The standard process for a closed-end real estate fund is that assets are acquired, the necessary management work is carried out to fulfill business plans and the assets are sold back into the market. Most funds are structured to allow extra time for this process to be completed, and this has been enough, most of the time.
The effects from the pandemic, combined with a hike in global interest rates and falling valuations leading to real estate repricing, has made the normal schedule difficult for many managers. Management plans have suffered delays and the overall market for selling real estate is considerably different from the one expected just a few years ago.
Stefan Lempen, co-head of private real estate partnership investments at investment manager Partners Group, says it is more difficult for managers to raise capital at the moment, so holding onto good assets and attempting to generate fees from managing them is a logical step.
“Today, investors are short of exits, and everybody’s keen to get distributions, so investors are more open to alternative ways of generating an exit,” says Lempen. “Indeed, quite often they are the trigger of continuation fund offerings because they put pressure on the managers to find ways to monetize assets. They do not really mind if this is through an open market process, or a continuation fund.”
Balancing stakeholders
Continuation funds offer a solution to both managers and investors. Typically, a continuation fund involves a new investment that allows a manager to continue working on an existing portfolio of assets. Investors in the earlier vehicle can exit by selling to the new fund, which will typically be backed by secondaries investors, or roll over their interest into the new vehicle. This gives investors access to liquidity if they wish, the manager a chance to complete its asset management program and secondaries investors access to a mature portfolio of assets.
With three parties to satisfy, delicate negotiation and transparency are required to ensure everyone is satisfied with the process. While continuation funds are considered manager-led secondaries and the same manager sits on both sides of the deal, the driving force for the continuation vehicle may be the existing investors or the new investors.
There are also issues of regulation, taxation and financing to be considered. Perhaps the key issue is price discovery.
Tweaking the formula
Christian Keiber, founding partner at Singapore-based secondaries specialist Aquilius, says: “Typically, early on in a continuation fund process there is a tensioned price discovery, which typically flushes out one or two lead buyers who set a certain price in a transparent fashion and lead documentation and structuring. Once pricing and the key transaction parameters have been established, it is important to give the investors the right to roll over or exit. Nonetheless, if you are holding a private market asset that you would like to sell before its natural maturity, there is usually an illiquidity discount.”
The option for existing investors to roll over their investment into the new fund supports the process, as they have more than a ‘take it or leave it’ option. In practice however, many are not in a position to roll over.
“We have not seen many investors choose to roll over into new continuation funds, except perhaps family offices, which may have different investment horizons,” says Lempen, who argues that, while valuations used to be a very strong point of contention, the momentum has shifted due to the changing market conditions in recent months. “It is more of a buyer’s market, and the buyside can dictate pricing and also negotiate better terms.”
In a white paper on real estate continuation funds, law firm Allen & Overy suggests that management fees for continuation funds will tend to be lower than for the existing fund, and carry arrangements are likely to be highly structured.
A&O also suggests continuation funds will tend to have a shorter life than the existing fund, with greater manager removal rights and more investor influence on the eventual exit from the vehicle. That control can be attractive to investors.
While the terms of continuation funds may be different for their managers, they must satisfy the manager for the fund to be successful, notes Keiber. “There must also be a formula that works for the GP, so it is incentivized to continue to manage the assets and drive value creation. This can be achieved in several ways but requires deep involvement of the GP in the process.”
Something that may be available to a manager in a continuation fund is additional capital, says Lempen. “Quite often the manager wants to include some unfunded capital in the transaction, which can be used for M&A or asset improvements of some sort.”
Every continuation fund is different, and an existing fund’s portfolio of assets may not necessarily be transferred entirely into a new vehicle, depending on the needs of the existing investors, new investors and managers.
Lempen explains: “We completed a transaction in December for a portfolio of retail assets across two countries. The selling investors wanted a solution for a larger portfolio covering further countries but we were able to choose the locations we felt comfortable, and we carved out that selection.”
Current market circumstances have led to a rising number of continuation funds both in real estate and the wider private equity world. While global real estate markets will settle down and readjust to new circumstances, the bespoke solutions provided by continuation funds will continue to be a tool for investors, managers and secondaries players for years to come.
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