Flexing fund terms will have knock-on effects, say lawyers

The private real estate transaction market has yet to shake off the inertia of the past 12 months, with buyer and sellers’ price expectations still far apart in most sectors. Against this backdrop, playing for time is as much a consideration for prospective buyers as it is for asset owners avoiding an unnecessary sale.

Some managers have therefore sought extensions to their funds’ investment periods.

Earlier this month, PERE reported Morgan Stanley Real Estate Investing had been granted a one-year extension to the investment period of its 10^th global opportunity fund by its investor committee. The manager was originally due to finish deploying capital from North Haven Real Estate Fund X Global, which reached a final close on $3.1 billion in September 2021, by the end of this year. But as pricing changed in early 2022, when central banks began a course of interest rate hikes, putting capital to work – particularly on the equity side – became a much more challenging affair.

In MSREI’s case, this led to only around a third of the fund’s capital having been deployed at the midpoint of last year. As such, the manager asked its investor advisory committee in Q3 to extend the investment period to the end of 2025. The proposal received unanimous approval.

Lawyers in the US and Europe say they are seeing an uptick in investment period extension requests from managers. But there are strings attached.

Roger Singer, a New York-based partner in the investment funds practice group at law firm Gibson, Dunn & Crutcher, expects to see a significant amount of investment period extensions in the coming year as transaction volumes have remained low. Requests he has seen so far have been “routinely granted” by investors.

“Investors want their money deployed – not least because they have paid management fees on their full commitment,” he says. However, he adds, questions are increasingly being asked about whether fees should continue to be charged per the traditional model in this scenario.

“There’s a greater likelihood that the compromise will be: you can extend the investment period, but you have to charge the management fee [only] on invested capital,” he explains.

Kieran Saunders, London-based partner and co-leader of the corporate real estate and funds team at law firm BCLP, has similarly observed a growing number of managers asking for more time to deploy capital. He says they are typically asking for a 12-month extension and are conceding the shift in management fees from committed capital onto invested capital in the process.

This pressure to extend the investment period is felt primarily by a particular segment of the market, Saunders says.

“If you raised a fund in 2019 or 2020, you may be okay, as you still had 2021 through early 2022 to deploy capital, and those were really good years. If you raised a fund in 2022, however, or the back end of 2021, and didn’t get a longer investment period in the first place, then you might start to worry at the back end of this year, because you would have had two years in a depressed market where you may not have been able to deploy so much,” he explains.

Indeed, firms coming to market with new funds are setting up longer investment periods than they did for their previous vintages, even with a similar investor base and strategy, he adds.

Blackstone is evidence of this. The New York-based manager’s Q4 2023 earnings show Blackstone Real Estate Partners X, which began investing in August 2022, has an investment period of 5.5 years. This is the longest ever in the BREP series by a whole year: the next longest investment period was 4.5 years for BREP VI, which began investing midway through 2011. By comparison, BREP X’s predecessor, BREP IX, deployed its $21.4 billion in capital commitments in 3.2 years between June 2019 and August 2022.

Backing up

While lawyers say there is generally alignment between managers and investors around extending the investment period, a subsequent extension to the fund term – although not always necessary – could be a thornier issue.

“Realistically, I can see a lot of managers thinking they need to extend the fund term by the same period as the investment period,” says Saunders, adding this may be more likely for managers with a value-add strategy for which a certain amount of time is needed to complete the business plan. “But they may not ask for it at the same time as asking for an extension to the investment period – they’ll wait until the back end.”

Singer agrees, adding this is not a case of fund managers “kicking the can down the road” so much as them waiting until investments have been made before making a call on it. “Managers will decide to revisit the fund term when they have the facts, and ask for permission to extend it only when they know they need it,” he says, adding that extending the fund term is not necessarily connected to a prior extension of the fundraising or investment period.

However, managers with funds that have got to the back end in the last 1.5 to 2 years are having problems in terms of realizing all their assets at attractive prices, observes Saunders. “Investors’ position is that, on the one hand, they want the manager to sell as quickly as possible because of their IRR. But on the other hand, they don’t want the manager to sell assets at a reduced valuation. They know values are not great, but their IRRs are being hit, and so some are saying it’s better to sell at a lower price than continue to hold.”

Singer points out sponsors could be willing to have a lower IRR in exchange for a higher multiple in this market. “If you have held an investment for five years and you’re ready to sell, if the market is not good, you decide to hold it for another year or two and maybe you need an extension of the fund term to do that. Then you sell it for the price you originally expected, but it takes two years longer,” he explains.

In addition to diluting IRRs, an extended fund term will also put further pressure on fee models, says Antony Grossman, partner at BCLP.

“It’s questionable whether you can have totally unchanged fees when you change the underlying economics of both the time period for deployment and the time period for realization. Paying fees for 15 years is very different to doing that for 10 years. It’s going to be something that investors will wish to think about if they are prepared to concede the amendments,” he said.

Eyes up front

Despite the impact on IRRs and fees, Saunders expects some investors will agree to a small extension of funds in today’s climate in order to mitigate further losses. Investors want their managers to remain incentivized, after all.

“If the manager knows they are not going to get their carry, if they get to year six or seven and the market has tanked so there’s no way they’re going to get their promote, there is a risk of misalignment. Investors need to be careful of managers that lack incentive when they know they’re not going to reach the hurdle,” he said.

However, he adds “the problem is when you then get to the end of the fund term and managers ask for more extensions, which is what is happening at the moment. Managers are effectively relying on the goodwill of investors once extensions have expired and [the assumption] that valuations will recover before investors feel the pinch of their IRR and force the issue.”

For those with capital still to be drawn down, meanwhile, the focus is on the immediate problem of putting it all to work. And as more managers, like MSREI, realize they need more time to do so amid the lack of investable opportunities, more investment period extension requests will filter through to investors.

Whether or not a fund term extension will eventually need to follow is less of a concern for managers at present, observes Grossman.

“A problem in a decade is a problem in a decade,” he says. “A manager will be more fixated on the issue that’s in front of them, which is the investment period, than they are on the exit.”