FEATURE: Realignment of interests

For most GPs, the current market dislocation is causing a few headaches. For some LPs, it's causing a few nightmares.

The volatility in the stock markets has pushed the majority of alternative allocations over target, prompting many LPs to review their strategies, and in some cases increase their target allocation ranges. But the so-called denominator effect is not the only thing worrying limited partners. As GPs struggle with declining property valuations and an almost frozen credit market, some are having to go back to their LPs to ask for additional equity. However, combined with declining LP distributions, investors are now questioning where all this money will come from. For some, they are even wondering how they are going to make the next capital call.

The noise surrounding fears of LP default has escalated to an unprecedented pitch over the past month. The aggressive portfolio management now being undertaken by all limited partners following several years of active investing has no doubt brought previously unknown issues to the forefront of all investment officers' minds.

For the majority of private equity real estate professionals, the situation remains just that: noise. More than a dozen fund managers PERE has spoken with believe actual investor defaults are unlikely. The fear remains though. And it is that fear that is driving another concern among LPs: whether the organisations and people they are investing alongside are acting more as counterparties than partners?

During the PERE Forum in New York, limited partners debated the problems being faced by investors amid the turbulence of the current markets. Alignment of interests was key – and not just between GPs and LPs, but also between LPs themselves.

And although there is little tangible evidence of actual LP defaults to date, there is mounting concern about the financial stability of some investors going forward. In a survey of limited partners, general partners, lawyers, bankers, consultants and industry participants conducted by placement agent Credit Suisse in October, one university endowment said: “GPs are underestimating the risk present in their LP base.”

A poll of GPs attending the PERE Forum also echoed that sentiment when it revealed that 22 percent of fund managers had been asked by their investors to delay capital calls.

But according to Peter Pereira Gray, deputy chief investment officer of the £15 billion fund run by the UK medical research charity The Wellcome Trust, some requests by GPs to alter fund structures in response to market conditions are meeting different responses from LPs – depending upon an LP's own circumstances. It's a situation, he says, that is bringing into “high relief” the lack of alignment between LPs themselves.

“The real issue today for the industry is whether your partner becomes a counterparty. You worry about the strength of the relationship that you once thought was very strong. We are all having to look now at our behaviour,” he says.

Does this therefore beg the question whether the blind pool, closed-ended private equity real estate fund model is appropriate in the longer-term? It was certainly something asked of the LPs at the conference. For Pereira Gray, he says that the experiences of the recent past have raised doubts. “I'm not sure that it will work for [The Wellcome Trust] going forward. Some of the lessons we are learning about this suggest that it might be inappropriate for us to commit into some of these structures.”

In the wake of the current crisis though, LPs say it boils down to transparency. In another quote from the Credit Suisse LP survey, an investor was asked to describe the future of the private equity real estate industry. Alluding to an increase in demand for transparency, he responded: “I'm going to ask a lot of questions when I get a capital call.”

“The industry has to become even more transparent,” adds Edgar Alvarado, head of real estate funds at Allstate Investments. And it is time for all sides to improve their behaviour, he adds. “Real estate has become an accepted asset class and as such we have to accept that transparency is part of the price of maturing into an asset class.

“Standardisation will be a key driver as well as benchmarking. The days of tension between LPs and GPs for information have to be left behind. This is an opportunity for the industry to mature and take our place with the rest of the asset classes.”

That's not to tar all private equity real estate funds with the same brush. Joanne Douvas, founding principal of New York-based fund of funds Clerestory Capital Partners and moderator of the panel, says: “There are plenty of funds out there that are extremely transparent, who will bend over backwards to help you.” But there are some, she says, who need to learn to open up more to their LPs – to the people they are investing on behalf of. “It is up to investors to ask questions of those that are less transparent.”