Coming to the realization

As private equity real estate funds deploy capital quicker than ever, they are returning to their fundraising trail more and more—but would LPs like to see less of them and more of a track record? By Aaron Lovell

To say the private equity real estate sector is awash with capital would be an understatement. As interest in real estate grows and investors continue to increase their allocations to the asset class, fund managers are taking advantage of that interest by raising larger and larger pools of money. Yet they are also spending those pools of money at a much more rapid pace, which means they are hitting the fundraising trail with increasing frequency.

Some of the most prolific firms are now heading back to their LPs less than two years after their last fund close. Given the current state of the market, it's a great time to be out raising capital—but should LPs be concerned about a dearth in realizations from prior vehicles?

Frank Blaschka, chairman of the investment committee at pension fund real estate consultant The Townsend Group, points out that, in the early days of the industry, firms would return to the fundraising trail every two to three years. He says the time in between fundraising has dropped, in some cases, to 12 or 15 months.

For evidence, one only needs to look at some of the marquee names in the investment space. San Francisco- and Boston-based private equity real estate firm Rockpoint Group closed its second fund on $1.7 billion (€1.3 billion) last November, exceeding its initial target of $1 billion. The vehicle closed a mere 17 months after its debut fund, Rockpoint Real Estate Fund I, which raised more than $800 million in 2004. Another example is Los Angeles-based Colony Capital, which is currently raising Colony Investors VIII, having recently closed a predecessor vehicle on $1.2 billion. Both firms have seen significant increases in size from fund to fund.

Along with growing fund sizes and increased competition comes some concern that funds are heading back out on the fundraising trail without a lot to show from their previous forays. “We are constantly seeing new funds come to market without many realizations from their previous funds,” Blaschka says.

It's a sentiment that's been echoed throughout the institutional investor community. At the recent Pension Real Estate Association (PREA) conference in San Francisco, one LP remarked, “We've had so many funds come back to us before they roundtrip.” Her fellow panelists all nodded in agreement.

“We've had so many funds come back to us before they roundtrip.”

While no LP expects a firm to completely realize all of its assets before going back out to raise a new fund, the PREA panel suggested that the trend caused some worry in the investor community. Yet while the pace of the current market may increase some LPs' antacid bills, the situation has been on the minds of investors for some time, going back to the very beginning of the industry.

“This has always been a standard concern of real estate private equity funds,” says Gary Koster, a partner in Ernst & Young's real estate department. “They don't want funds to get too far ahead of their focus.”

Despite the on-going concerns from LPs about realizations and good reporting, Koster says he has not seen a groundswell of concern from limited partners over the topic. He points out that fund documents often prohibit vehicles from raising money until approximately 80 percent of the previous fund's capital has been committed or, in some cases, invested.

Therefore, even if a GP has realized little of its previous vehicle, investors may be able to get comfortable with the makeup of the portfolio and the pace of change in the underlying assets—namely, whether or not the business plan for each individual investment is proceeding according to schedule, providing a predictor, albeit a limited one, for the fund's future performance.

“We can get a lot better visibility of existing funds by looking at individudal investments still being resolved,” says Townsend's Blaschka.

Another factor that can assuage investor concerns is, of course, a good track record. If a firm has delivered strong results to its investors in the past, it makes underwriting a follow-on commitment that much easier.

“If the group [has] a long track record of 10 or 15 years, the LP can [say], ‘Well, your current fund isn't sufficiently realized, but we like what you've delivered on funds four, three and two,’” notes David Kirby, a Greenwich, Connecticut-based placement agent.

Presenting a strong track record, however, can be a daunting task for a relatively young firm, which obviously does not get the leeway that a more established brand name receives. Though investors may be happy with what a new fund has done to date, making them interested in committing to a follow-on vehicle, they sometimes hold off until they have a better sense of how the existing vehicle will perform.

“As a result, the groups have gone back, continued to manage their portfolio, achieve realizations, and put fundraising off for a little while,” Kirby says. “It's important to note that if this were fund five or six, there would be less of a concern with a delay in fundraising than it would be if the new fund were fund two or three.”

Still, nothing replaces having a sufficiently realized portfolio. “From an LP standpoint, there are so many funds from which to choose and so many strategies from which to choose, that they're really not under pressure to go into a fund that has a relatively immature track record,” Kirby says.

Despite the inherent difficulties in underwriting firms with few realizations from their predecessor vehicles, several investors note that they are not worried by the rapid velocity of capital deployed by their general partners.

“If [the fund] is putting out the money, why wouldn't you give them more?” aks one former institutional investor, who points out that large funds usually return to the fundraising trail with little time lost in between vehicles. “Hasn't that always been the case?”

Many say the real concern comes not from not allowing enough time between fundraising, but rather from things like the dreaded “style drift,” personnel changes at the firm, disappointing performance in a previous vehicle and changes in terms. To a lesser extent, portfolio allocations can also change and make a fund strategy less essential to an institutional investor.

Other investors point to the fact that, despite GP concerns over competition in real estate, funds continue to find ways to put ever-increasing pools of capital to work—and in shorter and shorter periods of time—while still generating fairly strong returns. Perhaps this explains the relative lack of animosity between fund sponsors and fund managers on the issue.

“This has always been a standard concern of real estate private equity funds. They don't want funds to get too far ahead of their focus.”

In fact, many participants have been hearing concerns about a very different problem in such an active market: LPs are seeing capital return at a much faster rate than they had planned. Thus, at the same time that they are trying to boost, or even maintain, their allocations to the asset class, huge windfalls are being realized by the underlying private equity real estate funds.

“The money is coming back very quickly because we are at an all-time high with prices,” Koster says.

In other words, LPs have a high-class problem. And it's not one they can really complain about. Notes one institutional investor: “Ultimately, we're happy to see our managers taking advantage of the high levels of liquidity to harvest profits, generate attractive returns, create option value and, in that way, capture a unique opportunity to compensate their teams better and earlier than anyone had anticipated.”

In an ideal world, GPs would be able to invest their LPs' capital over the expected time frame. They would generate some early returns, while other investments may take longer to realize. And when they were ready to hit the fundraising trail again, even if the fund wasn't significantly realized, it would be in a strong enough position to demonstrate that its performance would come close, or even exceed, initial expectations. The world, of course, is never ideal. And in today's market, many of the largest opportunity funds see inefficiencies in larger and larger transactions, meaning they are putting out capital in bigger and bigger chunks and at a much more rapid pace.

“We expect [fund managers] to be continuously active in the market as long as their strategy is effective,” notes the institutional investor.