INTELLECTUAL PROPERTY: Public-private peril

Private real estate fund managers are turning to the public markets as they struggle to secure hard circle commitments from institutional investors.

And who can blame them? After the seeming ease with which Barry Sternlicht raised $810 million for his mortgage REIT Starwood Property Trust – $310 million more than originally planned – the public market is looking an extremely attractive place right now to find real estate capital.

Brookfield Asset Management and Marathon Asset Management are the latest to add their names to the growing list of fund managers seeking to raise capital from retail investors, floating debt REITs targeting $500 million and $300 million, respectively, in the past month. That makes at least eight private managers turning to the listed option in order to bolster their wallets in anticipation of the investment opportunity of a lifetime.

However, there is a fundamental conflict of interest when private fund managers offer public vehicles that target similar strategies to their existing funds. Can the GP ultimately serve two masters – public and private?

In all the recent cases of GPs turning to the public markets, the management team making the investment decisions is the same for the firm’s private vehicles as it is for the newly formed REIT. This should be a concern not just because of the demand on a manager’s time but – and much more importantly – because it raises issues about how that manager allocates investment opportunities between his private and public investors.

This conflict has been addressed in various ways by the public-private managers concerned. All have appointed independent directors to periodically review potential conflicts of interest and all have introduced an allocation policy of some sort.

For some, the conflict-management policy is wide-ranging, allowing a manager to allocate opportunities in a “fair and equitable manner” and according to the basis of need.

For some it’s much more precise. Starwood has introduced an allocation policy that prevents Starwood Property Trust from investing in equity interests in real estate or making “loan to own” investments for up to three years to protect Starwood’s private real estate funds, which have the right to invest up to a third of their capital in debt interests.

Meanwhile Colony Capital provides that its debt REIT, Colony Financial – which will be competing against the firm’s Colony Distressed Credit Fund, Colony Investors Fund VIII and Colyzeo Investors Fund II – will be offered the right to co-invest alongside the private vehicles by up to one-third of a deal’s capital needs for non-US investments and up to 50 percent for US collateral.

Like much in a regulatory filing, the warnings over conflict of interest are part of the small print of investing. They are only relevant to retail investors when things go wrong. However, as has been seen in the past year, when markets and investments sour, the public market reacts markedly different to the private one.

Qualified investors are just that, qualified to assess the risk of investing in an illiquid asset class. When things go bad, the investors – albeit unhappy – more often accept that it’s merely part of the game.

A fund manager opening his operations to public, retail investors (together with Securities and Exchange Commission scrutiny) also opens his arms to a more fickle investment world, including the worst-case scenario of lawsuits.

One need only look to Richard Fuld to judge the rapidly changeable moods of the public markets. The former Lehman Brothers’ chief has been named as a defendant in more than 50 lawsuits, according to the Wall Street Journal, many of them securities-fraud cases against Lehman and its top executives by municipalities that had invested in Lehman securities and say they had been misled about the firm's finances.

If the share price of a private fund manager’s public REIT declines precipitously, retail investors may be asking just whose interest the GP was ultimately serving.