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FEATURE: False reprieve

LP default fears have been assuaged by a lack of capital calls. But the issue of LP liquidity is still as pertinent today as it was last autumn. PERE July/August 2009.

When PERE last visited the issue of LP liquidity six months ago, there was a general consensus that the industry would see a massive increase in secondaries activity as investors sought to balance declining distributions against the denominator effect and pending capital calls. A combination of all three factors was, many argued at the time, a recipe for greater secondaries sales.

Since then, portfolio valuations have shifted somewhat. Listed equities and fixed income assets have risen in value since the start of the year, while real estate – and private equity real estate – portfolios have been significantly written down. The pressure on institutional investors with strict asset allocation targets therefore has eased. Couple that with the fact that many LPs have asked – in some cases vehemently so – GPs not to make capital calls for the immediate future, and the absence of distributions is no longer such an urgent problem.

It's the unknown, unknowns that will kill you and there are more than a handful contained in [the secondaries] matrix.

However, if you were to apply a stress test to many LPs you'd still find them extremely, well, stressed. Fundamentally, what they're stressed about is unfunded commitments. Although there is little hard information about uncalled equity commitments to private equity real estate vehicles, the figure is expected to be “significant”. According to data compiled by PERE, more than $251 billion of commitments were made to closed-ended, commingled value-added and opportunistic real estate funds between 2005 and 2008 alone. When commitments to unlisted core, core-plus and debt vehicles are also taken into consideration, that figure jumps to around $789 billion.

As Scott Landress, founder and chief executive officer of Liquid Realty Partners, says: “That's a pressing issue for many LPs, and the pressure is mounting every day.”

According to a US pension investment officer with knowledge of the situation, one endowment was so prolific in investing in the alternatives space that the market value of its unfunded commitments, when taken with its existing investments, is now equal to around 110 percent of the fund's total value.

$5bn of secondaries in market

Of course, LPs do have the option of selling fund interests or undertaking structured transactions in the secondaries market to resolve their liquidity constraints. Over the past 16 months, the secondaries market has seen roughly $10 billion of potential trades come to market, according to industry sources. Some LPs have since sold their interests, while others have retreated to the sidelines, leaving an estimated $4 billion to $5 billion of real estate secondaries transactions in the market today, one professional says.

There are a number of factors that have kept secondaries trading volumes low, not least uncertainty created by the market dislocation. One key driver though has also been the bid-ask spread.

During the third and fourth quarters of 2008, the discounts being offered by interested buyers was “less than palatable”, according to Landmark Partners' Chad Alfeld. Rather than being offered par or even premiums for fund interests, as might have been seen at the height of the boom, secondaries players were offering steep discounts, sometimes between zero and 20 percent of net asset values, according to another secondaries participant. Only the most desperate of LPs were willing to stomach such hits.

The release of year-end performance data over the past two months though has helped pique interest in secondaries activity. In part, it's a response to the write-downs made by GPs in 2008. Average write-downs of 25 percent in the fourth quarter alone have brought LP expectations much closer in line with buyer valuations. Few investment officials, after all, could successfully persuade their boards to approve a secondaries sale with a spread percentage of, say, 70 percent or more.

A lot of boards have been forced to ask ‘What do I really own? Where do I go from here’. Institutions are only just picking their heads up from that, as they've been concentrating on getting their arms around their portfolios.

Landress and Alfeld both say there is growing interest from LPs in the secondaries market. Landress, who says San Francisco-based Liquid is expecting deal closings to ramp up dramatically in the third and fourth quarter, adds: “It takes time for people to accept change. In just the last month, however, LPs have increasingly expressed acquiescence to dramatically lower property valuations, leaving most value-added and opportunistic funds with little or no net present value. It's a sea change that has taken 18 months to happen.”

Alfeld also notes that transaction volume has picked up during the second quarter of 2009, with Landmark having completed a number of structured transactions. After spending the past few months aggressively assessing their portfolios, LPs are now starting to look to the secondaries market more seriously. “A lot of boards have been forced to ask ‘What do I really own? Where do I go from here’. Institutions are only just picking their heads up from that, as they've been concentrating on getting their arms around their portfolios,” Alfeld says.

Finding a price

Valuing secondaries interests though still remains an extremely difficult art. At a New York IMN real estate conference last month, Charles Purse, managing principal of placement agent Park Hill Real Estate, quoted former US Defense Secretary Donald Rumsfeld in describing the secondaries valuation process: “It's the unknown, unknowns that will kill you and there are more than a handful contained in [the secondaries] matrix.”

GPs are expected to take further portfolio write-downs when they report first-half results to LPs later in 2009, further clouding the valuation waters. In terms of later vintage funds, secondaries buyers are also being extremely cautious. Madison International Realty president Ronald Dickerman said at the same forum his firm was avoiding 2006 to 2008 opportunity vintages, as fund interests had “very little equity value” left, owing to the leveraged employed and the price paid for fund assets. “We are not through the grinder yet,” Alfeld adds.

This LP liquidity logjam will start to be resolved as the bid-ask spread narrows. Landress says over the past two months, there has been some movement on the part of sellers as they become more “realistic”. However, the process will be a gradual one and won't necessarily result in a “wave” of secondaries sales as was, perhaps, expected.

What is crucial though is the market's capacity to meet demand. With $5 billion of potential real estate secondaries trades currently in the market, is there enough real estate secondary capital, manpower and experience to meet the needs of LPs? “Definitely not,” says Landress.