Over the summer, Landmark Partners issued a paper basically gnawing on the following question: When is a value-added fund an opportunistic one? And when is an opportunity fund really value-added?
The knotty question might seem like a thesis for a real estate course, but it is more than just academic. For, as Landmark argues, it matters to the many LPs that still construct portfolios along demarked allocations to ‘core’, ‘value-added’ and ‘opportunistic’.
Further, as Landmark says, differences in fund risk can come from investing in different property types, geographies and stages of a building’s life, as well as leverage and timing of investment decisions. Given the variety of investment strategies at the moment and that execution is so critical, just how useful are broad classifications of fund risk for portfolio decisions?
The reality for LPs returning from vacation and looking to make fresh fund commitments is that the task of allocating between value-added and opportunistic strategies has become trickier because a blurring of the lines has taken place between the two classifications. Examples abound but, in one case, PERE spoke to a firm this summer that used to consider itself an opportunity fund manager but investors consider it more of a value-added firm producing “opportunistic-like” returns.
Certainly, when an investor is weighing up a commitment, the one thing it shouldn’t do is attach undue importance to the ‘label’ of a fund or use target IRRs as the leading indicator of whether a fund is truly value-added or opportunistic. That is because, historically, Landmark has found little difference in absolute or relative performance between the two.
Having studied 706 private equity real estate funds invested over the last 30 years, Landmark found that average value-added IRRs for vintages prior to 2004 were in the ball park of target returns (12 percent to 15 percent). Opportunistic IRRs actually appear lower on average, but the variation is not great enough for Landmark to discern a statistical difference between the average value-added and opportunistic IRRs over that period. For vintages between 2004 and 2008, IRRs were unsurprisingly negative on average and statistically smaller than the average from earlier vintages.
Instead of looking at IRRs, therefore, LPs more than ever need to concentrate on underlying strategy to work out if the fund is value-added or opportunistic. The Landmark paper suggests that these are some key traits to look out for: Value-added investments certainly involve more management expertise than core products in the shape of re-leasing, repositioning or redeveloping existing assets, and they may use more debt. Opportunistic strategies, meanwhile, typically are involved more in land and development, as well as distressed properties in emerging markets, with probably more leverage still. Opportunity funds also are riskier by focusing less on current income and more on pricing and appreciation to generate returns. They also generally tend to be larger than value-added funds, less focused on specific property types and more international.
The upshot for LPs is a piece of common sense advice. One cannot just go on what a fund says on the tin. Look beyond the labels to really understand the basic strategies that the general partners are executing, as well as their track record and quality of the teams. If you are an investor searching for a value-added strategy, maybe there are some funds that have an opportunistic label that still fit, and vice versa. Armed with the right approach, LPs ought to be able to get an A for portfolio construction and returns this semester.