Point of View: Overpayment of Manager Incentive Fees— When Preferred Returns and IRR Hurdles Differ

Abstract

Executive Summary. An evolution has taken place interms of manager incentive fee documentation. Originally,incentive fees were based on a "preferred return"methodology whereas, today, most contracts use an IRRhurdle methodology. Although this change generally hasbeen treated as a non-event, the change has generatedunanticipated consequences that can be quite significant.In instances where additional equity capital is called afteran earlier split of profits, the equivalence of these twoformulations fails. Further, even when such is not thecase, if the investment is a portfolio and the contract allowsfor interim incentive fee payments based on onlyassets sold to date, the same problem can occur. For largeportfolios, millions of dollars of fees can hang in the balance,amounts that will accrue to the investor or themanager based solely on the calculation methodologyutilized. We believe that this phenomenon has been inadvertentlyembedded in many institutional real estateportfolio fee arrangements.With the recent sharp downturn in the real estate market,rates of return have been so low as to temporarilyrender this issue moot. With the market beginning to recover,this is an opportune time to 'daylight' this issue.