Friday Letter Strange bedfellows?

Getting backing from a hedge fund manager isn’t perhaps the most obvious way of launching a private equity real estate platform. For one thing, the flexible nature of the capital doesn’t lend itself readily to being tied up in a seven or ten-year fund.

For that reason, news this week that three former Morgan Stanley professionals are getting into bed with Amsterdam-listed investment firm Tetragon Financial Group and its London-based hedge fund affiliate, Polygon Management, is an interesting development.

John Carrafiell, Sonny Kalsi and Fred Schmidt, who worked together at Morgan Stanley for ten years until recently, have established GreenOak Real Estate with a $10 million working loan and $100 million GP co-investment from Tetragon in return for a 10 percent stake in their nascent firm. Polygon, the affiliate of Tetragon founded by Paddy Dear, Reade Griffith and Alan Jackson, has also agreed to provide a working loan and a limited co-investment commitment, plus take a stake in GreenOak too.

The idea is that sometime in the future, GreenOak can go out and use the capital from its new backers to raise a significantly-sized fund. When combined with money from GreenOak’s founders, that GP anchor commitment of $100 million from Tetragon – which has an unpublished shareholder base – alone could signal a potential fundraise of $3 billion if one assumes a GP co-investment would be 2-5 percent of total LP commitments.

But apart from the GP co-investment, Polygon offers start-up GreenOak a number of other things.

Polygon may not be well known by private equity real estate folk, but it is a medium sized established business which had $8 billion in assets under management at its peak and a team that has been together since inception in 2003.

Linked to that, what Polygon provides is strong operating, infrastructure, and administrative services that GreenOak will need as it expands. This cannot be under estimated in terms of importance.

According to those that know Polygon, what GreenOak has found is a sponsor which sized its back office operations as if it were managing $20 billion of assets, and the services it can provide such as disaster recovery are as good as anything that Carrafiell, Kalsi and Schmidt would have enjoyed at Morgan Stanley. This kind of thing will be crucial when GreenOak goes on the fundraising trail. Potential limited partners will absolutely require a new private equity real estate platform to have bullet-proof infrastructure.

It also means that the GreenOak team will not have to spend the next year trying to set it up themselves. After all, IT, reporting functions and so on, do not come cheap and would they want to hire such infrastructure? After all, GreenOak wants to grow a significantly-sized platform in markets of the US, Japan and Europe, plus it is further complicated by having an advisory arm as well.

Polygon is no stranger to real estate deals either and has had dealings with GreenOak founders in the past. For example, it invested with Morgan Stanley when the bank took Canary Wharf Group private in 2004. That deal was led by Carrafiell. It also supported the recapitalisation of Canary Wharf early last year, and reportedly brought in Carrafiell’s advisory business, Alpha Real Estate Advisors on German commercial property investments recently.

In launching a new operation, ultimately would Carrafiell, Kalsi and Schmidt have wanted to go for the few other options available to them, such as becoming the real estate group employed inside of one of the big private equity firms? Probably not.

What they have shown here is that they wanted to get established with a large enough financial sponsor with the necessary infrastructure and knowledge. In addition, it wants to retain governance over investments and strategy for the business. Polygon and Tetragon as a significant but minority investor gives them that.

But Polygon has much to gain too. It is looking to evolve into more of a platform for a series of niche alternative asset managers than just a hedge fund. After all, it is important to note that it has suffered from the vagaries of the economic downturn.

Its flagship Polygon Global Opportunities fund had a horrible 2008 when its fund lost a reported 48 percent of its value, and Bloomberg reported this May it is allowing investors the ‘chance’ to redeem their investments in the hedge fund at a 25 percent discount if they don’t want to wait two years to get their money out. At the same time, Polygon clearly sees an opportunity in distressed real estate.

Polygon needs GreenOak as much as GreenOak needs Polygon.