How Advisors Should Evaluate a Private Real Estate Fund Manager

A fund product managed by a competent manager can look like a great investment for your clients.  Not all private real estate offerings have the same boilerplate terms.  An advisor should understand the fund terms soon after the initial meeting with the manager.  This article will go over some of the main points of fit between an offering’s terms and the clients’ needs.

Client Fit

Funds provide a variety of risk and potential outcome measures, asset exposures, liquidity requirements, distribution plans, time horizon, tax benefits, and a lot of other concepts which go well beyond what this article can cover.  The process of identifying the right fund starts with the client.

Due to the often long-term and illiquid nature of funds, it is important for the advisor to understand the client’s profile and needs first before presenting investment options to the client.  After assessing the client's needs and parameters then the advisor can begin sourcing funds.

The advisor should also determine an appropriate allocation given the client's overall portfolio, existing alternative investment exposure and liquidity needs.

One sentence recap:  Match the client’s needs to the funds.  Don’t force a fund onto a client.

Is the Manager’s Mandate and Expected Outcome Clear and Easy to Understand?

The investment objective, target assets, business plans, leverage, and potential downside should be clear after hearing the manager’s elevator pitch and confirming what he or she is saying matches the PPM.

A private placement’s mandate should give the manager enough latitude to operate in a specific asset class or asset.  If the written investment objective is not specific enough for the advisor’s client, seek other opportunities elsewhere.

One sentence recap: Talk to me like I’m in grade school.  If the manager’s pitch is too confusing or if the PPM is too vague, it is probably not worth your time.

Track Record Analysis

The four main points are:

• Completeness and transparency — does the manager have large gaps of time in their track record and/or are they only showing winning deals?
• Return analysis — Ask how the returns were generated.  Do not look at IRR and EM as a single determinant of whether the manager can execute.
• Manager’s experience — Any manager with a decent number of deals in their track record will have some deals which underperformed.  Ask the manager what went wrong and what they learned from these poor deals.
• Strategy or style drift — The track record should show a historical focus on the same asset type and business plans that are consistent with the offering the investor is considering.

Here is a longer article on track record analysis.

One sentence recap:  Consistency and detail can be more important than return figures.

Ask How Managers Dealt With an Underperforming Asset or Fund

A good manager will own their inferior performance.  They should be able to explain what went wrong, where they made poor decisions, and how they corrected the course.  Mistakes will happen in investing as results are not guaranteed.  The red flag is if the manager makes the same mistake a second time.

Managers who blame the macro environment, do not take responsibility for their actions, or provide unconvincing reasons for why the investment failed to hit modeled returns should be questioned and possibly removed from consideration.

Use this question to better understand the manager’s investment process.  How do they screen, underwrite, approve, and asset-manage investments?  A strong process often leads to strong results. By approving the process, an investor can get comfortable with the manager’s outlook on future performance.

One sentence recap:  If the manager learns from a poor-performing asset, it can make the manager much better at their role when assessing future opportunities.  

How is the Portfolio Constructed?

Investors are buying assets owned by the fund they are investing in, so ask how the manager sources their investments, what limits their overexposure to geography, vintage, business plan, hold times, leverage, and concentration.  Ask for the ratio of deals reviewed to deals closed. The manager should be able to demonstrate both meaningful deal flow and a willingness to say no.  By understanding how the fund is created from the bottom-up, confidence in the overall fund can be achieved by the advisor.

Does the fund cross-collateralize its assets?  Is the carry calculated under a European or American method?  Is borrowing allowed at the fund level?  How is the carried interest charged by the manager?  What is the deployment period?  These are the questions which translate asset-level returns to investor returns.

One sentence recap:  Understanding of the asset selection and fund management are the keys to confidence in the manager and the fund.

How Does the Fund Structure Align the Manager and Investor?

The manager’s compensation is typically a two-part structure:  fees and carried interest.  

Fees should be understandable, clearly disclosed, and appropriate for the services being provided. Given the long life of some funds, it is essential for managers to charge reasonable fees to cover the overhead of running a fund.  However, these fees should be very straightforward and consistent with the investment objective of the fund.  When fees are charged on transactions within the fund or on commitments during the harvest period, the advisor should question the alignment of the manager and the investor.

Carried interest, or performance compensation, ideally is paid to the manager after the investor receives their capital back and a preferred rate of return.  At this point, the manager can participate in the upside of the fund’s performance alongside the investor.  Carried interest can create strong alignment when it is earned only after investors receive the agreed return of capital and preferred return.

Ask about the sponsor commitment in the fund and across the platform. A manager who consistently invests meaningful capital alongside investors demonstrates stronger economic alignment than one who makes only a nominal commitment in a single offering.

One sentence recap: Managers deserve to be compensated for performance, but only if investors receive their capital back first.

Alignment of Manager Fees and Carry

Although similar in concept to fund structure, fees and carried interest deserve their own section due to the direct tie between fund gross and investor net returns.

Managers can be compensated in many ways, but the PPM should disclose management fees, promote or carry, discretionary fees, and which expenses are paid by the fund versus the manager.

