How Institutional Investors Diligence Investment Managers

Cadre counts several large institutions as investors and has seen first-hand the depth of their diligence, which can often take several weeks or months. Institutional investors thoroughly review all marketing and legal documents, ask dozens or hundreds of questions, and conduct several meetings with a manager prior to making an investment. Institutions may often decline to invest with several dozen managers prior to selecting one.

While conducting diligence on a particular investment strategy or product is important in determining an investor’s returns, institutional investors’ diligence begins with the quality of the investment manager. A high quality investment manager can achieve upside potential and mitigate downside risks, potentially generating compelling risk-adjusted returns and outperforming the market. A multi-faceted manager diligence process requires thorough examination of the manager’s team, capabilities, track record, fiduciary mindset, alignment of interests, and reputation.

Below is a summary of what these institutional investors look for when conducting diligence on a manager. You can find an example of a Due Diligence Questionnaire, just one part of a typical institutional investor’s diligence, here.

Alignment of Interests

Investors should seek alignment from the managers with whom they invest, typically quantified via co-investment alongside investors and carried interest (or promote).

Co-Investment: A fund manager who invests their own money alongside investors demonstrates confidence in their strategies and aligns their interests with those of their investors. When managers have a personal stake in the success of the fund or “skin in the game”, they are more likely to make prudent investment decisions and actively work not only towards maximizing returns, but also mitigating potential losses.

Carried Interest: Also referred to as promote, carried interest is a share of the profits that fund managers receive once a certain level of returns has been achieved for investors. This mechanism encourages fund managers to focus on generating strong returns, as their compensation is directly tied to the fund's performance.

Alignment of interests can extend across an organization to promote a dynamic where all team members, not just senior managers, are incentivized to prioritize the success of the fund.

Track Record

While past performance is not a guarantee of future success, understanding how investments have performed historically is critical.

Some key items to look for include:

• Returns of both realized and unrealized investments: While realized performance information is important, such performance data is limited as it represents only a portion of a manager’s overall investments. Given the strong market cycle of the past 15 years, many newer managers will tend to have strong realized track records given they have not carried investments through multiple market cycles. It’s important to delve into the performance of unrealized investments to obtain a more complete sense of the performance of the overall portfolio.
• Length of track record: Look for consistent performance across multiple market cycles. Strong returns over the past decade were the norm given lower interest rates and robust growth, but it’s important to understand how a manager performs throughout various cycles. Some questions to ask:

• How did investments at senior management’s previous firms perform?
• Did the manager slow investing or sell assets into a peaking market, thereby showing restraint and discipline? Or did the manager’s investments perform worse than the broader market in a bear market because they took on too much risk or leverage in their investments?

• Relative Performance: It’s important to gauge the manager’s performance relative to the market’s performance overall to determine their ability to generate alpha against the wider market.

• A manager’s ability to preserve investors’ capital in a poor market is critical, and assessing the manager’s previous strategies in a downturn sheds a light on their ability to navigate future bear markets.

• Context Matters: It’s important to not only take the track record statistics at face value, but to dig in further.

• Even the best investors can make poor investments, but their ability to learn from such errors and improve as investors is critical.
• Unforeseen macroeconomic events, such as the COVID-19 Pandemic, could lead to negative performance in a sector through no fault of the manager.  For example, a manager who made office investments prior to the COVID-19 Pandemic should likely not be penalized for not predicting a once-in-a-century health crisis’s effect on the office sector. However, if the manager continued to make poor investment decisions on their office portfolio post-Pandemic, investors should be more wary of that manager.
• Conversely, a multifamily investor who acquired the bulk of its portfolio at the peak of the market with high leverage debt could be viewed more negatively given they are more likely to underperform their competitors.

• Team attrition: Was the track record generated by the professionals in the organization or by professionals who are no longer at the firm?
• Relevance

• The track record should be relevant to the stated strategy of the new fund.
• For example, if a manager has exclusively invested in multifamily, how would that experience translate into investing in hotels?

Team

A prospective investor should look for a robust team with complementary backgrounds and evaluate the team's track record in managing funds throughout business cycles.

Senior principals should have significant experience investing in real estate and managing investor capital, either at the current firm or at previous firms. Ultimately, investment performance will rely heavily on the team’s:

• Investment rigor: Both prior to and post-acquisition, the team’s diligence and approval processes should be robust
• Depth: A large enough team is critical to ensuring that the requisite diligence, structuring, and asset management can be done at a high level. A lean team may not be able to appropriately diligence new investments or manage a large portfolio, which can lead to poor performance.
• Relationships: The team should maintain strong relationships with a large network of sponsors, brokers, lenders and other third parties, which can lead to unique investment opportunities and the ability to achieve upside or mitigate downside risks throughout the hold period
• Tenure: A consistent team is defined by stability, minimal attrition, and continuity, particularly in senior management, ensuring that the track record, embedded knowledge, and relationships built over time are maintained.

Additionally, it’s important to conduct diligence into the depth and quality of the finance, operations, legal, and investor relations teams, all of which play an important role in investment performance and client service.

