Fees minus the performance is an unfair sum for investors

Investors recognise that they must pay decent fees to get capable managers and stable platforms. However, as Joe Valente, head of investment strategy at German investor Allianz Real Estate points out, managers have lost money while collecting “astronomically high fees”.

Investors are sore and pushing for changes. “They have realised that the fees have been quite an important factor in how managers have behaved, because some fees give the manager an incentive to maximise leverage, for example,” notes Antonio Alvarez, investment director at Aberdeen Property Investors. This January, consultancy Towers Watson warned that the fees for many real estate funds, particularly opportunistic ones, are too high, and pointed to features it would like to see changed.

These included a move to deal-by-deal payment of performance fees (with capital invested in individual assets returned), as opposed to prioritising the return of all capital first; and fees based on net, rather than gross, asset value, and on invested capital, rather than commitments. As Towers Watson indicates, levying management fees on gross asset value (GAV) rather than on net asset values (NAV) may not be in investors’ interest – yet this was the arrangement favoured by 53% of the European funds polled by INREV in a 2009 survey.

Bigger bets risked bigger losses

This approach to fees ignores gearing and encourages managers to increase their assets under management: in other words, to take bigger bets and risk bigger losses. “Gone are the days of trying to charge management fees on gross asset value – there’s definitely a sway by investors towards net asset value,” says Alvarez. Invista recently switched to charging a NAV-based fee for its flagship UK listed property trust.

Meanwhile, as part of a restructuring that raised £22.4m of fresh equity, ING agreed to swap GAV to NAV as the fee basis for its UK Property Income Fund. The fund manager also introduced six-month liquidity, capped at 10% of NAV, as well cutting gearing.

Investors are also questioning whether they should be charged fees on committed, rather than invested, capital, as they resent paying for idle capital. This arrangement was common when the real estate fund management business was starting up and mangers needed the fee income to survive while their first funds got under way. But now that most fund managers are well established, this argument has lost force.

However, using invested capital as the basis for fees runs the risk that managers will be encouraged to rush money into the market, buying property at the wrong time or wrong price. Some fund managers are also under pressure to lower their management fees, particularly for opportunistic funds. To help it raise equity from big US investors for two distressed debt funds, Lone Star recently cut the minimum management fee it will charge to 0.35%, from 0.75% in its previous fund.

INREV’s 2009 fees survey found that for unlisted European real estate funds, the average management fees (based on GAV) is 0.59% for core funds and 0.61% for value-added funds. In the past, opportunity funds tended to follow the “2 and 20” private equity model: charging a 2% management fee on committed capital and a performance fee, or ‘carry’, of 20% of the fund’s profit.

However, INREV’s survey found that for European real estate opportunity funds, the average management fee is 1.64%, with drawn commitment being the most commonly applied basis.

Covering costs, not making profits

Investors now argue that management fees should just cover the operational costs of running a fund and not generate any profits for the fund manager – especially if the fund already has a profit-sharing arrangement in place. Albert Yang, director of institutional business at Henderson Global Investors, says: “Investors want to change the way fees are paid.

But they realise that if they squeeze managers too much on fees this may not provide sufficient long-term management incentives. There’s a move by investors towards fees based on NAV and performance fees on realised gains. This seems to be a more acceptable way for fees to be created and paid out, rather than applying pressure for lower fees.”

According to INREV’s survey, 88% of European funds pay some kind of performance fees. Investors are sore that they paid out big fees on target-beating returns in the boom years but received nothing back when performance tanked.

Deborah Lloyd, a partner at law firm Nabarro, says: “Performance fees on realised gains rather than valuations is a key requirement for investors right now.” Hurdle rates are also being scrutinised. INREV found that the average differential between funds’ first hurdle and their target internal rate of return (IRR) was two percentage points across all funds and was highest for opportunity funds, where the differential was 5%-5.5%.

“There is likely to be some adjustment of hurdle rates, to move closer to the fund’s target internal rate of return in new funds,” said Lonneke Löwik, INREV’s director of research and market information, when the research was published.

