EY: Mid-market funds “cannot seem to get a break”

 In a new report, the London-based advisory services firm said that continued fundraising challenges have led some firms to quietly look for buyers.

Private equity real estate fundraising has been on a roll, and in 2014 reached its highest level since the global financial crisis, according to PERE Research & Analytics. But one group in particular has failed to benefit from the surge of capital going into property funds: mid-market firms.

“With the amount of global capital looking for real estate, mid-market fund must be wondering why they cannot seem to get a break,” said the report, which was written by a team that included Mark Grinis, global real estate fund services leader, and Howard Roth, global real estate, hospitality & construction leader.  The fundraising environment has remained challenging for many funds in this segment of the market, which typically raises funds in the $250 million to $500 million range. 

One challenge for mid-market firms is that “mega-funds are soaking up a disproportionate amount of capital,” said Grinis, in an interview with PERE. The top largest funds collected 40 percent of the capital raised last year, he noted. “That leaves a finite amount that goes into the middle.” 

Most investors have remained “intensely selective” about the fund managers to which they commit capital, and are particularly cautious about unfamiliar funds, the report said. Instead, these institutions typically choose to make follow-on investments with existing managers rather than establish new relationships. 

A second major challenge is that the growing push by sovereign wealth funds and other large institutions into co-investment vehicles, given the greater control and more favorable fees they can achieve through such structures. Consequently, a $200 million allocation that may have been deployed in various vehicles, including some in the middle market, is instead going to the largest funds or into co-investments on a deal-by-deal basis with preferential terms, said Grinis. 

“The trend is a continuing hollowing out of the middle market players,” he said. “A manager without capital is a melting ice cube, because the manager may have talent, but if there isn’t capital to allocate and they’re not successful fundraising, that talent will leave.” 

Because of all of these factors, the mid-market segment of the private equity real estate industry has not grown significantly in recent years and is unlikely to do so for the next two to three years. Interestingly, however, is that many mid-market firms no longer view themselves as being in survival mode, and instead have chosen to be acquired by larger real estate fund managers. Grinis said that merger and acquisition activity involving mid-market fund managers was up 25 percent in 2014 over 2013 within the subset of firms that he tracked. 

“What differs between current consolidation activity and the wave of activity that previously hit is that managers are engaging consensual deals, and many more are quietly expressing their interest in finding a buyer,” said EY. Some of the firms are opting to sell to in order to reinvigorate their businesses in the hands of new ownership, while others are seeking to expand their platforms and capabilities or branch out into new markets. “In the long run, this type of consolidation will strengthen the fund space and improve the overall health of the mid-market,” the report said. 

In its report, EY listed the top five factors in capital raising as a defined and differentiated investment strategy; experienced team; demonstrated track record; strong alignment of interest with investors; and clear capital raising strategy. The findings in the report were based on interviews with 20 fund managers in the US, UK, Europe and Asia.