By Michael Sala, michael.sala@jpmorgan.com
Launching a private equity real estate fund is not just about raising capital and buying
properties. The transparent – and hidden – costs of maintaining a platform can also be
large and complex.
Let’s face it. Starting up and operating a real estate investment
fund is a complex undertaking that requires significant real estate
finance domain expertise.
From the first capital commitments to initial property acquisitions,
from cash flow tracking to capital
calls – day in and day out, chief financial
officers have their work cut out for them.
In the early days of the life of a fund, managers
are raising capital and getting commitments;
only when these are in place are
infrastructure-related questions raised. Soon
thereafter, when investor commitments are
made and acquisitions close, the CFO must
provide administration support.
Over time, it becomes clear that managing
the requisite monthly and quarterly reporting
is an intense, manual undertaking.
To support this, CFOs have a choice. They
can build the administrative function themselves
– including a myriad of choices about
people, processes and technology – or outsource
their fund administration to a provider.
A good decision at this point requires some hard thinking.
How much senior management time is actually devoted to administrative
tasks and diverted from value-added work? What
are the hidden costs? Can this be quantified?
Outsourcing today
Outsourcing has become common practice for
CFOs across industries worldwide, in part due to
the influence of Six Sigma1 and other process reengineering
approaches.
Outsourcing offers two major advantages for
most CFOs. The first is the attractive option to
move from a variable to a fixed cost structure. The
second is the freedom for managers to focus on
their core capabilities; in this case, the value-added
fund and investor services that make all the difference
in today’s competitive market.
As might be expected, hedge funds have been by
far the largest adopters of outsourced fund administration
to date, followed by private equity firms.
While private equity real estate funds manage more
than an estimated $414 billion in commitments2, they have
lagged behind other types of funds in terms of outsourcing.
Key CFO questions:
- What tasks or burdens are preventing you from focusing on value-added functions?
- How agile is your firm in terms of forming new funds, buying new properties and accessing market opportunities?
- How confident are you that your real estate assets are performing well against industry benchmarks?
- What challenges has your firm faced regarding staffing, hiring or replacing key fund administration employees?
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There a several reasons for this. First, real estate fund structures
are highly individualistic, with no two transactions the
same. As such, processing requires a keen, educated eye to capture
the correct accounting transactions and compliance documentation.
Second, start-up CFOs are typically unaware that
an option to outsource exists before they commit resources to
building their in-house infrastructure.
Finally, there is the question of availability. Up until recently,
fund administration has not been a well-defined market offering
tailored to real estate fund managers. For years, CFOs simply
had no option but to hire and process internally, because of
a lack of viable market offerings to choose from.
As the market has matured, CFOs have found themselves
wondering: just when does it make sense to outsource?
A cost/benefit analysis may help quantify the cost of fund administration,
a vital first step in understanding the fund’s true
costs. In this article, we explore some of the key questions and
criteria you should be asking about the real costs of managing
your real estate fund.
The cost of people
When a new fund is raised or a key employee departs, fund
managers can find themselves scrambling to recruit, train
and retain skilled fund finance professionals.
Some managers only feel the pain of these people-related
costs when they’re hiring – and then only consider pay and
benefits.
However, both cost accountants and human resources professionals
point out that managers with this mindset are ignoring
significant hidden costs. Some people-related tasks and
costs are straightforward and transparent, such as hiring a recruiter
or providing the necessary technology and connectivity
and/or physical workspace.
Others, by their very nature, are voracious consumers of
managerial time, and difficult to extract from a cost/benefit
analysis. To help uncover these hidden expenses, an experienced
human resources professional recently shared some insights
into the key people metrics of this business.
Hidden costs of internal staff
When hiring new employees, general partners need to consider more than just pay and benefits – not just the time
spent in sourcing and hiring talent, but also training and managing staff |
| TASK |
HIDDEN COSTS |
IMPORTANT CONSIDERATIONS |
| Sourcing/hiring |
Interviewing time: four to eight
hours for each candidate means between
32 hours to 64 hours per hire
Administrative time: debrief,
reference and background checks,
drafting the offer letter |
Rule of thumb: on average, managers interview eight
candidates in order to hire one |
| Training |
Managerial time: five hours a
week per employee for coaching |
Training time: employees need to get up to speed and be
independent, taking six to nine months, perhaps even longer
with a larger organisation.
Evaluation time: two years before determining if hiring
cycle must begin again |
| Pay |
Time spent evaluating competitive
pay |
Existing employee pay in a normal market with two percent
cost of living adjustment annually – employers can expect a
five to 10 percent annual increase in total compensation for
performing employees |
| Benefits |
Managerial time spent negotiating
benefits with provider and enrolling
new employees |
Cost of benefits in the future |
| Managing |
Managerial time: average 15
percent of total working hours
per week |
Rule of thumb: on average, managers interview eight
candidates in order to hire one |
Notes: Hidden costs of internal staff refers to a generally accepted metric for a normal employment market.
Source: Dan Conroy, of Henderson Harbor Search, interview, July 2010
The costs of internal processing and reporting
Real estate funds’ monthly and quarterly processes are designed
to ensure efficient operations. For the CFO, this involves
a whole host of protracted, cyclical administrative
tasks, including:
- Property operators must provide financial and operational
data for each property in the fund. With the demand
for more transparency created by recent investment
scandals, managers must provide detail down to
the owned asset level.
