Discover how Small, Unknown Managers Deliver Strong Returns to Savvy Investors

Can small, relatively unknown real estate managers deliver better returns than large, well-known firms? Every investor who has opened the Wall Street Journal or clicked on a major online publication knows the brand names of private REITs and non-traded real estate vehicles. These are the multi-billion firms acquiring massive portfolio deals multiple times a year. However, there are many, less visible, smaller managers who can deliver outstanding returns. Here is a look at the benefits and downsides of choosing large or small managers for your next investment.

Manager Compensation

All fund managers are compensated by a combination of asset management fees and performance fees. Smaller managers, due to their lower investor assets under management (AUM), do not have the critical mass of assets to generate a meaningful, steady flow of fee income (typically a flat percentage of AUM charged regardless of performance). Large funds, due to their large AUM, may emphasize steady management fees over performance-based incentives.

Large fund managers’ business models can often sustain indefinitely on recurring asset management fees without the need for performance-based incentives. In order for smaller managers to be compensated, they must deliver strong returns to investors to trigger the performance hurdle and allow the manager to participate in the profits of the deal.

Fund level liquidity needs

Due to the structure of larger funds, which often require regular distributions and allow for investor redemptions, large fund managers must always have ample amounts of liquidity to meet the potential investor redemptions and pay distributions on schedule. Closed-end private funds usually have no redemption rights and have the ability and have manager’s discretion as to when to distribute cash to investors.

Due to fund-specific liquidity requirements, managers may be forced to hold varying levels of cash. Although cash does earn a low single-digit interest rate, the manager’s performance will suffer if higher levels of cash are required at the fund.

Deal Sizes

Small managers, by nature, can only operate in the smaller deal space. The smaller market presents a wide set of opportunities, given the large number of transactions compared to the $50MM+ deals where the large funds operate. Large funds must write large checks to effectively deploy their investor funds. Smaller managers will incur higher costs per deal relative to the large funds as measured by transaction size, but smaller managers will see a much wider opportunity set of potential investments.

Large funds are often in a space with other very sophisticated operators, making it less likely to find a below-market acquisition. Smaller funds can be much quicker when pursuing an acquisition without the need for committee meetings or large investor approvals.

Investor Access

Although reporting requirements depend on firm size and structure, it is very difficult to access the CEO of a large fund. Smaller fund managers should be very responsive to their investors as each member is a meaningful source of capital compared to a single investor of a larger fund.

Fund infrastructure and support

Large funds have advantages beyond scale, such as rigorous risk management, deep market research, and proven execution in complex deals, which smaller managers cannot execute.

Smaller funds will often utilize third-party services for accounting, legal, admin, investor relations and other aspects of the business. Larger funds, due to scale, can handle almost all of these ancillary needs in-house. The benefit of working with a smaller fund is many people on the team where multiple hats, whereas larger funds are not as susceptible to key man risk due to having departments dedicated to a single aspect of the fund instead of a single team member with smaller funds.

Track Record

All managers will have a bad deal occasionally. Investors should be looking for a manager with a track record showing the ability who can generate outsize returns over multiple deals instead of selectively picking outliers in an otherwise strong track record. Large fund managers often have a lengthy track record with large deals showing market-rate returns, but smaller managers can be much more strategic in their acquisitions to target niche markets and unique situations.

Larger funds tend to have more mainstream investments because the manager’s investment objective needs to cater to a more general investor group. Smaller funds can focus on more niche investments due to the market set opportunity size and the number of investors willing to invest in these strategies.

Smaller managers often have a significant portion of their net worth invested in their own fund, so there is a strong alignment of interest between manager and investor. Larger fund key personnel’s compensation can be tied to the fund level profits, which can be largely driven by AUM with a smaller tie to fund performance. The manager’s own compensation can reduce the direct alignment between investor returns and manager compensation. Although large fund managers can be incentivized to increase fund performance, it is in the investor’s best interest to verify how managers are compensated.

Conclusion

While large, well-known funds offer scale, resources, and stability, smaller managers often deliver strategic advantages: alignment of interests, nimble decision-making, access to niche deals, and close investor relationships. For investors seeking strong returns and direct engagement, small, unknown managers can offer opportunities that larger funds simply cannot.

Important Information 

This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.

The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.

Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.

Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.

Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.