Band of brothers

The upper floors of 25 Bank Street in Canary Wharf, the European headquarters of the US investment bank Lehman Brothers, provide a majestic view of the river Thames and the whole of London in the distance. On the horizon, visitors and employees alike can catch a glimpse of such landmarks as St. Paul's Cathedral, the London Eye and Sir Norman Foster's curving glass tower, known locally as “the gherkin.” It is a fitting perch for a firm that is making its mark on the European private equity real estate landscape. It is perhaps even more fitting for Gerald Parkes, whose office provides a birds eye view of the sprawling metropolis below.

“Cities fascinate me,” Parkes says. “I grew up in the countryside. I just enjoy living and being in extraordinary cities.”

As the head of Lehman Brothers' European private equity real estate team, Parkes does more than just exist in extraordinary cities. He has the chance to shape them as well. Together with Mark Newman, Parkes' predecessor and now the chief investment officer of the firm's global private equity real estate group, Parkes and his team have been building a substantial portfolio of assets across Europe, from residential projects in Warsaw to office buildings in Stockholm to mid-tier hotels in cities throughout the UK. Since 2001, when the firm closed on its first opportunistic vehicle, Lehman Brothers' private equity real estate team has invested in 26 deals in Europe aggregating approximately $1.1 billion in equity.

Yet while those numbers are impressive, Lehman Brothers does not have the same high profile as its counterparts Morgan Stanley and Goldman Sachs, two of the largest, most visible and most successful private equity real estate investors in Europe and beyond. Part of the reason lies in the historical structure of Lehman's proprietary real estate franchise. While Morgan Stanley and Goldman have been investing via opportunity funds since the early 1990s, Lehman did not raise its first real estate vehicle until 2001. (Prior to that, the bank's proprietary real estate investments were all financed on the firm's balance sheet. And even with assets that now top $350 billion, every balance sheet has its limitations.)

Yet a more substantive reason for Lehman's relatively low profile may be the culture of Lehman Brothers itself. As chronicled in the book Greed and Glory on Wall Street: The Fall of the House of Lehman, the Lehman Brothers of the early 1980s was a chestthumping, confrontational firm—an all-out turf war between the bankers and the traders led to the ousting of chief executive officer Pete Peterson, the fracturing of the partnership and the eventual sale to American Express. The firm, now a publicly traded company, seems to have learned well the lessons of the past. A recent Fortune profile of Lehman chief executive officer Dick Fuld described the collegial, partnership-oriented culture that has taken root at the firm. And more than once during our interview, Newman modified any claim about his firm's real estate capabilities with the caveat that he was hopefully being “modest.”

Today, modest may be the last word to describe Lehman's private equity real estate franchise. Under the leadership of co-heads Raymond Mikulich and Mark Walsh, the firm, over the past five years, has expanded its operations into Europe and Asia, raised more than $6 billion in capital and invested equity in more than 100 deals worldwide. In 2001, the bank raised $1.6 billion (€1.3 billion) for its debut private equity real estate fund, Lehman Brothers Real Estate Partners I. A second vehicle, the $2.4 billion LBREP II, followed in August 2005. And that same month, the real estate private equity group closed its inaugural mezzanine debt fund on $1.1 billion.

A HISTORY OF PARTNERSHIP
Modest may nevertheless be an accurate description of the firm's origins. What is today a thriving global investment bank began life in 1844 as a small general store in Montgomery, Alabama. Established by a young German immigrant, Henry Lehman, Lehman Brothers was officially founded in 1850 when Henry was joined by his brothers Emanuel and Mayer. Over the next decade, the store, which often accepted cotton as currency from the local framers, branched into cotton trading. After setting up an office in New York City and expanding into other commodities, the firm became a vital financier for some of the most important industries of early America from railroads in the 1860s to retailers such as Sears Roebuck, Macy's and FW Woolworth at the turn of the century to movie studios including Paramount and 20th Century Fox in the 1920s.

Though Lehman Brothers has experienced both golden ages and dark ones, the bank's family-based origins—as well as the lessons of its recent past—have had a positive impact on the current structure of Lehman's real estate business. Newman proudly describes how the firm's real estate business operates not as a series of individual fiefdoms but rather as a cohesive, integrated unit across capital markets, investment banking and investment management.

“We very much have one real estate business,” he says. “It's not that we have an equity business and then in another silo is a lending business and then elsewhere we have a banking division. We run this as one business.”

Industry observers seem to agree. “Other banks talk about this silo-free model where the whole institution works together,” noted Merrill Lynch analyst Guy Moszkowski in Fortune. “But among the companies I cover, Goldman and Lehman clearly do it the best.”

“It's not that we have an equity business and then in another silo is a lending business and then elsewhere we have a banking division. We run this as one business.”

Lehman's cooperative framework extends to its operating partner network. According to Parkes, who has spent much of his 25-year career in small, entrepreneurial organizations, it was Lehman's focus on partnerships—both internally and externally—that attracted him to the firm, which he joined in 2004.“We are very, very partnership-oriented,” he says. “Each year, about 80 percent of our business is with people we have already done business with.”

“It is clearly one of the advantages we have here at Lehman Brothers,” Newman adds. “We get to know people through our franchise either in an advisory or financing role. Then we can provide capital to them in a lower-risk way, get to know them and build a relationship with them.”

He notes that the firm has between 300 and 500 relationships in its global real estate practice that have each generated either $500 million worth of business, five deals or both.

THE PUBLIC SPHERE
After raising its first opportunity fund in 2001, Lehman used some of those relationships to make approximately 12 investments across Europe. According to both Parkes and Newman, a significant amount of LBREP I was invested in public-to-private transactions including UK property companies Haslemere and Burford, Dutch real estate investment firm Uni-invest and Swedish property group Tornet.

