INTELLECTUAL PROPERTY: When in doubt, spin out

While most people cling to their jobs during an economic downturn, some private equity real estate players opt to do the opposite by spinning out from their existing firms. It has a lot to do with carry. PERE Magazine December 2008/January 2009 issue

When Barack Obama told a group of liberal San Franciscans the only reason he had trouble winning over white, working-class voters was because they clung to guns, religion and xenophobia out of sheer bitterness over lost jobs, it caused a storm of protest for the President-elect.

Condescending elitist was just one of the nicer names he was called. What Obama, extremely ineloquently, was referring to during the Democratic nomination battle, though, was a tried and tested reality: in times of great hardship, people cling to what is most precious to them. Family. Property. Most of all they cling to their jobs.

Will a clean pair of hands – and a clean slate – trump the underperforming legacy fund managers?

During these unsettling times, most workers will reluctantly accept the prospect of little or no bonus, or even lower wages, for the guarantee of getting paid each month.

It perhaps seems counter-intuitive therefore that private equity real estate doesn't necessarily play along to the same song. Indeed, it is particularly during times of distress that some private equity real estate professionals start to eye the opportunity of spinning out from their current shop.

And that's exactly what is taking place in some quarters of the industry today. Numerous market participants, executives and headhunters PERE has spoken with have confirmed there are some fraught (and extremely quiet) conversations taking place, particularly among the larger private equity real estate firms.

The issue on whether to stay or go ultimately boils down to carry. In many cases the carry pie is getting smaller, and in some cases has vanished.

With average property prices in the US widely expected to decline by at least another 20 to 30 percent in the coming months and years ahead, the performance of assets and funds – especially real estate acquired during the past two to three years – will be hit. And all GPs, irrespective of how much leverage they have employed, are now working hard to ensure their portfolio remains solid over the next 12 to 24 months.

Zoe Hughes

For those managers that took advantage of the era of easy credit, and have seen their equity disappear under the watermark, the work required to salvage their deals – let alone their carry – is immense.

As one limited partner said recently, if a fund is 50 percent invested and those investments are already underwater, there is “no way” a manager is going to be able to catch up. It would be better to cut off further investments, the LP said, rather than trying to force the issue and lose whatever incentives might be left. Who after all wants to work for nothing?

It is this question that is currently racing around in the minds of several private equity real estate players as they contemplate their immediate future. Work for the next one to two years for a share of an ever-decreasing promote pot, or spin out on your own and receive 100 percent of the, albeit smaller, carry?

And when everyone around you is telling you this is the investment opportunity of a generation, and it hasn't been seen since the days of the RTC, when the founding fathers of private equity real estate made billions of dollars in profits for their firms – you can understand why some are contemplating a change.

Will a clean pair of hands – and a clean slate – trump the underperforming legacy fund managers?

As limited partners reel from the denominator effect, declining distributions from existing fund commitments and, for some, the prospect of potential capital call defaults, few investors are eager to rush into new – unproven – relationships.

Indeed, all LPs are actively, and aggressively, studying their current portfolios with the view of possibly selling real estate interests they no longer deem as critical to their core investment strategies. All are taking a “wait-and-see” approach before committing to existing, let alone new, funds.

To entice reluctant LPs out of their shells, new fund managers emerging on the scene to take advantage of the investment opportunities ahead should therefore have an immense track record. In fact, they should ensure they have a bullet-proof track record if they want to succeed.