Robust Policies and Procedures

Institutional managers typically have a robust set of policies and procedures in place to make and manage their investments. These policies and procedures include, but are not limited to:

• Major investment decisions should be formally approved by senior principals (the Investment Committee) only after multiple levels of approval and vigorous discussion.
• For new investments, a manager should have a formal process that requires rigorous due diligence, underwriting, and legal structuring for new investments.
• Real estate investments cannot be passively managed. A manager should actively asset manage each investment, understanding in real-time the performance of their investments so they can make controlling decisions with respect to the business plan or capital events, among other things. The team should also have robust processes that include formalized performance monitoring, monthly and quarterly reporting,  and investment decision-making, and annual budgeting and reporting.
• Formal, quarterly valuation processes that require in-depth re-underwriting and annual third-party audits to ensure investments are appropriately marked at market pricing
• Investment allocation processes to ensure investments are fairly allocated across different investment vehicles to avoid conflicts of interest
• Cash management strategies, AML policies, and anti-fraud controls to protect the operations of their funds and to ensure procedures are in-line with best practices.
• Compliance policies and procedures to ensure adherence to relevant laws and regulations. This can include regular compliance training for employees to stay informed about changing regulatory requirements, and having a system for monitoring and reporting compliance breaches, with mechanisms for corrective action.

Fee Structure

A fund’s fee structure should be fair and transparent. Additionally, excessive fees can create a misalignment of interests between the manager and investors.

There are two primary types of fees when investing in private funds:

• Management fees: Designed to cover the day-to-day operational costs of the fund (e.g. hiring a team and other expenses such as travel or an office lease) and compensate the fund manager for ongoing management services.
• Performance based fees: Commonly referred to as carried interest or the promote, performance fees tie the compensation of fund managers directly to the success of the fund. This fee is typically a percentage of the fund's profits after achieving a specified hurdle rate, ensuring that fund managers are rewarded only after outperforming a minimum benchmark.

Striking the right balance between management fees and performance based fees is essential to align the interests of the fund manager with those of the investors while ensuring the sustainability and profitability of the management firm. For example, a manager charging high asset management fees but no performance-based incentives could lead to a heavier focus on increasing assets under management and/or holding assets indefinitely, with little focus on generating strong returns.

Management fees should cover the operation of a comprehensive team with expertise in acquisitions, asset management, legal, fund operations, compliance, and investor relations, ensuring that the private real estate fund is well-equipped to navigate the complexities of the real estate market, manage risks effectively, and deliver value to investors. The fees are integral to supporting a high-quality team that is able to attract leading talent in order to drive the overall success of the investments.

Investors should be wary of managers charging ancillary or hidden fees that may be excessive, unclear, or not directly related to the fund's management, resulting in above market fees. Examples of these fees include, but are not limited to, acquisition fees, financing fees, affiliate fees, and exit fees. Investors should be cautious of fees that are not transparent or appear to be disproportionately high relative to the services rendered or the market standard. It's important for investors to thoroughly review the fund's offering documents and fee schedules and seek clarification on any fees that seem unclear or excessive.

Investing in a private real estate fund involves not only recognizing fees that are paid to the fund manager, but also understanding the economics of the various parties involved in the investment. For example, if a manager invests with operators, the operator typically earns fees and a share of the profits from the real estate investments. The structure may include acquisition fees, asset management fees, and a promote once certain return thresholds are met, further aligning the interests of the operator with the investor.

Regulatory Framework

Institutional fund managers are regulated as investment advisers by the Securities and Exchange Commission (“SEC”), under the U.S. Investment Advisers Act of 1940 (“Advisers Act”).  The Advisers Act imposes upon fund managers a broad fiduciary duty to act in the best interest of their clients.  Registered investment advisers must adhere to various requirements set forth by the SEC, designed to protect investors, and provide third party oversight and governance to hold investment managers accountable to their investors.  

In addition to numerous requirements intended to compel fund managers to act in the best interest of their investors at all times, broadly referred to as fiduciary duty, there are more substantive prohibitions designed to prevent misrepresentations, fraud, and other bad behavior.  This includes guidelines on how prior performance and track record information is presented to investors or prospective investors.  In other words, registered investment advisors must present their track record in a standardized, fair and balanced format that is not misleading to investors.  

The SEC requires registered investment advisers to adopt and implement written policies and procedures designed to prevent a registered adviser or its personnel from violating the Advisers Act.   An adviser’s policies and procedures should address potential conflicts and other risks.  As an important step in an investor’s diligence, they should validate a fund manager's registration status via the SEC database, and can request to view a fund manager's policies and procedures to ensure appropriate safeguards are in place.  

Recommendations and Social Proof

A manager with a positive reputation among peers is likely to have reputable investors allocated to their funds, have a high degree of industry recognition, and enjoy positive feedback from their current and past investors. Long-term investor relationships and a history of repeat investments can indicate a high level of investor satisfaction. Furthermore, references and testimonials provide valuable insights into the manager's performance and conduct.

Reputable and well-established investors committed to a fund may signal confidence in the manager's capabilities. Knowing that sophisticated investors have conducted their own due diligence and committed capital to the same fund can be reassuring for prospective investors.

Additionally, speaking directly with other investors who have worked with the fund manager provides an opportunity to gather firsthand experiences and unbiased insights. These perspectives provide valuable context beyond quantitative metrics and can contribute to a more comprehensive due diligence process.

Transparency

Transparency encompasses various factors such as detailed offering materials and ongoing reporting practices, as well as proactive communications throughout an investor’s hold period.

Transparent managers provide regular, consistent, and comprehensive reports to investors. This includes detailed financial statements and performance reports. These reports should go beyond mere numbers, and offer insights into the fund manager's strategy, market conditions, and timely updates on any material events.

Transparent managers maintain open lines of communication with investors. This involves providing contact information for inquiries, being responsive to investor questions and concerns and responding in depth to inquiries about investment strategy, risk management, setbacks, challenges, and overall fund performance. The willingness to engage in meaningful dialogue fosters trust and confidence.

Conclusion

A top-tier real estate manager is able to synthesize their skills and experience to deliver favorable returns across market cycles. Ahead of deploying capital, investors should conduct thorough due diligence on prospective fund managers to ensure that they are aligned, have a robust track record, a deep and talented team, and a fiduciary mindset.