Funds forever

Private equity real estate firms are increasingly looking towards permanent capital vehicles to boost their funding base. But despite the dollars to be had, it's not all wine and roses. By Aaron Lovell

It's no secret that private equity real estate firms are looking for new ways to access capital outside of the traditional opportunity fund. Public listings and real estate investment trusts have all become popular routes in recent years for fund managers to expand the scope of their capital base and business lines. And investors, both retail and institutional, have been eager to place money with a manager that has proven themselves, regardless of the organizational and legal structure they choose.

“There is definitely a movement afoot,” says Allan Swaringen, managing director at Chicago-based La-Salle Investment Management.

The advantages to launching permanent capital vehicles are myriad. Not only do these structures give firms the freedom to pursue long-term investment strategies, they also eliminate the need to constantly raise capital. Another benefit is the expansion of the firm's brand name and its ability to reach out to a whole new set of investors. A public listing also raises liquidity for the firm's founders and early investors.

Yet there are also disadvantages to these permanent capital strategies. And the cost-benefit analysis depends on the type of vehicle utilized, the strategy the firm is looking to pursue and the always-lingering possibility that poor performance in a new setting could damage a firm's once-stellar reputation.

The permanent capital structure that has generated the most headlines, as well as the most question marks, has been the movement towards public listings of private equity. The most notable firms to try this tact have been Kohlberg Kravis Roberts and Apollo Management, two stalwarts of the private equity community who have listed interests in their buyout funds on the stock exchanges of Europe.

One firm that is following in their footsteps is distressed specialist Fortress Investment Group, which has long toyed with the idea of a public offering—cofounder Wesley Edens hinted that the New York firm could go public way back in 1998. An IPO on the New York Stock Exchange is now eminent—underwriters are pricing shares of the firm at $16.50 to $18.50 per share—which will give investors entrée to Fortress' successful track record of German housing and ski resort investments.

Despite the numerous listings by brand-name private investment firms, however, there is mounting concern that these vehicles are not all they are cracked up to be. Since their listing on the Euronext, KKR's shares are trading at €22.95, down from the IPO price of €25. The Apollo listing missed its target capital-raise by a reported $1 billion and its shares currently trade at around €19.50 each, only slightly off their IPO price of €20.

Given the public reception to the two listings, Doughty Hanson, which had announced plans last fall for a €1 billion, listed property and technology fund, shelved those plans in early October, citing poor performance of similar vehicles.

Still, even if the rash of public-market offerings has come and gone—remember the year of the business development company?—real estate firms are eyeing other ways to access the flow of capital into the asset class, including more long-term, less risky strategies.

Opportunistic real estate investors are increasingly eyeing the money that is pouring into open-ended core vehicles or REITs, some market participants say. They note that these stable, income-generating property funds are increasingly appealing to sponsors who usually busy themselves chasing riskier fare.

“You have a lot of opportunity fund managers who were successful with their funds, but have seen all the capital pouring into core, stable-value real estate,” says Swaringen at LaSalle. Two-and-a-half years ago, the firm launched its own open-ended core vehicle in association with investment manager US Trust; thus far, the fund has acquired $900 million in assets.

The rationale for these vehicles is that fund sponsors see a lot of profitable opportunities that hit their desks, but not all of them fit into a value-added or opportunistic strategy. By accessing lower-return capital, firms are able to capitalize on this business.

To launch this sort of vehicle, Swaringen contends, firms have to already have an established track record. “They definitely need to have a brand name,” he says. “They need ties to the institutional community.”

The opportunistic investors also need to show investors that their team is as adept at capital preservation as it is at capital creation. “It's all about convincing institutional customers that they can do that,” he says. “The space is crowded.”

The real estate space is indeed crowded, but that has not stopped firms from launching a number of public and private REITs in order to access evergreen capital. These vehicles can not only target all different kinds of investors, from traditional institutional players to high net worth individuals to punters playing the markets, they can even move away from the core strategies usually associated with trusts.

Denver-based private equity real estate firm Black Creek Capital launched its Dividend Capital business line in 2002. In December of last year, the firm listed its private industrial REIT, DCT Industrial, on the New York Stock Exchange in a $1.6 billion IPO.

In June 2004, Virginia distressed loan and real estate specialist JER Partners launched JER Investors Trust, a REIT investing in CMBS, mezzanine, bridge loans and other forms of high-yield debt. The REIT, which raised $172.5 million and is managed by JER, later went public, raising a total of $213 million in its listing on the New York Stock Exchange in July 2005.

The same year JER launched their vehicle, venerable New York LBO shop KKR raised $780 million for its private REIT, KKR Financial. A year later, the San Francisco-based trust raised $839 million in an initial public offering on the New York Stock Exchange. By that time, it had already amassed $6.3 billion in assets and securities.

The REIT shares have all been benefiting from the run-up in public real estate shares in recent years, capped off by the battle for Equity Office Properties. After an initial private offering at $15, the JER trust went public at $17.75 per share and in January, the stock was trading at around $20. KKR Financial priced shares at $24 for its IPO. They now trade at around $27 after steadily climbing for most of 2006 from a 52-week low of around $20.

Any manner of public offering, be it a REIT or a fund interest, brings new challenges to a fund. The scrutiny of quarterly financial updates, Wall Street analysts and Sarbanes-Oxley reporting requirements can be a stiff price to pay, particularly for a private equity firm that has traditionally completed large-scale deals under the radar. Take a firm like Fortress, long one of the quieter firms in the very quiet private equity space. Now the firm's business is splayed across numerous Securities and Exchange Commission filings.

“I've had so many people in the real estate business say to me, ‘Boy, I'm never going to run another public company again,’” says Don Suter, a Chicago-based managing principal with M3 Capital Partners, the investment bank formerly known as Macquarie Capital Partners. “It's a lot of work and it's a level of transparency a lot of them are not ready to deal with.”

Public listings can also cause friction with limited partners, who might chafe at the fund business being open to even more investors—not to mention concerns about distractions and strategy drift, as a firm adds new business lines. Suter also says the alignment of interests between an LP and a firm can be disrupted with expanded public business lines. Does the public or private vehicle get first stab at a particularly good deal? How do you entice top talent to work for a public vehicle that may provide less compensation than a private vehicle? With the twists and turns of the public and private markets, one or another of the vehicles could fall in or out of favor, Suter adds.

Considering the lackluster valuation of some of the recent private equity listings, performance in the public markets could also be of concern, as poor performance on the public exchanges can bring increased pressure on a firm and damage its reputation in both the private and public arenas.

Some firms are taking a different tack—launching REITs for retail investors without listing them on a public exchange. It is a strategy that has been harnessed by groups like Dallas-based Behringer Harvard, a firm that was born out of the merger of an opportunistic investor and a REIT and which now pursues a mix of both strategies.

In addition to working with institutional investors, the firm has launched two non-listed, public REITS: one pursues traditional core properties, while the Behringer Harvard Opportunity REIT looks at value-add and opportunistic investments.

“It gives the investors an alternative to the whims of the stock market,” says Jason Mattox, an executive vice president with the firm, adding that the opportunistic vehicle can take advantage of the REIT structure while maintaining a relatively short lifespan of three to six years. He says that the vehicles provide three major exit routes for the firm: selling off assets one-by-one, merging with a public company or a listing on an exchange.

As the flow of capital into the real estate universe continues, private equity investors are likely to continue to find ways to tap permanent and public capital, even as some routes like public listing become more or less attractive at a given point in time. Most players in the space predict further expansion going forward as real estate becomes ever more popular.

“I don't think this is just today's fancy,” Swaringen says. “Real estate has come of age.”