Alternative investments programs involve many conflicts of interest, and offering documents often have an entire risk disclosure section dedicated to this issue. But not all conflicts are the same and vary by product and sponsor. Assessing conflicts really come down to two central questions:
- How are conflicts managed?
- How are interests aligned?
Assessing existing and potential conflicts is important because an investment will become a long-term relationship that the investor may not be able to exit early or without incurring redemption penalties. Many offerings are written to provide the sponsor/affiliates with significant discretion to make decisions that impact investors’ returns and time horizon. This is not necessarily a bad thing because it provides the sponsor flexibility to manage the program. Often, the sponsor has the ability to:
- change the investment policy, target leverage, distributions, redemption program, etc.
- approve valuations, affiliated transactions, reimbursable costs, when to implement an exit strategy, etc.
In a perfect world, there wouldn’t be any conflicts, and the fund’s performance would match the model’s forecast. However, over a long-term hold, there’s a good chance that market conditions change outside of the manager’s control, and reality differs from the model’s assumptions.
Assessing how a sponsor approaches conflicts of interest can fall on a continuum from disclosing conflicts, to avoiding conflicts, to pursuing alignment. From left to right, this continuum increases the level of benefit to investors and effort to implement.
A conflict of interest arises when a sponsor/advisor/manager can use their position of power and trust for their own benefit, or the benefit of another pool of investors, which may be at the expense of investors of a particular program. Common examples of conflicts of interest include:
- Allocation of management’s time and resource among funds and business lines
- Allocation of investment opportunities among funds
- Related party transactions (see Kemp Hanley's blog post: How to Assess Affiliated Transactions in Private Placement Programs)
- Back-end splits that incentivize sponsors to increase the risk to investors
- Incentives to grow assets under management when capital can no longer be deployed efficiently
- Business model that relies on transaction fee revenue, which can lead to a sales culture
- Business model that relies on AUM, which can disincentive a liquidity event
The goal is not to eliminate conflicts. Some level of conflict is unavoidable because mitigating one conflict may create a different conflict. For example, if the asset management fee is based on the valuation of investments and management is responsible for determining the valuation, then management may be incentivized to choose aggressive valuation assumptions. If the asset under management fee is based on cost, then the sponsor may be incentivized to quickly deploy capital rather than focus on long-term performance.
Rather than eliminate conflicts, the goal should be to balance conflicts and create alignment based on the facts and circumstances.
Alignment of interest is an arrangement that provides a win/win so that all parties benefit from a particular target outcome under various market conditions. If everything goes according to plan, then the result should be win/win. But when things don’t go according to plan, the additional gain or loss should be shared. This means that the additional gain or loss should not benefit just the sponsor or just the investor. It should provide the sponsor with sufficient compensation to implement the fund strategy and reward it for achieving results in line with the sponsor’s role in achieving the result.
Trends in Industry Standards
Professional codes of ethics within the alternative investment ecosystem seem to support moving the minimum standard from disclosure to avoidance of conflicts. It is also a sensitive regulatory topic for broker-dealers.
Professional associations such as the American Institute of Certified Public Accountants (AICPA) and Chartered Financial Analysts (CFA) Institute cover conflicts of interest in their codes of ethics to maintain and enhance public trust. They recognize responsibilities to different stakeholders including both clients and the general public. Both organizations cover similar principles such as professionalism, integrity, due care, and independence and objectivity. The implication is that members of the AICPA and CFA Institute that serve as part of sponsor management teams and board of directors should be held to high ethical guidelines in carrying out their professional duties.
The AICPA is a volunteer organization for CPAs in the United States. The AICPA’s principles of professional conduct address conflicts of interest under objectivity and independence. It states:
“A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services…In providing all other services, a member should maintain objectivity and avoid conflicts of interest.”
AICPA members who practice public accounting are held to the standard of avoiding conflicts of interest in both fact and appearance. While members not in public practice cannot eliminate conflicts of interest, they are still held to other standards such as public interest, integrity, and due care.
CFA Institute is an international organization for financial professionals. The Code of Ethics and Standards of Professional Conduct was last updated in 2014 and is in process of being updated. The comment period for the draft recommendation is open through March 6, 2023, and there is a proposed change for conflicts of interest. Currently, the standard is to provide full and fair disclosure of conflicts of interest. However, the draft update states:
“Avoidance and Disclosure of Conflicts of Interest. Members and Candidates must, when feasible, avoid all matters that could reasonably be expected to impair their independence and objectivity and interfere with their duties to clients, prospective clients, and employer.”
Under the proposed change, the standard would be moved from disclosing conflicts of interest to avoiding conflicts of interest.
