Point of View: Overpayment of Manager Incentive Fees— When Preferred Returns and IRR Hurdles Differ

Executive Summary. An evolution has taken place in terms of manager incentive fee documentation. Originally, incentive fees were based on a "preferred return" methodology whereas, today, most contracts use an IRR hurdle methodology. Although this change generally has been treated as a non-event, the change has generated unanticipated consequences that can be quite significant.In instances where additional equity capital is called after an earlier split of profits, the equivalence of these two formulations fails. Further, even when such is not the case, if the investment is a portfolio and the contract allows for interim incentive fee payments based on only assets sold to date, the same problem can occur. For large portfolios, millions of dollars of fees can hang in the balance, amounts that will accrue to the investor or the manager based solely on the calculation methodology utilized. We believe that this phenomenon has been inadvertently embedded in many institutional real estate portfolio fee arrangements.With the recent sharp downturn in the real estate market, rates of return have been so low as to temporarily render this issue moot. With the market beginning to recover, this is an opportune time to 'daylight' this issue.