It has long been a priority of most investors to ensure the interests of their investment managers are closely aligned with their own interests. These investors are attempting to solve for what is commonly referred to as “the agency problem,” a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests.
Within real estate investment, the agency problem usually refers to a potential conflict of interest between the investor and investment manager. As a steward and fiduciary, the investment manager is obligated to make decisions on behalf of its capital-provider clients that will maximize investor wealth — even though it’s actually almost always in the investment manager’s best interest to maximize its own wealth. And therein lies the problem.
Attempts at aligning interests most often are accomplished by insisting the investment manager have some form of “skin in the game” by placing some of its own capital alongside investors’ capital.
On paper, this works perfectly. But, if you’re talking about taxable investment managers serving the interests of taxable investors, such as insurance companies, trusts, family offices or individual investors, having skin in the game actually should help create the longed-for alignment of interests. Because both sides are taxable, the outcomes under almost all situations will be identical for both parties.
It’s another matter altogether for tax-exempt investors with taxable investment managers. Going into a relationship like this, both parties, of course, invariably want and intend to do everything possible to deliver with respect to the capital provider’s investment objectives. After all, the investment manager’s reputation and track record depend upon it delivering what it has promised.
Unfortunately, things don’t always go as planned, such as when an investment takes a turn for the worst, through no fault of the investment manager. Regardless of the reason, the options available to the investment manager at this point can become hopelessly conflicted with the interests of the capital providers.
In some cases, of course, it will be in the best interests of everyone involved to commit more capital and buy time to help turn the investment around. But in other cases, no amount of additional capital is going to salvage the investment. The only optimal solution under those circumstances is to sell the asset, book the losses, and move on.
The agency problem arises here because the outcome of a distressed sale is going to be different for the tax-exempt investor than for the taxable investment manager. The tax-exempt investor can book the loss without any tax consequences.
The investment manager, on the other hand, will have to book the tax losses on its capital investment. In some cases, that could be advantageous. But in cases where the asset has even moderately depreciated, the investment manager may face the adverse outcome of having to recapture some of that depreciation and related write-offs, and actually end up with a tax bill to pay, with no net sales proceeds to cover — what is commonly referred to as “phantom income.”
So while the investor and the investment manager both stand to lose all or a portion of their capital, the investment manager also will have to pay taxes, with no net proceeds to cover. Consequently, in this case what is in the best interests of the investor definitely is not in the best interests of the investment manager. The alignment of interest both parties originally sought to engineer has evaporated. Requiring an investment manager to have skin in the game — when the investment manager is taxable and the capital provider is tax-exempt — actually amplifies, rather than reduces, the inherent conflict of interest resulting from the agency problem.
Instead of attempting to engineer alignments that can’t truly be engineered, I’ve instead been advising investors to focus on the character of the investment managers with whom they’re doing business. If I’ve learned anything in my business career, it’s if someone truly has the heart of a fiduciary, it really doesn’t matter what the terms of the contract are, or the consequences to them of taking a particular action that’s in the best interest of their clients. They’re going to do the right thing. Of course, the converse is true as well.
As for investment managers, I’ve been advising them to focus prospective investors on the character of their firms, and on convincing investors they have their best interests at heart, no matter what happens during the course of their relationship.
You may or may not agree with my views on this subject. (And if you don’t agree, you’re not alone.) But one thing I can tell you. 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., the parent organization to Real Assets Adviser.