Regulators have also been focusing on this topic. Historically, disclosure of conflicts of interest was sufficient to meet SEC requirements. That changed with Regulation Best Interest (Reg BI), which became effective June 30, 2020. Reg BI requires broker-dealers, registered representatives, and associated persons to act in the best interest of retail investors when making investment recommendations. Reg BI includes four component obligations: disclosure, care, conflict of interest, and compliance. The SEC updated Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest on August 3, 2022, and “conflict(s) of interest” appear 89 times. The bulletin discusses identifying conflicts, examples of conflicts, obligation to eliminate conflicts when appropriate, ways to mitigate conflicts, and disclosing conflicts.
Source of Conflict of Interest
In order to avoid conflicts of interest, first we need to understand that conflicts can come from people, structure, and time.
At the most basic level, conflicts of interest raise the fundamental question: will management act in the best interest of investors?
- Bad actors. Worst-case scenario, management is so motived by greed and/or ego that the sponsor will resort to fraud and deception to benefit themselves at the expense of investors.
- Owners vs. management. If the sponsor’s owners are not involved in the sponsor’s day-to-day business, ownership may be more focused on distributing profits from the sponsor, which could prevent management operating the business in a way that makes sense on a long-term basis. For example, the business model might rely on transaction revenue to support operations, forcing management to focus on short-term results.
- Employee compensation incentives. People responsible for implementing the investment strategy might not be incentivized to deliver results for investors. For example, if the head of acquisitions receives a bonus based on transaction volume, then that person would be motivated to increase the number of transactions regardless of the forecasted risk/return to investors or the operational burden to the asset management team.
Even when people want to do the right thing, structural factors may incentivize people in ways that conflict with investors interests.
- Culture. Sales-driven organizations tend to take a more short-term view than organizations focused on long-term results. For example, a sales-driven culture might focus on raising capital even when the sponsor can no longer deploy it efficiently.
- Oversight. If the sponsor is wholly owned by a single manager, then the sponsor might not have a governance structure in place the provides accountability. The owner’s success could lead to arrogance and unwillingness to implement best practices that protect investors.
- Business focus. Sponsors might have affiliated entities that provide services along the supply chain. For example, if a real estate sponsor owns a property management company, this could create incentives to acquire properties in locations based on where the property manager’s regional manager has capacity. Or the sponsor might engage the affiliate at less attractive terms compared to a third-party property manager. However, vertical integration can also provide the sponsor with a competitive advantage.
- Investor base. The sponsor might source capital from multiple types of investors, including institutional investors, foreign investors, and retail investors. If retail investors represent a small portion of their overall assets and revenue, the sponsor may favor programs funded by its other investors.
- Differing levels of skin in the game. Sponsors might have different levels of co-investment for different product offerings. If a sponsor co-invests 30% on an institutional fund and 1% on a retail fund of equal sizes, the sponsor will be incentivized to allocate more attention to ensuring the success of the institutional fund because more of their capital is at risk.
- Products lines. The sponsor might offer different investment strategies or follow-on products that compete for resources or investment allocation. For example, a sponsor with value-add funds and stabilized funds may be incentivized to sell a value-add property to the stabilized fund once the asset has been stabilized.
- Sponsor profitability. Since performance fees are tied to fund-level performance, then the sponsor will earn more on successful programs. If the sponsor manages two similar funds with one performing well and the other performing poorly, management might focus its efforts on the one performing well in order to maximize total performance fees.
- Fund-level fee structures. Funds often have various fees, including transaction fees (e.g., acquisition, loan-origination, refinance, development, leasing, disposition, etc.), recurring fees and costs (e.g., asset management fee, administrative fee, expense reimbursement), and performance-related fees (e.g., annual performance fee, back-end split). If a fund isn’t performing well enough to earn performance-related fees, then the sponsor may be incentivized to continue to hold properties so it can continue earning recurring fees. Also, if governance documents allow reimbursement of sponsor overhead, including of management and employee wages, then management fees may become a profit center to the sponsor.
- Fund-level legal structure. There are different rules for different types of investments (e.g., non-traded REITs vs. DSTs). For example, DSTs do not have performance fees and cannot commit the seven deadly sins without consequence. This may encourage sponsors to shorten the holding period (e.g., two five-year DSTs over 10 years) so they can show positive returns and redeploy capital into a new DST to harvest more transaction fees.
- Sponsor lifecycles. New sponsors have different motivations than established sponsors. A new sponsor needs to build relationships and establish a track record. Since new sponsors may not have significant assets under management, they will be incentivized to generate transaction fee revenue in their early lifecycle to cover operating expenses. On the other hand, large established sponsors may have more affiliated entities that provide services to the fund, resulting in conflicts from related party transactions.
- Growth in AUM. As sponsors become established, they often rely more on asset management fees to cover most of their operating expenses. This may incentivize the sponsor to extend the holding period of a fund.