‘Style drift’ among funds is another issue that has come to the fore. As the market heated up and yields compressed, some fund managers were tempted to move higher up the risk curve; sitting on cash because the market was too hot would not have earned them performance-related fees. But when the slump came, investors discovered that what they thought was a core fund had drifted into making value added, or even opportunistic, investments.

Hence investors are now trying to limit fund managers’ discretion to invest – even though this runs the risk of hamstringing them by slowing down the investment process. The industry is also trying to develop performance benchmarks and hurdle targets that include a broader definition of risk, to better classify different investment styles.

Claw-back agreements are another area of contention. These entitle investors to retrieve a proportion of the performance fees paid to managers if, at the end of a specified term, the fund underperforms. Last month, Hermes announced that it would roll out its claw-back option across all its businesses, including third-party mandates. This gives investors the option of splitting annual performance fees, to be held in escrow and paid over three years. If a fund underperforms in any given year, Hermes will forfeit the fee for that period. But according to Nabarro’s Lloyd, clawback provisions have rarely covered all of investors’ losses.

Investors also have to consider the financial strength of the company the obligation is coming from. “If you are going to have a claw-back, you want it to be from a company of substance,” says Peter Hughes, a partner at law firm Salans. “If you’re dealing with a small fund, or an entrepreneurial individual, I would say you shouldn’t even have the concept of a claw-back, because you shouldn’t allow a situation to arise where the general partner receives a penny until the investors receive every penny of their investment back.” Acquisition fees are also being questioned. These fees, paid by investors on transactions, can amount to around 15-20 basis points (based on an acquisition fee of 1% on a property held for five years, over which period amortisation takes place). Such fees can encourage fund managers to spend money quickly.

Argument for acquisition fees

Simon Redman, head of European product development at Invesco Real Estate, insists that acquisition fees have their place, however. “If you look at the resources you have to deploy as part of the business – a big transaction team and the associated underwriting and legal teams – it is a very heavy resource,” he argues. Although Invesco does not charge acquisition fees for its open-ended, pan-European fund, it does charge them for most of its other funds. “You look at the overall economics on the fees you get, so that the economics stack up for the manager,” Redman says. “If you don’t have acquisition fees, you have higher overall annual management fees.”

Instead, back-end disposal fees hold more weight. David Kirkby, group head of funds management at Valad, says that in the future, alignment of investors’ and managers’ interests could come from splitting fees between asset value and income, to ensure that the manager focuses on the performance of the fund. Although INREV’s 2009 poll found that only 22 of the 258 funds surveyed had actually changed their fee structures, it is clear that new funds launched this year will be rather different.

For example, Grosvenor says it has not felt any pressure from investors to change its “fairly conservative” management fees. But it does not plan to charge performance fees on any of the four new funds it is thinking of launching this year, though it is establishing a system that lets individual fund managers share in the funds’ rewards. Invesco’s Redman believes more aggressive fees will be curtailed and some boutique managers will disappear as a consequence of a maturing market. Others are more sceptical. “There is still a level of arrogance in part of the industry, which is ‘very 2006’,” says Allianz Real Estate’s Valente. “Not all, but many of those managers haven’t recognised the full extent of the change in the market, despite what they say.”

Net asset values may be no solution to fees problem

Although net asset value is being touted as a fairer basis for management fees than gross asset value, it too can be problematic – especially during a market slump. Peter Hughes, a partner in the investment funds team at law firm Salans’ London office, points to the case of  the general partner of one private equity fund, which approached the limited partners regarding a restructuring because the net asset value – on which management fees were based – had plunged so far that fees would not cover a fraction of the management costs, making it difficult to motivate individual fund managers.

On the condition that the sponsor would inject extra capital, the limited partners agreed to pay a flat-rate management fee  for the remainder of the life of the fund, decoupling it from net asset values. “If they hadn’t come to an agreement there may have been no commercial alternative than for the fund to be wound  up – which is the worst case scenario at the bottom of market,” explains Hughes. “So the investors had a commercial incentive to be reasonable in terms of restructuring the fees.”