Principal–Agent Issues in Real Estate Funds and Joint Ventures

Abstract

The motivations created by the use of incentive fees (or promoted interests) in private equity (real estate or otherwise) are examined through the lens of traditional principal/ agent problems. In general, in-the-money promotes tend to create conservative actions by the manager (or agent), and out-of-the-money promotes tend to create risky actions. These incentives are mitigated, however, by a number of factors, including the “moneyness” (the degree to which the promoted interest is in the money) of the promote, the dispersion of potential choices, concerns about future fund-raising efforts, and the changing shape of the manager’s utility curve over time (as the manager experiences other gains and losses). Because these incentive fees are intended to improve the alignment of interests between the principal and the agent, this article suggests that lowering both the investor’s preferred return and the manager’s promoted interest—in a manner that maintains the expected value of the promoted interest—improves that alignment of interests. Finally, this article also suggests that the use of indexed preferences, rather than a fixed percentage, ought to better serve investors.