FEATURE: Signs of secondaries

Almost one in four fund managers have been asked by their limited partners to consider delaying capital calls, according to a poll of GPs at last month's PERE Forum in New York. With the volatility in the stock markets showing no signs of ending anytime soon, that figure is only expected to increase.

The mounting pressure on LPs to rebalance their portfolios in the wake of the credit crunch has caused much pain in the real estate investment world. A combination of the so-called denominator effect and declining distributions has seen many limited partners actively seek to rebalance their portfolios as they search for ways to meet unfunded commitments.

For sale, one real estate interest

For some LPs, there is a real need to raise capital quickly as they contemplate their next capital call. For others, however, the aggressive asset management being seen across the board is opening up the possibility of further investment in the asset class – not as primary investors in private equity real estate vehicles, but as direct investors in secondary positions being sold by their more distressed colleagues.

Both UK medical research charity The Wellcome Trust and Allstate Investments have revealed they see secondaries as the most attractive investment opportunity in the real estate space over the coming months and years. The Wellcome Trust recently put part of its £3.8 billion (€4.5 billion; $5.6 billion) private equity and real estate portfolio on the market saying it was looking to sell some of its assets as well make new investments in the asset classes. Wellcome deputy chief investment officer Peter Pereira Gray said secondaries would play a part in that strategy, telling PERE it was a “very interesting” area to the charity.

With talk of discounts to net asset value (NAV) of some fully invested real estate fund interests of between 40 percent and 60 percent – and for highly-leveraged funds sometimes well in excesss of that – it's easy to see the attraction. However, as the industry prepares to see a massive increase in secondary activity, established players have warned pricing such interests is proving increasingly difficult.

”

Wild west secondaries

It's a little like the Wild West. There really is no consensus on pricing private equity real estate secondary interests at the moment,” says Michael Hoffman, president of placement agent Probitas Partners. Falling real estate prices, the lack of easily available financing and the state of existing assets in real estate funds, are all increasing uncertainty on all sides of the fence. Couple those with the issue of using NAV as a means of valuing secondary real estate assets, and the waters become even more murkier.

In the US, the Securities and Exchange Commission had intended to rectify the lack of “apples-to-apples” valuations of assets by making it obligatory for all companies to use markto-market accounting from January 2009. In the light of the credit crunch, and the massive wave of write-downs seen by all sectors following the rules, the SEC clarified its position in October giving companies more flexibility for valuing assets in markets that had dried up or where assets were being sold at fire-sale prices. “It means that all bets are off for 2008,” Hoffman adds.

NAV, however, also presents its own problems. Traditionally, there is always a time lag between the valuation of a real estate asset and its true valuation in the market at a given point in time. The NAVs being seen today, therefore, are the valuations reported three or four months previously. Few expect to see year-end NAV valuations reported until March and April – with one professional telling PERE, some NAVs could even be delayed until May.

So when people talk of discounts of secondary real estate interests, it can be a little bit of a misnomer, according to Chad Alfeld, real estate partner at secondaries specialist Landmark Partners. “The question is, what is fair value? Assets in the market in both the corporate and real estate markets at the end of 2007 were marked at the high water marks so what are those values going forward? If you are discounting today, at what point are you discounting from – today, three months ago, six months ago? This makes underwriting much more challenging today.”

Jeff Giller, managing principal and chief investment officer of real estate secondary firm Liquid Realty Partners, adds that understanding asset values in a volatile market is “absolutely paramount to making sound investments”. The San Franciscobased firm is currently working with LPs faced with pending capital calls that are in excess of their distributions. However Giller adds: “There is general market disagreement on where assets should be priced across all asset classes, and real estate secondaries are no exception to that rule.”

One key issue to factor into pricing a secondary real estate interest though is financing and the relationship a sponsor has with its lenders. In today's credit markets, that relationship could mean the difference between multiples on exit and simply breaking even (or worse).

“So many of the existing real estate funds have incredibly difficult challenges in front of them right now,” says Paul Odland, managing director and founder of Belveron Real Estate Partners. “These range from financing maturities, former equity commitments that may not materialise, and even management team flight risk. As a secondary buyer one has to really do a greater level of diligence just to gauge risk today. The market has changed so fast that our modeling efforts have difficulty staying current.” However, he contends, it is still one of the “best times ever” to be entering the market.

As the saying goes, in the world of secondaries the greater the uncertainty, the greater the discount. However one thing that is more certain is the scale of activity now taking place on the real estate secondary stage. Although few expect a massive wave of LP defaults on capital calls, most participants agree the opportunities in the sector will be “extremely large”.

All firms involved in the secondary space say they have seen an unprecedented increase in interest in secondary sales from LPs. Belveron, which traditionally focuses on non-institutional limited partners, has been approached repeatedly over the past month by institutional investors to take on larger positions, according to Odland.

“We are now seeing a number of institutions actively seek to rebalance their portfolio through strategic sales,” adds Giller of Liquid. Over the coming months, that interest is expected to turn increasingly into solid deals as real estate fundamentals continue to crystallise. It is all setting the scene for an extremely active secondaries market, something that may already be enticing other players to join the game.

However, as one industry specialist speculates: will LPs be able to make any significant impact on the sheer volume of deals expected to emerge in the coming months? Probably not. That fact though isn't stopping well capitalised limited partners from looking to the sector as a prime investment opportunity.