Look for fees passed to the investor that do not directly support the investments.  Items such as the manager’s overhead, broker-dealer fees at the fund level, or excessive or duplicative deal-level fees paid to the manager.  Ask if there are any conflicts of interest between the manager and the fund.  For example, if the manager owns a brokerage company that will be managing all the acquisitions and dispositions of the fund’s assets, this should be questioned by the investor.

Read the distribution schedule and look for the investor to receive their capital back and preferred rate of return prior to the manager receiving any type of carry or promote share.  Look for a GP catch-up in the distribution schedule. This is typically a mechanism that directs distributions to the GP after investors receive their preferred return until the GP has received its negotiated share of profits. After the catch-up is satisfied, subsequent profits are generally split between the investors and GP according to the carried interest provisions.

Here is a longer article on fees and terms.

One sentence recap:  Fees and carried interest determine how much of the fund’s gross returns land in your client’s account.

Liquidity, Lockups, Redemptions, Defaults

Getting an investor into a private placement is easy, but exiting can, at times, be at the control of the manager and the Fund’s mandate.  Advisors should have a thorough understanding of:

• Lockup and redemption rights
• Gates controlling how much a fund can be redeemed in a given period
• Fund term and extensions
• Transfer and secondary sale restrictions
• Manager’s discretion on these concepts
• Plus, many other terms and conditions disclosed in the PPM.

A subscription agreement is a contract and investors must fulfill their financial commitment or face dilution in the form of a forced buy-out at below-market value or, in some cases, forfeiture of invested funds.  These default penalties can be severe and must be understood by the advisor and investor prior to subscribing.  In most cases, investors are not liable for funding additional capital calls beyond their commitment, but review the PPM, governing agreement, and subscription agreement for the specific default terms.

One sentence recap:  What is the earliest I can get my money out, what is the latest I could be stuck in the investment, and who controls that decision?

What is the Valuation Policy?

Understand how the fund’s NAV, or valuation marks, are determined.  Private funds are rarely marked daily, but can be marked monthly, quarterly, or annually.  The timing of these marks is often driven by the market pricing of the assets themselves, so look at the timing policies of other funds in the same asset class to provide guidance of appropriate timing for this fund.

Funds may use third-party valuation firms to assist in determining asset values, while independent auditors review the fund's financial statements and valuation practices as part of the audit process.  Third-party oversight can give the advisor confidence in the valuations.

However, all valuations are not created equal.  Spend time understanding the valuation policy and the method used to value assets.

Read a detailed article here on valuations 

One sentence recap:  Valuation methods and timing vary by fund.  Understand the process.

Operations

Advisors should ask about the manager’s back-office functions.  Items like tax, administrators, auditors, legal can be handled either by competent third parties or in-house.

If handled in-house, question the experience and size of the teams.  Funds with large investor counts can require a significant labor component to ensure all communications and investor questions are handled efficiently.

If third parties are used, ask for names and look for best-in-class third parties.  There are a lot of options available to managers and their choice of third parties is a reflection of their product.

One sentence recap:  The operations of a fund are the infrastructure behind the investment. Make sure they are built to support it.

1099 vs. K-1 

The tax reporting structure of a fund can have a meaningful impact on the investor. Investments reporting on Schedule K-1 may pass through items such as income, gains, losses, and depreciation to investors. K-1s can also arrive later in the year and may require an investor to extend their tax return.

By comparison, investments reporting on Form 1099 generally provide simpler tax reporting and are often delivered earlier in the year. Advisors should understand both the potential tax benefits and administrative burden before recommending an investment.

One sentence recap:  Ask if this investment will be handled with a 1099 or K-1?

What Should an Advisor Request Before Recommending the Fund?

Managers should have a data room with easy-to-access documents including:

• Fund Overview & Investment Strategy
  • Investment deck
  • Manager and team information
  • Current portfolio summary 
• Legal & Offering Documents
  • Private Placement Memorandum (PPM)
  • Limited Partnership  or LLC Agreement
  • Subscription Agreement 
• Track Record & Performance
  • Realized and unrealized investments
  • Gross and net performance
  • Track-record methodology and disclosures 
• Financial & Investor Reporting
  • Audited financial statements
  • Quarterly investor reports
  • Fund and asset-level performance reporting
  • NAV reporting schedule (if applicable)
  • Look at the quality, quantity, and consistency of reporting
• Operations, Compliance & Due Diligence
  • DDQ
  • References including current and former LPs, operating partners, and service providers.
  • Valuation and relevant compliance policies
  • Fund administrator, auditor, legal counsel, and other key service providers

To help with the initial review of the data room, download all the documents and upload them to an AI assistant.  Then ask for a summary of the data room along with any red flags or questions an advisor should be asking the manager.  

One sentence recap:  A data room should offer a lot more than a fund doc and a subscription agreement.

Summary

Finding the right private fund investment starts with the investor.

Private funds have a long hold time and should be approached more like a marriage than a summer fling.

What does the investor want the investment to look like in terms of asset class, risk, return, duration, liquidity, structure, governance, and tax treatment?  Does the manager have the experience, track record, and process to execute those objectives?

From there, the advisor can evaluate managers who are qualified and capable of executing on those objectives.

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.