“How do timberland investment managers make money?” The question itself, asked by an analyst working for an institutional investor, was straightforward enough. However, it was the third time in the past week our team had received a call with such a question. Since “reading tea leaves” in our research business often involves better understanding the questions and concerns on the minds of those in the marketplace, I’m taking this as an opportunity to review the general business model of timberland investment management organizations (TIMOs).
TIMOs are asset managers. They generate income through transaction fees, management fees (which grow with their assets under management) and performance fees. That said, fees and fee structures vary widely across TIMOs. In part, variance in investment strategies and fee structures help match the investment objectives and risk tolerances of different investors with appropriate timberland investment managers.
Specific fees earned by TIMOs may include:
- Placement fees based on the purchase price of the timberland investment properties:
- Management fees as a percentage of asset value (after purchases and dispositions);
- Management fees as a percentage of appraised market values of the timberland assets over time; and
- Performance fees (overage) that provide profit-sharing above a pre-specified hurdle rate. Hurdle rates may be stated in real (without inflation) or nominal (with inflation) terms.
An example of an overage arrangement would be where the TIMO receives a carried interest in the fund if returns exceed a stated hurdle rate. For example, with a hurdle rate of 6%, the fund might receive 20-25% of the returns above this hurdle, called the overage. This overage would remain in the fund and grow with the investment, giving the fund managers an “interest” in the fund that can compound over time.
Total annual fees paid to TIMOs are expected to approach, but not exceed, one percent of the assets under management in the timberland portfolio. In the past, some TIMOs reported publicly their estimated fees. For example, for the fiscal year ending 2002, The Campbell Group indicated average management fees at the property level of 96 basis points (0.96%). Hancock Timber Resource Group used 95 basis points (0.95%) to approximate management fees in publicly available timberland investment analyses. Over time, annual fees have consistently ranged between 85 basis points (0.85%) and 100 basis points (1.00%), with other structures based on services provided or weighting more or less to performance.
TIMOs can generate the bulk of their income at liquidation, upon the sale of the timberlands, so the appraised values/appreciation estimates carry great importance to all stakeholders. As such, the appraisal process and asset valuations remain ongoing concerns with timberland investors because of the potential for conflicts of interest. Fee structures that pay-off towards the end of the investment period moderate these concerns as TIMO managers collect performance fees following the actual liquidation of the fund. At that point, the market dictates the total returns associated with the properties.
A useful exercise in our equity research has been comparing the relative per-acre administrative loads of TIMOs and publicly-traded timberland-owning REITs. At the end of the day, the earnings potential of timberland assets varies more by location than by ownership structure, assuming structures of comparable tax efficiency.