisition financing.

“That's the hot negotiation at the moment,” Watson says. “And it goes back to the idea of institutions putting money to work. From the investor's perspective, they don't get paid for the return. They get paid for putting money out.”

Economic terms such as fees and catch-ups occupy a fairly important place in an LP's heart. Yet in recent years, much of the debate around the negotiating table has focused on non-economic factors. As investment managers branch out on their own and sponsors employ ever more complex investment strategies, issues such as control, fund governance and management succession have risen to the forefront of LP's agendas.

For example, given the number of managers leaving larger institutions to form their own funds, key-man provisions are coming under greater scrutiny. A related area of focus is the extent to which the carry is spread out amongst the various principals of the GP—the more compensation a partner is receiving, the less likely he or she will jump ship or strike out on their own. Investors are increasingly digging down to make sure that all critical members of a partnership are sharing significantly in the GP's upside.

“Alignment of interests is the most important thing,” says Michael Crawford, a partner at placement agent CP Eaton. “If you're not spreading out the carry among your people—you know, it's not the old days.”

Investors are also keenly focused on their governance rights, whether a key man leaves, an investment team breaks up or, simply, the investors decide they don't like the fund manager anymore. According to Watson, no-fault provisions, which typically require a super-majority vote of the LPs, are fairly common, particularly those that freeze the fund manager's ability to make future investments—as he puts it, “if 80 percent of your investors don't want to put more money in, you probably shouldn't be asking them for money.” He adds, however, that no-fault provisions that provide for the removal of the fund manager are very uncommon—at least for now.

“Investors are very focused on all of the issues related to the management team and removal provisions,” says Watson. “We haven't seen a lot of no-fault removal provisions yet, but people are asking for it.”

Investors are also asking for greater control in terms of how their money is spent. Though opportunity funds have generally had wide discretion in the past, Watson says that LPs are now looking to put parameters on that authority, particularly on the number of investments that are made outside the US, as well as what types of assets, such as large portfolios or operating companies, can be acquired.

“In private equity, it's called strategy drift, but they don't have a name for it yet in real estate,” says Watson. “We have some clients that have made so much money that their investors will let them do whatever they want. But we see this a lot in newer funds or first-time managers.”

TERMS OF ENDEARMENTSelect terms for private equity real estate vehicles based on a survey of 179 funds

Terms Average
Targeted gross returns 21%
Target net returns 17%
Percentage raised from sponsor 8%
Preferred return hurdle 10%
GP promote 20%
GP catch-up percentage 50%
Original investment period 4 years

As opportunity funds scan the globe for new investments and investors, doing deals is one thing—repatriating profits is another.

Anyone who has ever studied the voluminous family tree of the British royals would probably be familiar with the mystifying series of diagrams that constitute fund structures in the modern-day private equity real estate industry.

A fund with tax-exempt and taxable US investors, non-US investors and a global mandate may have a variety of parallel structures incorporating private REITs, US limited partnerships, UK limited partnerships, Luxembourg SICARs and Dutch CVs, not to mention special purpose LLCs in each of the countries in which the fund is investing.

“You send investors these diagrams where you have five entities between the fund and the dirt,” says David Watson, a partner at Goodwin Procter. “And investors get very nervous very fast when they see the tax implications.”

Of course the industry itself has changed very fast—and as it has, tax structuring has become an even more important point of discussion between GPs and LPs around the negotiating table. Opportunity funds are not only investing in countries around the world—each country with its own tax regimes and regulatory agencies—they are also courting capital from an ever widening source of global institutions and individuals. Private equity real estate funds, which are structured based primarily on the nationality of its investors as well as the scope of its geographic focus, must be flexible enough to accommodate a wide range of investors and strategies, while also remaining rigid enough to achieve the bottom-line goal: repatriating cash from one domicile to another as efficiently as possible.

A gross return of 20 percent is nice—losing 500 basis points to inefficient tax structuring is not.

“Common structures are few and far between. You have to look at each deal on its own.”

Fifteen years ago, when it was primarily US investors investing in US assets, the structures were relatively straight forward, typically Delaware limited partnerships. As European investors came to the US—and US investors went abroad—the complexities involved increased.

“Historically, Delaware partnerships have not been very friendly to investors outside the US,” says one US placement agent. “As a lot of European investors have come on-line, they have spent a lot of time focusing on the tax drag and alternative structuring. One question they're asking is how much work am I going to do and how much is the GP going to do.”

Whoever does the work, there is a lot to go around. And it has expanded as the range of available options has increased— REIT structures, for example, are now often embedded in some US partnerships. Though the format limits what types of investments a fund can make, they do provide tax advantages for many taxable investors.

Moving into Europe, the number of structures increases dramatically, from UK limited partnerships to Dutch CVs to Luxembourg SICARS, to name just a few. Which of these options to utilize—or how many of them to incorporate—again depends on a variety of factors, including the types of treaties between the country that is being invested in and the country where the institutional investor is located.

“It's a little bit of treaty shopping,” says Geza Toth-Feher, a partner at Paul, Hastings. “If you look at real estate funds, going through a Luxembourg structure has some attractions, but I've also seen some Dutch double-tiered structures.”

Rob Short, non-executive director of fund administration firm Mourant, agrees. “You might be a US operation buying a Spanish shopping mall,” he says. “But you're using a Dutch CV because you have a very good treaty network, for example, between Holland and Spain.”

Perhaps understandably, the Dutch CV is also a popular vehicle for Dutch institutions, which have traditionally been one of the more active investors in the European real estate market.

Another popular structure is the Luxembourg SICAR, which has proven popular for investors in both private equity and private equity real estate. Mourant's Short says that 55 SICAR structures have been completed thus far in the two asset classes.

“The SICAR is totally tax transparent,” he says. “And Luxembourg has one of the most robust treaty networks. It's very favorable to investors and very flexible in getting cash out of the structure.”

Given the diversity of legal and regulatory structures across Europe—and even beyond the Continent—experts point out that it's difficult to draw broad conclusions about which structure is common or most applicable. As much as real estate is a local business, so too are the choices available for tax structuring.

“Common structures are few and far between,” says Watson. “You have to look at each deal on its own.”

That becomes even more true when investors move to the developing markets in Eastern Europe and Asia, where treaty agreements among countries are perhaps not as robust as in the West. Private equity real estate fund manager JER Partners, for example, is currently looking at the Russian market— Mourant's Short points out that the firm is using a UK limited partnership going through Cyprus, because of favorable treaties between the two countries.

In Asia, a region many opportunistic investors are targeting, the choices—and complexities—increase. Short says that domiciling partnerships in the Cayman Islands is a popular option. He adds that investors going to India are looking at vehicles in Mauritius. And China?

“I'm not sure I've got my head around that yet,” he says. The increasing globalization of the industry ensures that investors, lawyers and GPs will be busy getting their heads around these topics for years to come. Yet despite the difficulties perhaps involved, Toth-Feher points out that the end goal remains the same: simple repatriation of cash.

“It's not rocket science,” says Toth-Feher. “Real estate funds use the same structures as a typical private equity fund. More or less everybody is using, if not the same, then similar structures. As we say in Germany, they all cook with boiling water.”