Double or nothing

Doubling down with a co-investment is reserved for some of the biggest LPs on some of the biggest deals. With the right fund manager and the right deal, it can mean big profits. By Aaron Lovell

Last month, the US Department of the Navy officially turned over the decommissioned El Toro Marine Corps Air Station in Irvine, California to representatives from homebuilder Lennar and real estate finance group LNR Property Corporation. The transition represented the official changeover for the site, from idle military airport to a future multi-use development.

The much-heralded deal, called Heritage Fields, was announced in February. The plan for the 3,178-acre site includes 3,400 houses, 2.6 million square feet of industrial and retail space, a college campus and a golf course, in addition to a 1,375-acre public park for the city of Irvine.

The winner of the $650 million (€529 million) military auction was a consortium of Lennar and LNR, then a subsidiary of New York-based hedge fund Cerberus Capital Management, Cerberus' private equity real estate arm Blackacre, opportunity fund Rockpoint Group and MSD Capital, the investment arm of the Michael Dell family.

But also included in the deal were co-investment partners, a select group of some of the nation's largest pension funds, including the $48 billion Oregon Public Employees Retirement Fund, the $190 billion California Public Employees' Retirement System and the $121 billion New York State Common Retirement Fund, who were offered a piece of the action above and beyond their fund commitments.

Known throughout the industry as “doubling down,” a coinvestment typically involves a private equity limited partner investing additional capital alongside the GP in a specific deal. In return, the GP often provides economic incentives on that particular equity contribution, including reduced management fees and carried interest obligations. While the practice has been relatively limited in the private equity real estate industry thus far, the Heritage Fields transaction is not the sole example. And as GPs look to bigger and bigger targets and LPs seek greater and greater real estate exposure, the potential for more co-investment opportunities increases – as does the potential benefits and risks.

For general partners and limited partners alike, the primary benefit of a co-investment is that it allows a fund manager to target deals they are unlikely to pursue otherwise. In the Heritage Fields deal, for example, the GP consortium was able to target a deal too large for the comfort of the individual private equity firms and the limited partners were able to invest directly in what they anticipate will be a good transaction.

“In a competitive marketplace, [a co-investment] allows GPs to win deals they might not otherwise win,” says Michael Crawford, a partner at placement agent CP Eaton.

This is particularly true for bigger deals. If the transaction is successful, not only does the GP see a potentially greater absolute level of carried interest for the same amount of their own equity, the firm has also proved that it can handle transactions of a certain size – something that is helpful if they are planning on raising a bigger fund in the future.

That said, there are plenty of benefits for limited partners, as well. Any boost in returns that the GP sees from the deal obviously accrues to the LP. In addition, institutional investors, flush with cash and facing increasing real estate allocations, are looking for more and more ways to put their money to work in the sector. “It's a carrot for LPs,” Crawford adds.

In addition to returns and increased real estate exposure, a co-investment also provides for diversification for both parties involved. The GP is able to reduce the amount of equity that is put into any one deal and, according to Bradford Child, real estate investment officer at the Oregon State Treasury, the LP gets the chance to broaden their real estate holdings.

“To some extent, it gives you the chance to have a greater exposure to international, development, residential or industrial in your portfolio,” Child says. “You can pick and choose, in that regard. You hope you're able to get into good, solid investments that the parameters would have otherwise prevented.”

Of course, before any co-investment takes place there must be a base relationship between the fund manager and the investor, which helps to further cement the LP-GP relationship and hopefully leads to an increased alignment of interests, as the LP's economics increasingly resemble that of the GP. Because of this symbiotic relationship and increased responsibility, placement agent David Kirby of New Canaan, Connecticut-based Kirby Capital Advisors says most coinvesting LPs work alongside funds that they have invested with a number of times. “You don't cold call for a co-investment,” he says.

The practice oftentimes offers LPs the chance to mitigate the costs associated with fees and promote that are part of private equity funds, says Michael Hoffman, a partner at Probitas Partners, a San Francisco-based placement agent. “If [an LP] is investing $50 million in a $500 million fund and they have the ability to do a $50 million co-investment, the investor has brought the management fee from 2 percent to 1 percent and the carry from 20 percent to 10 percent,” says Hoffmann.

