Top five sponsor issues in 2019

Here are key pressure points US managers currently face.

1 Attracting new investors

As savvy investors continue to enjoy a winning streak since the global financial crisis, there is little incentive for them to consider fund managers that are new to them. At the same time, institutional investors are looking to reduce the number of their investment sponsors with the goal of establishing deeper relationships with larger, more established sponsors and obtaining more favorable economic terms from them.

Barriers to securing new investors, particularly for smaller and mid-market managers, create increased pressure to outperform the competition as a means to attract new capital for future investment vehicles.

2 Downward pressure on promote and affiliate fees

The prolonged boom in this real estate cycle is driving down spreads and investment returns without any reactionary changes to waterfalls and hurdle rates. That, coupled with more heightened scrutiny of affiliate fees by existing and potential new investors, has resulted in a lower amount of absolute dollars finding their way to managers.

In response, certain managers have strayed from their core strategies in search of niche classes with the hope of generating higher returns for both investors and themselves, such as traditional multifamily players moving to student housing and/or tertiary geographic areas.

3 An ever-changing tax environment

Fund managers regard taxation as an unpredictable variable in their firm’s financial futures. They must account for increasing real estate tax assessment valuations and rates, and the threat of greater taxation at the state level. The 2017 US Tax Cuts and Jobs Act is widely viewed as reducing the overall tax burden for real estate investments and real estate investors, but it created new challenges for managers, such as an industry-wide pivot toward greater utilization of real estate investment trusts in fund structures and an overwhelming interest in opportunity zones; both have resulted in increased complexity in fund structuring, investor education, and fund reporting and accounting.

Many managers implementing REITs for the first time in their 2018 and 2019 vintage funds and those pursuing opportunity zone investments are incurring significant education and compliance costs as they try to keep up with the pace of the market.

4 Stricter regulatory landscape and increasing compliance costs

Managers are seeing increasing demands on their personnel and financial resources in the form of new laws and regulations abroad, such as the EU’s General Data Protection Regulation and the Cayman Islands’ Anti-Money Laundering Regulations; and stricter enforcement of existing laws and regulations at home, such as Regulation S-P, the primary SEC rule regarding privacy notices and safeguard policies of investment advisors and broker-dealers.

Many managers are focused on privacy, security and AML best practices above and beyond what these laws and regulations require in an attempt to distinguish themselves from peers and to avoid the very public consequences of a breach or misstep. Although scaling investment platforms enables managers to dilute compliance costs across multiple funds, these costs ultimately reduce the overall return on equity for each investment.

5 Scarcity of quality investments

For all of the factors described above managers are increasingly finding themselves in situations where they must decide to pursue investments within their investment strategy at top-dollar pricing, pursue investments at the edge of – or outside – those strategies, or simply wait.  The challenge is to remain disciplined and patient for the right potential investments to present themselves and to resist the desire to deploy capital for the sake of deploying capital. But there will eventually be a point where waiting too long results in getting left behind in the capital and real estate markets.