Friday Letter The matter of size

Future private equity real estate fund sizes could be 50% off their peaks of 2007. For GPs in market, that could mean some stark choices.  

With fundraising for private equity real estate vehicles down 60 percent in the first half of 2009 compared to the same period two years ago, according to PERE magazine, few should be surprised that fundraising targets are being affected.

It goes without saying therefore that few should also be surprised that fund sizes in the future will be smaller, and possibly much smaller. This will impact the operations of the fund managers. The question is, by how much?

During the real estate boom of 2005 to 2007, private equity real estate funds flourished. Capital raised in closed-ended, value-added and opportunistic vehicles rose by 62 percent between 2005 and 2006 and 70 percent between 2006 and 2007, according to PERE.

It wasn't just a case of new managers descending on the asset class in search of profits. More often than not, fund managers who had just closed on one vehicle would launch a follow-on platform attempting to raise double, sometimes triple, the prior amount of capital.

Today, many GPs are closing vehicles with just half or two-thirds of their original fundraising targets. It’s a trend Cohen & Steers’ funds of funds chief investment officer Stephen Coyle said will continue. Speaking to PERE, he predicted fund sizes would be on average 50 percent off their peaks.

This sounds bad, but in fact the dynamic at work leading up to our current mess was worse. As Coyle said in his market outlook report released late last week: “The danger is that investment managers can realise their best successes when the assets they invest in are overpriced. By selling into overheated markets they can realise outsized returns. Those same strong realisations then allow them to raise—and, unfortunately, invest—even greater amounts of money in those same overheated markets.”

While it may be the case that the funds currently being formed stand much better chances of investment success, their smaller sizes will spell potential trouble for the firms that manage them. In the current fundraising environment, GPs face stark choices. Those that opt to extend fundraising periods in the hope of hitting original targets do so in the knowledge that more time spent on the road soliciting commitments is less time for getting on with the business of investing, and often without the benefit of management fees.

There will be heartbreaks for some firms, as a fund that fails to cross a certain size threshold may require certain LPs to pull out. And smaller funds mean smaller management fees, which may not support the firm infrastructure built by the larger fees earned on larger funds.

What this all means is that smaller funds may ultimately coincide with better returns, but the GPs that produce these returns may experience great pain on the way to this success.