StepStone on GP-led secondaries’ golden age

This article is sponsored by StepStone

StepStone, as a quasi-investment manager and adviser, allocates around $15 billion a year to real estate funds, including approximately $2 billion to secondaries and co-investments last year, principally in the US and Europe.

Jeff Giller, head of StepStone Real Estate, along with co-founding partners Josh Cleveland and Brendan MacDonald, began investing in real estate secondaries in 2005. In 2009, seeking greater information transparency and more control of their investments in the wake of the GFC, they began investing in secondaries in which the GP, rather than the LP, was their counterparty.

What is going on in the secondaries market today?

I think it is important to stand back and have some perspective. The post-GFC era of cheap debt was simply an anomaly that had to come to an end. So, while 2021 was a good year to invest, interest rates rose in early 2022 and a slowdown ensued that became more pronounced in 2023.

As a liquidity provider to real estate managers and their investors through our advisory practice, discretionary funds and separate accounts, we had over a thousand meetings with GPs in 2023 to discuss the potential to allocate capital to their funds. We also use these interactions to discuss potential liquidity needs for their funds and investors, and as such, our advisory practice creates a differentiated sourcing opportunity for our GP-led secondaries funds.

 

 

 

 

 

 

 

“With lending restricted and LPs experiencing liquidity constraints, there is a high demand for liquidity solutions, so it should be an exceptional time to invest in secondaries”

Jeff Giller
Stepstone

The significant pipeline that this connectivity to GPs creates enables us to cherry pick from the most attractive opportunities. On average, we end up investing in less than 2 percent of the secondaries opportunities that we see, and we believe this ability to be highly selective about our deals results in strong performance.

LPs may need to sell positions as they have big liquidity constraints. In this market, distributions are down, and many LPs are facing a liquidity crunch. We estimate that distributions overall are down by 70 percent year-on-year, and capital calls are only down by around 30 percent. So, when GPs need to pay down debt for their assets that have become over-leveraged due to value declines, the LPs may not be in a position to fund.

LPs can try to create liquidity by selling existing positions as secondaries. However, since managers have yet to take meaningful write-downs, their funds tend to be overvalued and the discounts that an LP would have to accept to consummate a secondaries sale would be substantial.

Consider the scale of the valuation problem. Our estimate is that in the European markets, real estate valuations are down by something like 26 percent from their peak, while in the US it is closer to 30 percent. Most managers’ markdowns are not even coming close to those levels, so the discounts that secondaries buyers need to achieve to justify an investment are too high for most LPs to accept. As such, there is little trading in the LP secondaries market at present.

However, there continues to be many interesting special situation opportunities. This is the sector which we invest in.

What are the main catalysts for the high number of special situations?

In this market, the biggest driver for dealflow is the need for managers to pay down debt as loans mature. With interest rates up by 500 basis points from when they financed their existing loans, refinancing proceeds will not be sufficient to pay off existing debt balances, so they will either need to give the asset back to the lender, sell it or recapitalize it to fund the gap between refi proceeds and existing loan principal balances. There are an estimated $3 trillion of commercial real estate loans maturing in the next four years, nearly all of which will have to be resolved, creating a tremendous recapitalization opportunity.

The dearth of real estate sales activity is also a catalyst of GP-led secondaries. For example, merchant builders that develop, stabilize and sell their assets are holding unsold inventory that they do not want to sell at rock bottom prices.

Consequently, they cannot recycle capital into new projects, and their businesses are stalled. An alternative to selling at the bottom of the market or ceasing activity is to recapitalize their existing portfolio and use the proceeds to continue their development activities.

Recapitalizing existing portfolios of assets to support managers struggling to raise capital in this challenging fundraising environment is another catalyst for GP-led secondaries. Fundraising in 2023 was half of what it was in 2022 and the volume of capital raised in 2024 is likely to be similar.

Not only is fundraising down, but about a third of what is raised is being allocated to the 10 largest managers, leaving a significant number of strong small and mid-cap managers struggling to raise capital. We have closed several transactions where we have recapitalized a GP’s existing portfolio, and in some cases committed some additional capital that the GP uses to continue investment activities to get around the market’s fundraising challenges.

Our large pipeline also allows us to invest predominantly in sector specific funds and therefore to build targeted portfolios that are consistent with our house views. By contrast, in typical LP secondaries investments there may be an element of adverse selection as LPs seek to sell their interests in diversified funds that may include a lot of troubled asset types or sectors.

Where are the greatest opportunities in real estate right now?

Nothing too profound here: We like industrial and living sectors, as well as alternative asset types like data centers and cold storage. Debt can also be very interesting.

In the case of industrial, this is the first time in years where the market is actually becoming approachable from a pricing perspective. In residential, we have also done a lot in the student-housing space, manufactured housing and senior housing, particularly in the UK.

We also think that elements of the hospitality sector can be attractive, if acquired at the right point in the market cycle. We have also had success in data centers.

We red-lined retail beginning in 2015 and we have done only one transaction in that sector since then. But I feel now that the sector is finding its bottom and is repositioning well, so we are open to considering retail again.

Like retail, we have very little office exposure in our secondaries portfolio. The office market seems to have replaced retail as the problem child. The work-from-home phenomenon is devastating, particularly in the US, less so in Europe, and is not really a factor in Asia.

Then there is the reality that a significant portion of existing office stock is functionally obsolete given technology specifications, environmental retrofitting requirements and the need for the floor plans and amenities that will inspire the workforce to return to the office. The cost to retrofit existing stock to fit these requirements is usually prohibitive.

I think there has been a permanent step down in the level of demand in the office sector, with the exception of the new generation of Class A properties such as Hudson Yards in New York City. But these have very low yields and are only attractive as core investments, rather than to high-yield investors.

How is the future of the real estate secondaries market looking?

The purpose of secondaries is to provide liquidity to real estate vehicles and their investors. With lending restricted and LPs experiencing liquidity constraints from a dearth in distributions from their private investment portfolios, there is a high demand for liquidity solutions, so it should be an exceptional time to invest in secondaries.

Although the GFC presented attractive secondaries opportunities for many of the same reasons, the economic recession resulted in operational distress across the real estate sector, making secondaries investments more risky and more difficult to price. The current environment, where there is a liquidity crunch that can be solved by accessing the secondaries market but without the operational distress seen during the GFC, provides an attractive, yet much less risky, investment climate for secondaries.

What should investors look for and what should they avoid when investing in secondaries?

We believe that GP-led secondaries investments can provide an asymmetric risk/return profile, in that high yields can be achieved with more core-plus risk. To mitigate risk, we look for investments with discounted entry bases, moderate levels of leverage, strong current cashflow, portfolios of predominantly stabilized assets and investments with short durations.

Atypical of traditional secondaries investments, where passive, non-controlling interests are being sold, we seek to invest in situations where we have some level of control and we can do granular, asset-level due diligence. That is the advantage of transacting with the GP who can provide information and can agree to cede or share control, rather than the LP.