- Capital call and distribution processing require massive
Excel workbooks with no defined workflow or
controls, linked together by custom formulas engineered
on a one-off basis.
- Managing cash receipt and distribution requires efficient
cash management, and CFOs can effectively
leverage bank services that support these processes.
- Valuation of properties requires maintaining a clean
record of periodic valuation integrated with core accounting
processes, and a detailed awareness of market
lease assumptions (attributes) which vary between
regions and asset types.
- Quarterly financial reporting involves accumulating
all the data necessary to create financial statements,
including asset books and records for fund consolidation
and delivery to investors.
- Costly annual audits: Excel spreadsheets used as a main calculation
engine and book of record can raise audit concerns.
- CFOs who are not supported by state-of-the-art automated
processing and reporting can raise concerns
during annual audits, prolonging the costly, time-consuming
audit process.
Designing, managing and re-engineering these critical processes
requires substantial commitments of management time
and attention – thereby incurring real, if hidden, opportunity
costs.
The cost of technology
Technology heightens your efficiency, but comes with some
significant costs of its own. Establishing repeated processes
and acquiring, managing and upgrading the technology to
support them may well be the biggest internal challenge that
real estate funds face today.
The typical technology investment in the first year of a new
fund is likely to be in the significant six-figure range. This
includes a mandatory, all-encompassing fund administration
platform, an integrated portfolio and asset management
solution and an investor communication portal.
To properly assess the costs for each, you should identify
the hidden expenses in addition to the outright costs of
purchasing the hardware and software and maintaining the
system. A similar approach should be used for those separate
costs of maintaining adequate disaster recovery for all of
your books and records.
Hidden costs of fund administration technology
In identifying the costs of introducing an all-encompassing fund administration platform, GPs should also consider the
hidden costs of buying technology, including time spent on evaluating systems, implementation and maintenance |
| TASK |
HIDDEN COSTS |
IMPORTANT CONSIDERATIONS |
| Evaluation |
Time: requirements, RFP process,
demonstrations, vendor visits,
scorecards. |
Do you know your requirements? |
| Implementation |
Time: scoping, project management,
parallel processing of old
and new system/process, process
re-engineering, un-met expectations
Economic: customisation, scope
creep, sub-par implementation |
What if the implementation is unsuccessful?
Can you assure continuity of resources, both internally and
for your vendors? |
| Software |
Time: negotiating contract
Economic: legal fees, unforeseen
maintenance fees, further customisation |
Do you have external counsel with technology background? |
| Hardware* |
Economic: additional network/
IT resource time, periodic server
replacement and maintenance |
Do you have in-depth knowledge of complex hardware
requirements? |
| Business continuity* |
Time: designing and testing plan,
failure to execute |
What if your plan doesn’t work? What happens to your data? |
*Assumes hosting technology in-house
The real cost decision
Once upon a time, real estate fund CFOs had no choice but
to grow their own in-house administration. Today, the industry
has matured, and CFOs have outsourcing options
undreamt of even five years ago.
The decision to outsource poses a challenge to conventional
cost accounting thinking for many funds. And the
question now becomes – what is the real cost of dispersing
the focus of a talented executive team? For fund managers,
this introspective exercise can be the start of a tantalising
line of questioning:
- "What would happen to my overall fund performance
if I took steps to alleviate some operational burdens?"
- "What if I focused more time on developing an exceptional
executive team, attracting investor capital
or identifying assets that we can use to maximise return?"
- "What would my IRR look like in such a brave new
world?"
Many funds have found that alleviating their administrative
burden has many positive outcomes, among which
are:
- Increased focus on core capabilities: In an increasingly
competitive market, identify new opportunistic
assets that meet the fund’s investment objectives.
- Flexibility and speed: The ability to quickly alter asset
and portfolio strategy based on rapidly changing
market conditions.
- Better information: Use your in-house market and asset
expertise to create better, more accurate market
lease assumptions, forecasts, models and strategies.
Could these be in your future, too?
Can your fund administrator do this?
Not all providers are created equal. Be sure to ask any potential providers whether they offer these important capabilities: |
- Leverage an integrated data warehouse encompassing portfolio, property, lease, occupancy, investor and fund
accounting data
- Integrate with an easily updatable contact management system
- Offer a cutting-edge online portal where investors can see information at any time
- Provide an online communication portal for fund-to-administrator instruction to facilitate fund operations
- Provide full disaster recovery for all books and records, supported in an offsite, secure environment, stored and
backed up against any eventuality
- Constantly look to the future, evaluating the best options for sourcing and implementing the next new technology
- Offer related products to meet growing fund, portfolio and organisational needs
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Michael Sala is an Executive Director of business development
for real estate fund managers for J.P. Morgan Worldwide
Securities Services. J.P. Morgan provides middle and
back office outsourcing of fund administration services such
as fund and partnership accounting, tax support and comprehensive
reporting services for real estate fund managers
and limited partners. J.P. Morgan also provides a wide range
of complementary services to the real estate community including
transaction advisory, cash management, credit products,
escrow, foreign exchange and derivatives.
1Six Sigma is a highly disciplined process focused on developing and delivering near-perfect products and services. To achieve Six Sigma Quality, a process
must produce no more than 3.4 defects per million opportunities. An “opportunity” is defined as a chance for nonconformance, or not meeting the required
specifications. http://www.ge.com/en/company/companyinfo/quality/whatis.htm
2According to Andrew Moylan of Preqin, interview 5 August, 2010
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