Related-Company Fees: Normal Industry Practice or Conflicted Compensation?

Editor’s Note: The question of whether certain fees collected by alternative investment managers constitute conflicted compensation has become more prominent recently, with regulatory agencies as well as investors exploring the topic. Brian Farmer and Alina Grinblat of law firm Hirschler Fleischer explain the issue from the real estate fund perspective, a segment of the market where related-company fees are relatively common.

Related-Company Fees in Private Real Estate Funds — Normal Industry Practice or Conflicted Compensation?

By S. Brian Farmer and Alina Grinblat, Hirschler Fleischer

In a recent speech to the Managed Funds Association, U.S. Securities and Exchange Commission Chair Mary Jo White gained the firm attention of the private real estate fund industry. In her speech, White noted that the SEC’s Office of Inspections and Examinations (OCIE) is concluding a survey of real estate fund managers, and that as a result, there is concern among the SEC staff about inadequate and potentially misleading disclosure to private real estate fund investors regarding related-company services being furnished to private real estate funds and their portfolio properties, and in particular, whether market rates are being charged.   

Many private real estate fund managers view themselves as “fully-integrated” commercial real estate operators, and see their ability to provide leasing, property management and brokerage services as a competitive advantage to investors in their fund. 

For example, it is not uncommon for a private real estate fund manager to have an affiliated property management company providing property management services to the fund’s portfolio properties. This company may have an active business providing property management services not only to the fund’s properties, but also to properties owned by unrelated clients. Many times, this company will have been in business much longer than the manager has been overseeing private real estate funds.  

In our experience, there is often no offset of these related-company fees against the management fee paid by the fund to the manager. Contrast this practice to the typical full or partial offset of related company fees in the private equity fund industry.  

Is there something unique about the real estate fund model that drives this difference in how related company services are treated? To the extent that property management and leasing services are viewed as essential services that must be performed for any commercial property regardless of whether it is owned by a private fund, then there would seem to be some potential efficiency and informational advantages in the fund manager using its own related company resources to perform these services. In comparison, it is not as often that a private equity sponsor has an established investment banking or management consulting business already serving outside clients. 

Whether market rates are being charged by the real estate fund manager’s related company is a separate question, and one over which the SEC is expressing skepticism (many real estate fund managers structure their portfolios in a manner they believe avoids an obligation to register as an investment adviser). Our experience is that a real estate fund manager whose related company is already serving outside clients is in an ideal position to document that its rates are consistent with the market. 

Any third-party data (price surveys, broker market reports) can also be valuable. Often, fund disclosure documents take the focus off the market-rate inquiry by stating a fixed or maximum rate (for example, 4% of gross rental receipts) that can be charged by the related company for these services, rather than providing assurance that the rates are market or arms-length.    

What about transactional fees – origination, structuring, disposition or refinancing fees – charged to portfolio properties by a real estate manager or its related company? If these fees are for actual real estate brokerage services and the related company is licensed and regularly works with outside clients in similar engagements, the question would seem to focus more on ensuring the market pricing of the services rather than whether the manager is “layering on” fees that could prudently be avoided.    

Transactional fees beyond the brokerage example are more challenging, yet many real estate fund managers charge them. Often the fee is justified as reasonable by the manager because of the manager charging a fund management fee at a lower than customary rate – in effect, an advance management fee offset for these transactional fees.   

However, transactional fees such as origination, disposition and refinancing fees raise trickier conflict of interest issues. How can investors feel confident that the timing of a portfolio property sale maximizes the return to fund investors rather than providing the manager a helpful inflow of cash, particularly if the fund is not yet making carried interest distributions to the manager?  

What exactly is the real estate fund manager doing to earn a separate origination fee – isn’t the manager getting paid the fund management fee in part for identifying and structuring portfolio investments? Does a refinancing fee cause a manager to use more leverage on a portfolio property than it otherwise would? Because of these types of conflicts, transactional fees in our view create the biggest challenge in an SEC examination. In addition, depending on the type of transaction, receipt of these types of transaction fees may raise questions of not only real estate brokerage licensing, but also securities brokerage registration.

We typically advise real estate fund managers who are charging transactional fees of this sort to provide clear and conspicuous disclosure in their offering documents – not only as to how the fee is calculated, but also what services beyond those traditionally associated with fund management are being compensated by the fee. 

Managers may also consider better aligning these fees with investor returns. One example is to provide in the fund documents that if the fund investors have not received, at a minimum, both a full return of their capital and the stated preferred return at the end of the fund’s life, the manager would return not only any carried interest distributions previously taken (the typical carried interest “clawback”), but also transactional fees charged. Partial management fee offsets against these fees might also be explored.  

One thing is certain – there will be a continued high level of regulatory interest in real estate fund managers whose related companies charge fees to the fund or its portfolio properties without an offset against the fund management fee. Even for real estate fund managers who are not registered, this regulatory interest may drive the market towards more of a private equity model of fund management fee offsets, particularly in the case of transactional and other fees charged for services that the manager or its related companies do not typically charge to clients outside the fund.

About the authors: S. Brian Farmer chairs Hirschler Fleischer’s Business Section, and leads the firm’s Investment Management & Private Funds Group. His practice focuses on the investment management industry, and he works with both institutional investors and investment managers. Alina Grinblat is an attorney in Hirschler Fleischer’s Business Section, and focuses her practice on investment management and mergers and acquisitions.