With apologies to William Shakespeare, some deals are born with long holding periods, some deals achieve long holding periods, and some deals have long holding periods thrust upon them.
Over the next three years, your GPs will likely spin their performances using the first two explanations, when the reality will most resemble the third.
The credit crunch has brought up many issues for market participants to debate, but one fact that is not up for debate is this – for the time being, many steps in the real estate investment process are going to take longer. Limited partners will ask more questions prior to committing to the next fund, GPs will (hopefully) take more time in due diligence before agreeing to a deal, lenders will be slower to commit financing. Then there are the more insidious potential time issues: buildings will take longer to lease up, values will take longer to rise and buyers and sellers will, possibly for years, take longer to arrive at a mutually agreeable valuations.
Until recently, private equity real estate investors have enjoyed incredible optionality with regard to exit method and exit timing. GPs being incented the way they are, many found it hard to not quickly sell a property once the return objectives had been more than surpassed, a temptation that often presents itself in a fast-rising market. The “value-add” was for the most part owning the property before the next guy. In many parts of the world, and certainly in the US, that game has changed. As a general partner recently put it to a conference crowd, it used to be that a fund could buy a property, refurbish it, partially lease it and then sell it. Now it looks like these funds are going to actually have to do a lot more of the leasing work themselves before being able to pass it along to new owners. This takes time (and effort).
The issue of holding periods is a particularly sensitive one in private equity real estate. While on the one hand, real estate is supposed to be a long-term asset class, private equity real estate funds are measured based on the IRR, which is based on dollars in, dollars out, and how long did that take? Time kills IRRs. Hitting a two-times return on a property investment after two years earns you a 41 percent gross IRR. A two-times return after three years is a 26 percent IRR, and after four years it’s 19 percent. Now apply a more modest return expectation and things get scary.
In addition, real estate investors confront all kinds of delays that are unique to the strategy – materials and labor issues, zoning issues. Every step in the property investment process is shadowed by time goblins, ready to take a bite out of returns.
The time issue is made all the more pressing by dint of the fact that opportunity fund managers are not expected to merely track the performance of property values. They are supposed to add value to the properties, as the fee structure indicates. GPs are supposed to own a property, if you will, during the best, most transformative months or years of its life, and then deliver it with a bow to another owner with a different risk/return expectation (and lower fees).
The specter of a quieter market and declining property values means private equity real estate fund GPs may find themselves hanging on to their portfolio items, unwilling to sell at a loss but watching as the lengthened holding period chips away at their overall track record. Keep in mind that for most of these GPs, a weaker performance now affects a far larger capital base. It’s no consolation to an LP if you delivered a 3x on a $10 million investment but a 0.9x on a $100 million investment several years later.
The key to maintaining strong relations with LPs during a longer-than-expected holding period is communication. LPs across the alternative asset classes have shown an amazing ability to forgive weak performance if they are kept abreast of developments and if they understand that the GPs acting in the best interests of the partnership as a whole.