Co-investment has become more than just a tool for managers to acquire costly assets. Increasingly, private real estate investors are openly pursuing these opportunities, even making fund commitments contingent on them.
Also known as sidecars, these structures have become popular among investors with ambitions to add direct exposure to their property portfolios, maintain greater discretion over these exposures and seek better returns – all while paying reduced fees to familiar sponsors.
Savvy investors are hiring real estate underwriters and amending their internal policies to make swift decisions and allocations. The goal is to secure the most attractive positions in investments possible.
“We’ve been adding support staff and I think the biggest thing we’ve done is organize our team to have more processes and procedures to make sure we’re reacting to these opportunities in a more cohesive and uniform way,” Jennifer Wenzel, head of the Texas Teachers Retirement System’s Principal Investment program, tells PERE.
Top fund managers have raised steadily more co-invest capital in recent years and investors of all sizes have petitioned for favorable terms. However, there is a gulf between investors that would like to co-invest and those that actually can.
Only 31 percent of investors that responded to the Investor Perspectives 2019 survey said they planned on participating in a real estate co-investment in the coming year. Meanwhile, 52 percent said they would not and 16 percent were unsure.
The top two reasons investors gave for not co-investing were the risk involved and the speed required to execute these deals. One-third of respondents feel they are not properly staffed for co-investment, and nearly a quarter said ticket sizes are too big.
Investors sometimes have only a few days to pull the trigger on co-investment opportunities. This makes co-investing impossible for pensions and other institutions that need the approval of boards that meet monthly or quarterly.
Even large institutions, such as Allianz Real Estate, which has €60 billion of assets under management, have had to retool to meet these arduous demands. The Munich-based insurer has focused its effort on co-investment and other shared-ownership structures during the past two years.
“It’s all about speed,” Annette Kroeger, CEO of Allianz Real Estate in North and Central Europe, says. “We’ve set up our approval processes internally that we only work with a veto right and not [the] full approval that we’d usually have when we do the main fund investment itself. That has allowed us to execute on these co-investments.”
Co-investments carry relationship value. Investors and managers alike are using them to lay the groundwork for future collaborations. This contributes to the trend of consolidation in the private real estate space, Philip Marra, head of US real estate funds at audit firm KPMG, tells PERE.
“LPs are narrowing the playing field and focusing on investing with fewer managers, which leads to a higher degree of trust between the advisor and LP and higher levels of co-investment activity,” Marra says.
Co-investment is trickier in private real estate than corporate private equity, where the practice is common and long-standing. The real estate industry, as of late, has struggled to reach a consensus about what constitutes co-investment and what types of incentives it should entail.
Some attribute this to investors that are new to co-investing – or new to real estate altogether – confusing it with a joint venture, club deal or structures. But managers play a role in this confusion, too. Rather than offering sidecar opportunities to existing investors exclusively, some managers have branched out to other institutions to complete these transactions. Often this is because the fund investors cannot be relied on for the fast cash required for these acquisitions, but this deviation from the norm proves that rules for co-investing are not static.
As co-investment becomes more intertwined with real estate strategies, Wenzel adds, a lack of uniformity could become an issue as managers set expectations and investors compare sidecar outlays.
“It just muddies the water,” she says.
This murkiness also makes it difficult to quantify exactly how much the practice has grown in recent years beyond the escalating anecdotes and noise surrounding it.
There has been a clear uptick in sidecar use among the sector’s top 20 firms, according to PERE data. Co-investments accounted for almost 13 percent of the total five-year equity raised for private real estate funds by these firms in 2017 and 2018, up from about 10 percent in 2016. In absolute terms, $29 billion was raised for sidecars from 2014 to 2018 by the top 20 managers, a 52 percent increase on the $19 billion they raised for the vehicles between 2012 and 2016.
However, a senior executive at a global private equity firm told PERE that with much attention being given to co-investments, investors of all sizes feel obligated to ask about co-investment opportunities, even if they do not have the capacity to participate in them.
“The investor talk about co-investing is so overbearing, I think there might be some investors who might not really want co-invest, who feel compelled to say to themselves or their bosses or the market that they are active co-investors and want to grow their proportion of co-investment as well,” he says.
Also, as co-investments become breeding grounds for future deals, they run the risk of creating conflicts of interest. One long-time industry participant tells PERE some consultants have already raised eyebrows by placing outside capital into co-investments while also advising investors in the underlying funds.
“The inherent conflict comes in when consultants are advising investors on strategies while managing money for outside co-investors,” the participant says. “It raises the question: ‘Could the advice I’m getting be biased?’”
Everything is negotiable (for some)
Mid-size managers have the most to gain from sidecar dealing. Hard-pressed to compete with mega-sponsors for large investors’ capital, the firms can use co-investment incentives to entice large investors to commit to future comingled funds, PERE understands.
Negotiations often focus on dollar-for-dollar ratios and discounted management and carried interest fees. Even smaller investors have started asking for these guarantees to keep from being passed over when co-investment opportunities arise.
Joshua Sternoff, a lawyer with New York law firm Paul Hastings, who advises managers on structuring funds, told PERE he advocates against making blanket concessions during fundraising.
“Some GPs feel like, if we’re co-investing, we don’t want to pre-judge any particular opportunity’s attractiveness to outside capital at the time of fundraising and cut off our ability to raise capital from third parties on more attractive terms,” Sternoff said. “So, even though co-investing is becoming more prevalent and the LPs are asking for reduced economics up front, it’s a little bit of a varied experience and depends on the circumstances whether those GPs will agree to the economics [requested].”
Predictably, managers will dangle favorable co-investment rights to top-tier investors, PERE understands, to secure pivotal fundraising commitments and build relationships. In these negotiations, the biggest investors can secure fee discounts beyond the normal 50 percent, as well as governance rights and advisory board seats.
Co-investing’s rise in popularity has been driven by investors in search of direct exposure to assets they believe will complement their portfolios and drive their returns. Sidecar performance can be judged by comparing the internal rate of return to that of the underlying fund, PERE understands. Wenzel said Texas TRS, for instance, aims for its direct investments to perform 200 basis points better than equivalent comingled holdings. In other instances, it is benchmarked by stability and income.
Nevertheless, co-investments do result in greater concentrations of capital and require large amounts of cash on hand, sometimes even doubling an investor’s initial fund contribution. Alive to that inevitability, investors have grown more sophisticated, their mandates shifting toward establishing greater portfolio controls. A long bull run in the market has given them the funds to do so too.
And so ascendant public pensions, such as Texas TRS and the California State Teachers’ Retirement System, have targeted greater asset exposure through various investment vehicles, including co-investment and separate accounts. Along with giving it more control over the makeup of its holdings, Texas TRS’s Principal Investment program also helps it align interests with its managers, Wenzel tells PERE.
“We’ve found that by doing a co-invest directly with one of our managers, we really get to know them well, a lot better than just going to an advisory meeting, and that’s probably one of the biggest by-products that we’ve seen,” she said. “You really get to know your managers better, how they think and how they view risk and how they underwrite specific deals. So that’s been really helpful.”