- Management composition. It’s fairly common to have some management turnover over a fund’s holding period. New members of the management team may have different motivations or core competencies compared to the management team in place when the offering was issued.
- Business model. As a sponsor grows, it might build out business lines to support vertical integration. For example, a real estate sponsor might create a property management company or development company. If these different business lines generate better profit margins or have significant fixed costs, the sponsor may allocate more resources to grow and sustain these areas and/or cause the investment funds to enter into affiliated transactions that may or may not be in the best interest of the fund.
- Strategy. A sponsor that has traditionally focused on real estate might shift its strategy from one sector to another. If the sponsor wants to show success in the new strategy, it might devote more time and energy to creating a resumé piece and less effort on managing an existing fund.
- Market environment. Over a long-term hold, it is likely market conditions will change. The sponsor may need to cut back on overhead costs, which could adversely impact resources needed to manage existing funds, and/or pursue new business strategies.
Assessing conflicts of interest
Assessing the level of conflicts of interest versus alignment of interest is not a check-the-box exercise. It requires a wholistic and subjective view of the sponsor and the product.
Here are questions to consider:
- Who are the stakeholders? Who has authority to make decisions that impact the performance of the fund? What are their motivations? How are they compensated?
- How involved are the owners? What is their level of commitment to the long-term success of the sponsor or affiliated entities? How much capital have they contributed? How do they distribute sponsor profits to themselves?
- How open is management to receiving and incorporating constructive feedback to improve alignment of interest with investors?
- Does the sponsor or the fund(s)have independent boards? If so, how much of an overlap is there in directors across funds? How are directors chosen? What are their qualifications? Do they have a fiduciary duty? What professional code of ethics govern their behavior?
- Who is on the executive management team? What is their experience? What professional code of ethics govern their behavior?
- What is the sponsor’s culture? What are its core values? How does it demonstrate those values? Is it focused on short-term profits or long-term results? How does it define success? What types of internal controls does it have in place? What type of transparency does it provide to investors? What types of industry best practices does it follow?
- What is the sponsor’s business model? How much do they rely on transaction revenue, assets under management fees, and performance related fees? How much of their expenses are fixed verses variable?
- How does performance align with results? Do performance fees have a hurdle or catchup provision? Is the hurdle appropriate for the amount of leverage and risk? Can the sponsor increase leverage? What has the sponsor done in the past?
- How much does the management team co-invest into the fund, both as a percentage of the fund size and how much relative to their personal wealth? Are the terms pari passu? If not, is it adequately disclosed and are the different terms reasonable?
- Does the fee structure fit the investment objectives of the fund? Is the fee structure outside of industry norms? Are fees relatively consistent across the sponsor’s funds?
- How has the sponsor managed funds through difficult market cycles? Does the structure provide flexibility for the sponsor to waive or defer fees?
- Is the asset management fee based on cost or estimated market value? If estimated market value, how is the valuation determined?
- How are distribution rates set? Has management increased their compensation while distributions were suspended? Are the sources of distributions adequately disclosed? Is there a reasonable plan to cover distribution from operating cash flow?
- What level of accountability does management have to investors? Can investors redeem their investment at reasonable terms? How easy or difficult is it to remove the manager? What rights do investors have? How reasonable are those rights? How reasonable or prohibitive are the conditions to exercise those rights?
Since the sponsor structures and manages the funds, the investment community can focus on sponsors and products that seek to minimize conflicts and try to create alignment when possible.
Sponsors that try to align their interest with investors should have the following characteristics:
- Owners and managers are committed to a long-term business plan that can sustain through difficult market conditions.
- Members of the management team make meaningful co-investments at terms that are pari-passu with investors.
- The sponsor has a culture of seeking out and implementing best practices around functions such as governance, operational control, employee compensation, etc.
- Fee structures and reimbursement across all funds provide fair compensation so the sponsor can operate but receive profit based on performance.
- The sponsor operates funds with a reasonable level of transparency, independence, and objectivity (e.g., benefit to the fund outweighs the audit and third-party valuation costs).
- Funds are structured to provide fairness to investors through reasonable redemption programs for the investment focus and fund structure, timely and transparent performance reporting using appropriate performance measurements, and appropriate investor rights that provide accountability from management.
Since illiquid alternative investments have a long-term commitment, it is important to invest with sponsors that you trust to manage conflicts appropriately over the holding period. For all sponsors, look at the people, structures, and potential impacts of change over time. For new sponsors, pay close attention to how they structure a deal to avoid conflicts of interest and how they incorporate feedback to create better alignment of interest. For established sponsors, pay attention to the actions they took during a challenging period and what has changed since that time.
My hope is that sponsors that seek to create alignment will provide better long-term results for investors and enhance public trust in the industry.