Published in Superfunds journal, June 2009, pp. 44-46.
Fund managers and their fees are under the spotlight as a result of the economic crisis. Although fees have always been a sensitive issue at the best of times, they are inevitably more contentious in an environment where negative returns are prevalent. The global financial crisis brings the issues of alignment of interest and incentive structures to the forefront of the discussion.
Bluntly, investors ask: “why are we paying so much when we are losing money?” What was normal and standard practice during boom times is now under fresh examination.
Most of the focus of this article will be with the value-add, unlisted property sector in mind, though almost all of the issues are relevant to other sectors in the funds management industry.
The basic premise behind external value-added funds management is to provide investors with superior risk adjusted returns that they otherwise would not have access to. In so doing, the fund manager takes a slice of the upside. This assumes that the upside justifies the fees.
Particularly in the value-added space, investors are questioning whether there has been sufficient alignment of interest, transparency of fee structures and whether the rewards are too skewed to the manager, rather than the investor.
Some practices give the industry a bad name. All too often, structures have been implemented that allow fund managers to take out more than their fair share.
Good fund managers work hard to achieve the best returns for their investors. But, what fees are appropriate? How high should these fees be? Which fees are inappropriate?
There is a variety of fee structures that are charged by fund managers. These include transactions fees, gross asset fees, establishment fees, success fees, consultancy fees, research fees; and the list goes on. This article will postulate suggestions on best practice and argue for transparency.
Transaction Fees
One key driver of fees of recent years has been transactions. That is, charging a management fee as a manager acquires an asset. This type of fee provides a perverse incentive to the fund manager to acquire more. The more they buy, the higher the fee income. The emphasis might not be on the merits of the deal, but on the transaction itself. This is wrong.
At the peak of the commercial property market in 2006 and 2007, the number of transactions was staggering. Expression of interest campaigns were swamped by funds managers trying to outbid each other. Ironically, many have had a similar investor base.
The incentive was clear – buy more and grow the empire. This model appears to ‘work’ in a growing market. But when the market declines, a portfolio is swamped with over-priced, over-geared assets.
There is little doubt that transaction fees were a key driver in the eagerness to acquire assets. The incentive structure it provided did nothing to sedate the property market. The result now is revaluations and write-downs.
Transaction fees should be discouraged in the funds management industry as they provide the wrong incentive.
Ideally, no fund manager should charge transaction fees.
Base Management Fees
Base fees are the most common form of fees charged.
Essentially, this represents an annual management fee on assets with the fee charged depending on the size of the fund and the type of fund. These fees are intended to provide the fund manager with an appropriate ongoing revenue base for the life of the fund.
There is, however, a key distinction as to whether this fee is charged on gross or net asset value.
If fees are charged as a percentage of gross asset value, there are two consequences.
One is the incentive to gear aggressively. That is, the greater the portfolio gearing, the larger the fund and the larger the gross asset fee.
The other consequence is the incentive to aggressively revalue assets. That is, the greater the revaluation, the higher the gross asset value, the higher the fee.
If fees are charged as a percentage of net asset value, the former consequence is avoided but the latter is not.
These kinds of incentives need to be severely discouraged in the industry. Portfolios are now in trouble given their high levels of gearing and the previously aggressive valuations. In a business environment that is de-leveraging and where asset prices are falling, the impact is severe.
The most appropriate annual base fee is to charge on committed equity over the investment period and on historic invested equity thereafter.
Fees should not be dependent on market revaluations as these are “paper profits” and the fund manager should only be rewarded when these are converted into realised returns. Such a fee structure substantially mitigates the incentive to acquire assets in order to increase fees.
The base management fee should be enough to provide the fund manager with a reasonable income stream to recruit and retain talented staff, but should not falsely enrich the fund manager before a fund’s total return is realised.
Success Fees
The best way of rewarding the fund manager for achieving good returns is a “success fee”. This is usually applied best to a closed end trust with a defined end date.
Success fees provide the best incentive to reward fund managers through actual performance when a trust produces a realised return. This ensures that performance matters – not revaluations.
Generally, the fund manager charges a fee for achieving a certain benchmark in returns to investors.
One example might be where the fund manager earns 20 per cent of any profit above an absolute benchmark return of 10 per cent per annum, most commonly measured as an internal rate of return (IRR).
It is important to back-end all success fees and judge performance on the fund as a whole, not on an asset-by-asset basis.
It is not appropriate to charge investors “success fees” on select assets that have performed well when the overall performance of the fund has been below the benchmark return. Investors care more about their overall return, rather than piecemeal successes and failures.
Although back-ended success fees on realised returns are preferable, this might not be possible for an open-ended trust, with no defined end date.
The majority of unlisted property funds tend to be closed ended, but where they are not, performance can be calculated on a whole-of-fund basis using valuations each 7-10 years.
It is important, in this instance, that the valuations are conducted by an independent valuer appointed and instructed by the Fund’s investors, to ensure that appropriate probity requirements are met.
Alternatively, in such instances, it may be appropriate to pay asset-by-asset success fees on realisation, provided these payments are at least partially subject to escrow and claw-back provisions.
Manager Co-Investment
One way to ensure that there is a strong alignment of interest is through manager co-investment. If fund managers truly believe in their product they should put their money where their mouth is. There should be some “hurt money” in a fund for the manager. The dollar amount invested needs to be significant, relative to the net worth of the fund manager.
This ensures that the fund manager has a strong pecuniary interest in the performance of the fund and discourages excessive risk taking.
Other Fees
Many additional fees are often hidden in the fine print. These may include consultancy fees, debt arrangement fees and asset management fees – all charged for services typically included in the base fee. These fees should be avoided wherever possible.
Legitimate fund expenses are usually borne by the fund, but lines tend to blur when fund managers cross-sell other ‘services’ to captive trusts in order to generate fees. This occurs particularly when a fund manager charges separate fees for debt arrangement and asset management.
There are select situations where a fund manager has expertise in an area that is quite separate from funds management. These need to be spelt out explicitly in the trust deed along with the circumstances and fees payable. This then allows the trust deed to prohibit all other related party transactions.
The current economic climate has focused investors’ minds on the fees they are paying to fund managers and the incentives that such fees give rise to.
The quantum of fees is best left to the marketplace, but what is important is that the fees are transparent and structured for maximum alignment of interest between fund managers and investors.
Postscript (2015)
Alex Banzic, then employed at EG, helped write this piece.
In 2009, Adam Geha and I were inspired by a joint statement issued by the heads of the two largest asset managers advising the Australian superannuation industry.
Colin Lau, then head of real estate at the China investment Corporation (CIC) in Beijing told me that he circulated the article to his colleagues in CIC as a useful guide on “what to look out for.”
