Some big public pension funds are considering renegotiating what they consider to be poorly constructed and overly generous real estate money manager incentive fee contracts.
Incentive fees, typically based on appraisal estimates, are paid on top of base and other fees to managers.
Among the actions:
The $22 billion Los Angeles County Employees Retirement Association, Pasadena, Calif., has launched a study of its incentive fee contracts. The fund paid $23 million in fees to four real estate money managers over three years; the four firms manage about $1 billion in total for the fund.
The $22 billion Alaska Permanent Fund Corp., Juneau, has revised downward some incentive and performance fees and other contracts for real estate in recent months.
The $86 billion California State Teachers' Retirement System, Sacramento, eliminated incentive fees for real estate money managers in recent contract renewals. The contracts involved $1.5 billion in assets. The fund will look at the issue again after it selects a real estate consultant.
Peer concerns about incentive fees contracts have led the $10 billion Alaska Retirement System, Juneau, to develop what a fund official calls "third-generation" incentive fee contracts. The new contracts, for a $300 million allocation in total, are based more on cash flow than appraisals and encourage selling properties at market price highs.
Some other large pension funds have been quietly renegotiating incentive fee contracts, said Micolny Youlanis, vice president ofconsultant Callan Associates, San Francisco.
Ms. Youlanis said some pension fund officials, when facing large incentive fee contract payments, say: "We know that is the contract, to pay the incentive fees, but we had no idea the performance was going to be so good. We want to renegotiate."
She mentioned one unidentified fund wanted to renegotiate fees already earned, in addition to future fees.
Big pension funds are involved in most of the renegotiations, simply because they're in a better bargaining position than smaller funds.
Smaller funds tend to invest in pooled funds, where incentive fees can be non-negotiable. But larger pension funds often have contracts for separate accounts where they can terminate managers with 30 days' notice. Just the threat of termination tends to put real estate money managers in the mood to re-negotiate fees, consultants said.
For many pension funds, incentive fees became a replacement for flat fees during the real estate recession a few years back.
Back then, flat fees, based on a percentage of assets under management, seemed high in comparison to the investment returns. But in today's real estate boom, some pension officers are wondering whether those incentive fee contracts they happily signed a few years ago are giving too much money away.
For money managers, however, renegotiated contracts can mean multimillion dollar cuts in fees they were promised in exchange for taking lower fees during those bad years.
Over a three-year period ended June 30, the Los Angeles County fund, for example, paid San Francisco-based RREEF $8.5 million in incentive fees; Lowe Enterprises Investment Management Inc., Santa Monica, Calif., $9.8 million; Invesco Realty Advisors Inc., Dallas, $1.16 million; and TA Associates Realty, Boston, $3.5 million.
The incentive fees are paid on top of acquisition fees and asset management fees.
John D. McClelland, senior real estate officer, said his study might recommend changes in real estate contracts, which were made before he joined LACERA in 1995.
A key question is whether the pension fund should be paying incentive fees based upon unrealized gains in properties that are estimated through appreciation, as its contracts now specify.
Property appraisals are only estimates, and can be wrong. Another problem is that until property is sold, the gains aren't locked in, and can decline.
LACERA does delay paying 25% of its incentive fees, called a hold back. But it still has paid its four money managers about $17.25 million in incentive fees for the three years.
Another issue is whether a pension fund should start paying incentive fees on earnings before the fund's target return has been reached. LACERA begins paying its incentive fees when the money manager produces returns in excess of 5% net real rate of return, when LACERA's targeted return for real estate is a 6% net real rate of return.
A third issue is whether clients should pay incentive fees for performance that might have resulted from market conditions, rather than the money manager's skill.
Being able to identify the performance gains resulting from a manager's skill is easier in stock investments, where there are indexes to use for comparisons.
Mr. McClelland would not estimate how much LACERA might have paid had it stuck with flat fees.
Some sources say LACERA's separate account contracts, drawn up with the help of consultant The Townsend Group, Cleveland, aren't unusual for large public funds.
Peter Naoroz, investment officer for real estate at the Alaska Permanent fund, said even though some contracts were revised, others were left unchanged.
Skimping on manager fees can hurt real estate portfolio performance by creating such problems as deferred maintenance on properties, he said.
But for those contracts his fund did change, Mr. Naoroz said he just wants to pay the fair market price for fees. Its program is a conservative, diversification-aimed one and not a risky, "hitting-the-lights" one, he said. The fund has about 8% of assets in real estate.
CalSTRS, meanwhile, eliminated realty incentive fee contracts for $1.5 billion under management because they were badly structured, said Patrick Mitchell, chief investment officer.
Under the old contracts, the pension fund sometimes was forced to pay incentive fees on poor-performing properties transferred from another manager that was fired or quit.
Mr. Mitchell said he generally is troubled by the concept of paying incentive fees on unrealized gains estimated by appraisals.
That still leaves the door open for CalSTRS to pay performance-based fees based on distributed cash-flow from properties.
Ken Wisdom, an investment officer with the $20 billion Massachusetts Pension Reserves Investment Management Board, Boston, said he doesn't believe his fund would approve an incentive contract based on unrealized gains. He said his fund focuses on cash flow. More funds are expected to follow PRIM, investment officials say.
Don King, a managing director in the Chicago office of RREEF, dismissed the idea that the amount of money being paid out under incentive fee contracts is a serious concern among pension funds.
He said clients tell him, "You guys did a great job. This is what we had in mind."
He said many real estate clients are grateful that RREEF and other managers were willing to accept incentive fees during the years when real estate returns were low. Asked if real estate managers like RREEF are making substantial money from incentive fees now, Mr. King declined to comment.
"Pension funds always believe their fees are high," said Kevin Lynch, a principal with The Townsend Group. He said he hasn't received any complaints from pension funds about fees.