Property fund managers are starting to move to net asset value or committed capital as the basis for calculating their fees, INREV’s fifth Management Fees and Terms Study suggests. Carried out in late 2009, the report found that investors are encouraging managers to eschew gross asset value as the basis for fees because this had encouraged some funds’ managers to over gear, and to invest too quickly and expensively.
The report, which aimed to identify how the global market downturn was affecting fee terms and pressuring managers, also reveals one stark consequence to be that 85% of managers did not expect to earn any performance fees in 2009 (see fig 2). Managers are therefore heavily reliant on management fees; of the 88% of 268 funds in the sample base that charge an annual fund management fee, 53% said they base it on GAV. The average percentage of GAV charged is 0.6%, but in the UK – the most mature and competitive market – the figure is 0.42% for core funds and 0.52% for value-added products.
However, Lonneke Löwik, INREV’s director of research and market information, says investors are now “less prepared to accept fund management fees based on GAV”. She adds: “Fees based on net asset value or committed capital are favoured instead. Committed capital fees are seen as beneficial in markets that have not bottomed out, to temper the pace of investment.” Opportunity funds have always been more likely to base annual management fees on commitment or drawn commitment. However, with only 29 funds so far making or planning changes to fund fee structures, the pace of change has been slow.
INREV was able to collect little up-to-date information on the level of annual management fees charged as a percentage of GAV. Most of its data only goes up to 2007, but it did find that the average fee level for five value-added funds launched in 2008 was 0.56% of GAV – a big drop from the 0.8% average reported by eight value-added funds launched at the peak of the market in 2007.
The report contains insights into the importance of structuring fees to align investors’ and fund managers’ interests, rather than primarily to serve managers. Performance fees – charged by 219 funds, or 82% of the sample – are the most contentious area. A total of 73 funds (most being value-added) apply performance fees at termination only; most opportunity funds charge these fees on a per-deal basis as assets are liquidated during a fund’s life.
Investors wanted to see managers rewarded for market outperformance, but current practice has rewarded managers before they reach their target internal rates of return (IRR). Most managers have enjoyed payouts based on hurdle rates lower than target IRRs (see fig 3) – a practice investors believe should change (see panel, right). Again, the report contains few signs that managers are reforming their fees, except when funds are extended or rescued via recapitalisations; then, performance fees are often rebased to start at the extension period, rather than the fund’s inception. Another beef for investors was performance fees based on unrealised returns. Some 60 funds reported charging such fees, usually on valuation uplifts, or fees based on both unrealised and realised returns, with 50 of those 60 saying that they based performance fees on valuations.
While 40 funds used third-party valuations, six did not (the valuations were done in-house by fund managers); four said valuations were based on a combination of internal and external calculations. Looking forward, investors said they will only agree to pay future performance fees on realised returns (see comments panel).
They also struggled to see how acquisition fees, which are charged by 40% of funds (see fig. 1), are justified and would like to see them scrapped, as part of a move towards simpler fee structures with fewer components. Investors also said that there were no clear patterns relating to how performance fees were paid to teams, rather than to their management company. Clearly, they wished to see a portion of fees going to the management team.
Investors had other concerns and ideas about minimising risk. They are interested in more co-investing by individual management teams at fund level, without which “the fund manager could be incentivised to take on more risk than appropriate, to try and meet the hurdle rate for the performance fee”, the report says.
INREV study puts fund managers under the spotlight
In total, 77 managers of 268 funds replied to at least some parts of INREV’s questionnaire, sent out in September 2009. Of this total, 33 were opportunity funds, 90 were value-added funds and 145 were core funds. Five fund managers, including Grosvenor Fund Management, Schroder Property Investment Management and Valad Property Group, were interviewed, as were seven investors, including Aberdeen Property Investors Indirect Investment Management,
Allianz Real Estate, ATP Real Estate and Russell Investment Group. Fee levels reported are based on agreements with investors in final fund documents, so don’t take account of special side deals agreed with larger investors. The report and a Fees Study Supplement use the five fee categories set out in INREV’s Fee Metrics Guidelines: initial charges, management fees, performance fees, fund expenses and property-specific costs.
How life has changed
• With the market downturn, investors’ bargaining position has improved, leading to pressure to cut annual management fees.
• Performance fees based on reaching hurdle rates lower than target internal rates of return (IRR) should be scrapped, or should be based on smaller percentages of the return above the hurdle rate than is current practice. Performance above target IRR could be rewarded with a larger share of the outperformance.
• Investors are very unlikely to agree to pay performance fees based on unrealised returns (ie valuation uplifts). Instead, such fees should be charged on a per-deal basis as assets are sold (with clawback clauses to avoid problems reclaiming them later if the fund fails to meet targeted performance at termination), or as ‘back-ended’ fees, charged only at the end of the fund’s life, or paid after investors have received back 100% of their capital.
• Acquisition fees are unjustified because very few deals are ‘off-market’ and managers should not need incentives to do a core part of their job: finding deals.
• Fund managers must be motivated to continue managing funds and most are not earning performance fees in current market conditions, but significant performance fees were paid out during the market upturn.
Fund managers’ comments:
• Managers are often understaffed and co-ordination between investors to renegotiate fee terms can be very time-consuming.
• With new or restructured funds likely to be lower geared in future, and so smaller in terms of GAV, less fees will be paid out, even if percentage fee rates remain unchanged.
• Personal co-investment by management teams is very difficult to achieve, except for boutique fund managers, where the management team owns the companySmaller first-closing investors – as well as large investors – frequently demand fee discounts in side letters to the final fund documentation. Thus fee structures are becoming less, not more, transparent.