One of the firm's most successful investments from the first fund can indirectly be viewed as a public-to-private deal according to Newman—the acquisition of Nexity, the real estate arm of the publicly traded French media and utility conglomerate Vivendi.

Partnering with two preeminent French developers, CDC and LBO France, as well as company management, Lehman was able to buy the business for the relatively cheap price of €625 million. By selling off the company's non-core assets—Nexity owned health clubs, a time-share business, a portfolio of office buildings and an asset management company, among other things—the consortium was able to quickly recoup its equity and re-focus the company on its core residential development business. In 2004, following a refinancing of the company, Nexity went public on the French stock market.

“We did great,” Parkes says. “Management did fantastic. That's the way it should be.”

In the second fund, Parkes notes, the public-to-private opportunities are limited given the valuations of most listed property companies. “Not to say there aren't deals to be done,” he adds. “They are just less obvious than two to three years ago—to the extent that any deal is truly obvious. They're only obvious in hindsight when they turn out well.”

One area Lehman is focusing on is the residential sector, particularly in Eastern Europe and especially in Poland, where it has joint ventures with two Israeli homebuilders. Thus far, the firm has developed, or is in the process of developing, several apartment projects in Warsaw, three in Krakow and one in Gdansk. Asked about Lehman's interest in the region, Parkes points to Poland's economic development, the rise in median household income, an emerging mortgage market and an obsolete housing supply left over from the Soviet era.“And people want to own their own homes,” he adds, “which is very different from, say, Germany.”

Parkes' views on Germany may explain why Lehman has been relatively quiet in the country, despite all the activity in the residential market there. Parkes points out that Lehman has been an active lender in the country, but he says that many of the large portfolios that have traded in recent years have benefited not from their original business plan—selling units back to their inhabitants—but by cap rate compression.

Nevertheless, Lehman Brothers has been extraordinarily active in the residential business elsewhere, according to Parkes, from its projects in Poland to condominiums in Milan to land development in California. He estimates that approximately 40 percent of Lehman's deals globally have been in the residential sector recently, a significant figure given the industry's historical focus on office properties.

“Historically, most institutions are not interested in residential and yet, to my mind, it is the asset type that tends to have the most consistent demand,” he says. “Homes – people always need somewhere to live.”

Newman points out, however, that Lehman's recent focus in the residential arena is less a function of Lehman's expertise—though he concedes the bank's knowledge and comfort in the sector— and more a function of the current market environment. He notes that as an opportunistic investor putting capital to work around the globe, Lehman must be quick to adapt to different markets and environments.

“If you look back over the history of the business,” he says, “you'll see a huge transition in the places that we have focused our business, from distressed to public-to-private to portfolio acquisitions to funding commercial development. Our business spans all facets of the real estate business. The only way you can deploy these amounts of capital is to follow this strategy.”

Underscoring that point, both Newman and Parkes point to another sector in Europe that has recently drawn the firm's attention: hospitality. Last year, the firm teamed up with Canadian real estate operator Realstar Group and GIC, the investment arm of the Government of Singapore, to acquire 73 UK hotels from Intercontinental in a deal valued at €1.4 billion. According to Parkes, Intercontinental had spent approximately £250 million on upgrades after the industry downturn in 2001, but it had yet to fully realize the benefits of that program. He also credits Newman's long relationship with Jonas Prince, the co-founder of Realstar, as a critical component of the transaction.

“You know how they say golf is a demanding sport because you have to be perfectly focused and perfectly relaxed at the same time? In many ways our business has that type of dichotomy…”

In addition to European residential and hospitality sectors, the bank has also been active in a number of other geographies and sectors over the past several years, purchasing a substantial Swiss property portfolio from the state-owned telecom giant Swisscom, partnering with the French real estate developer Atemi and acquiring Swedish property company Linco Fastighets, the owner of four office buildings in Stockholm.

“You know how they say golf is a demanding sport because you have to be perfectly focused and perfectly relaxed at the same time?” Newman asks. “In many ways our business has that type of dichotomy: you have to be both generalist enough to cover all sides of the market, while knowledgeable and sophisticated enough that on any particular deal you can discern value where it is and where it is not. That is the trick.”

Thus far, the private equity real estate team—in Europe and beyond—has demonstrated an ability to keep its eye on the ball. According to Newman, Lehman has already invested or committed approximately two-thirds of its current $2.4 billion vehicle—at that pace, the investment bank could be back on the fundraising trail in the very near future.

Where could they go from here? Well, beyond Europe, the firm has been expanding significantly into Asia, where it expects to deploy approximately ten to twenty percent of Fund II. In Europe, Parkes notes that his team is looking at Turkey, where Lehman has already been active, recently purchasing a portfolio of non-performing loans via its balance sheet. And even though Russia is not a region of interest at the moment, that's not to say it won't be in the future. If Lehman's recent history is anything to go by, you can't cross any region of the world off its list.

“I hope that the business stays as exciting ten years from now as it is today,” Newman says. “One of the great things about working at a global investment bank like Lehman Brothers is that we get a huge amount of support as we go out and try to break into new markets. The bank is very supportive of us growing the footprint of the business.”

LEHMAN BROTHERS
European headquarters

25 Bank Street

London E14 5LE

United Kingdom

www.lehman.com

Other offices: New York, Tokyo

Key personnel

Raymond Mikulich Co-head

Mark Walsh Co-head

Funds

LBREP II (2005): $2.4 billion

LBRE Mezzanine Partners (2005): $1.1 billion

LBREP I (2001): $1.6 billion

Recent European transactions

July 2006: Acquired Cannon Bridge, a landmark London office building

February 2006: Acquired Linco Fastighets, a Swedish property company

March 2005: Acquired 73 UK hotels from Intercontinental for €1.4 billion