How do you align the interests of a tax-exempt investor and a taxable investment manager? Bringing them together into the same room to let them network and engage in interesting conversations certainly isn’t the way. (You might be able to break down some of the normal barriers to open communication, but you have done nothing to alter the nature of the relationship dynamics that drive investment outcomes.)

The way in which most tax-exempt investors attempt to align the interests of their investment managers with their own is by insisting their managers have “skin in the game” and by employing various incentive compensation arrangements. (If you’re not doing one or more of those things, you’re most likely not aligning their interests.)

The problem, as I have noted in this column before, is that the potential outcomes each faces when joining in a transaction together are almost always going to be quite different.

Now, it should go without saying that, when entering into any relationship, most if not all investment managers want to produce the best possible results for their tax-exempt investor clients.

The problem arises if and when their jointly controlled investments threaten to produce less than desirable results. At that critical juncture, the choices and associated outcomes facing tax-exempt investors and their investment managers often are going to produce different after-tax outcomes for the two parties. If the investors are tax-exempt, taking losses, while painful, won’t trigger any adverse tax effects for their beneficiaries. This isn’t always true for the investment manager.

If an investment manager sells an asset at a loss, for example, it may be exposing itself to phantom income on the money it has invested into the asset. And those losses may end up being taxable and punitive.

Again, the tax-exempt investor typically is going to be insulated from this kind of tax exposure. So, this is precisely when and where their interests are going to diverge — and at the worst possible moment in the relationship.

To make matters worse, the manager also stands to lose fee income if it sells the asset, an interest that also can’t be aligned with the interests of the tax-exempt investor. Sometimes it is in the best interest of the tax-exempt investor to sell and cut their losses; at other times, it makes more sense to hold onto the asset. But the manager’s interests at that critical decision point simply cannot be aligned with those of their tax-exempt investors because of the difference in their tax status.

(There is an exception to this kind of dilemma. When tax-exempt investors are investing in nondomestic markets, they are going to be exposed to tax liability, and so their interests are going to become more united with those of their investment managers. But investing in nondomestic markets also exposes the tax-exempt investor to currency risks that can wipe out any potential gains. So, investing in these markets is not for the fainthearted.)

The other problem is that, for the most part, incentive compensation arrangements rarely are symmetrical. Managers typically stand to share in the gains on the upside but are insulated from sharing in the losses on the downside. (Yes, fees based on assets under management will decline if the asset is written down, but the manager has very little exposure other than its co-investment position sharing in downside capital losses. These losses are going to be disproportionately small when weighed against the fee revenue it stands to earn over the course of the investment.)

I believe Joseph Pagliari Jr., clinical professor of real estate at the University of Chicago’s Booth School of Business — a well-respected real estate educator and researcher — has written extensively on this point.

So, is it possible to align the interests of a tax-exempt investor and an investment manager? I would argue that you really can’t — but not because investment managers don’t want to do the right thing by way of their tax-exempt investor clients. (Most do.)

The problem is there really is no way to reconcile the conflicted interests of a tax-exempt investor and a taxable investment partner. At least, not at that point in the life of an investment when you need that alignment the most — when the investment has headed south and you need to make decisions that will optimize the outcome for both parties.

What, then, is a tax-exempt investor to do? I would argue the best course is to forget about trying to structure alignments of interest. These only work on the upside and never on the downside when you need them to work the most.

Instead, I’d recommend tax-exempt investors focus more on underwriting the character of the people they are hiring to manage their money.

In my 44 years in this business, I have noticed that if you hire the wrong people, it doesn’t matter much what the documents say, they are going to find a way to do what is in their own best interests — even if it conflicts with the interests of their clients. But if you hire people with the correct fiduciary mindset, it doesn’t matter what the documents say, they are going to find a way to put the interests of their clients first.

Simply put, hire the right people and the rest will take care of itself.

And, as always, it’s important to be careful. Be very, very careful. It’s a wacky world out there.

Geoffrey Dohrmann is president and CEO, publisher and editor-in-chief of Institutional Real Estate Inc., parent company to Real Assets Adviser.