But as the capital in the market has increased, the negotiating leverage has shifted towards GPs who are increasingly able to charge fees or a promote on these sorts of deals, says Gary Garrabrant, chief executive officer of Chicago-based investment company Equity International. Now the gamut can run from a fee-free investment to a fully promoted one.

“It goes to show the excess liquidity, where the level of capital far exceeds the amount of good ideas,” he says. Garrabrant's firm has seen situations where they could potentially plan to offer a co-investment promote-fee for existing investors, followed by a second round of promoted financing with new investors. “At the time of the investment, it's hard to make the case to promote them,” he says.

Scott Landress, managing partner with secondaries fund operator Liquid Realty Partners, says the phenomenon of rising fees are a function of a dearth of valuable coinvestment opportunities. “Good real estate transactions are so few and far between that investors are more than ever willing to pay for co-investments,” he says.

The LP co-investments are a particularly good deal for investors who are so far happy with a fund's performance and are willing to make bets on the same managers they've backed before. The right co-investment project can be icing on the cake.

“[LPs] like the returns,” Crawford says. “They like the value creation. If they put $25 million or $50 million in directly, they're getting that at a much cheaper rate.”

But the possibility of more upside has its downside, too. Co-investment deals increase an LP's exposure to a single asset and a single manager; if a deal goes bad, the coinvested limited partner stands to lose the percentage of its fund commitment that was allocated to the transaction, as well as the capital it has placed through the co-investment.

Because of the increased need for risk assessment, limited partners must have the real estate staff to evaluate the proposals from fund managers. The ability to make quick, educated decisions on these sorts of large – oftentimes complicated – deals is not something every institutional investor can do.

So co-investments put additional responsibilities on the desks of the investment professionals, something many LPs attempted to avoid by investing in discretionary funds in the first place. While consultants can help manage the increased workflow, a co-investment project requires more attention than a normal fund allocation

“Now the burden is kicked over a little from the advisors to the limited partner to make a decision if it wants to do it or not,” says Child. “You're going to have to do some underwriting one way or another and do you want to double down or not?”

Kirby points out that co-investors must be large, sophisticated investors with seasoned real estate programs. “Co-investments aren't for new entrants in any asset class,” he says. “The investors that do this have evolved over time.”

While most LPs want the right to co-invest, Hoffmann says, “the reality is only a small subset have the ability to quickly act on an opportunity.” He adds that a deal in the works for four months may only afford possible co-investment partners one or two weeks to decide whether or not to invest. LPs largely have to rely on their GP's due diligence.

As Oregon's Child puts it: “It's coming down the pike and you only get one swing at it.”

But with the amount of capital in the market, Garrabrant says he's seen increased interest in co-investment projects from institutional investors that may not have the sort of real estate staff to handle the projects.

“The sophistication level has risen very substantially,” he says. “People will have an interest without necessarily having all of the human resources needed to fully evaluate them. They're leveraging their GP.”

Hoffmann says smaller LPs who cannot or do not want to co-invest sometimes look unfavorably on the practice. They don't like seeing the fund manager doing the extra work for the benefit of a few larger LPs, so GPs must make sure they strike an appropriate balance to not alienate their non-coinvesting LPs with too many co-investment deals.

“The fund manager has to be careful that they don't disincent the regular investors by giving away the shop to the co-investors, or vice versa,” says Child. “You don't want to make it harder to be a coinvestor than a regular investor.”

But Kirby points out that nonparticipating co-investment LPs still benefit from the fund's participation in a deal, provided it's a good transaction.

Because of the amount of capital flowing around the real estate asset class, investors are increasingly looking for diverse ways to put their money to work and co-investments offer that diversification and potentially higher returns as well, albeit with greater risk. Garrabrant has even had investors ask for the right to coinvest disproportionately more than other LPs and, in one case, for the right to co-invest without a fund commitment – it was not something he was willing to do.

“You've got to be in the club before you can take advantage of the golf and tennis,” says Garrabrant.

Overall, Crawford says co-investment opportunities remain relatively rare in real estate investing when compared to other private equity sectors because of the abundant financing available in the space and the fact that real estate deals are usually smaller than the multi-billion transactions found in the LBO space.

Still, Oregon's Child notes that, if an LP is looking to place capital and believes in a fund manager's abilities, then the coinvestment play could be a smart move.

“The fund is going to do the deal anyway, so you're going to get a piece of it,” reasons Child. “The question is: Do you want a bigger piece?”