When alternative investment manager Kayne Anderson Real Estate Advisors expanded into core real estate last summer, the Boca Raton, Florida-based firm sourced a seed portfolio from a seller it knew well.
Who was the seller? It was Kayne Anderson. Two initial institutional investors participated in the $225 million fundraising for the core fund’s seed portfolio, which comprised six senior housing assets in Texas. The firm had purchased the assets in 2013 and 2014 through its third opportunistic fund.
Kayne Anderson received unanimous deal approval from both funds’ limited partner advisory committees, but one consultant was concerned. Despite what all parties agreed were great returns for the opportunistic fund’s investors, the consultant told PERE the deal presented an untenable conflict of interest and asked Kayne Anderson not to sell among vehicles in the future. A spokeswoman for Kayne Anderson declined to comment on the transaction.
The episode serves as an illustration of the potential for similar conflicts expanding private real estate businesses might contend with going forward. As more traditionally opportunistic or value-add managers tack on core or core-plus platforms, providing what could be an easy exit strategy for assets in existing funds, the ethics of such a sale increasingly come into question.
PERE sources say the issue is particularly pertinent as managers sit on ever-larger piles of dry powder and are unwilling, or unable, to put the capital to work when prices seem so high, especially for portfolios that increasingly are commanding a premium. As values tick up and distressed assets are scarce, the solution to sell from one entity to another becomes compelling.
In the last month, PERE spoke with two managers soon to introduce core-plus funds. After surveying the conflicts and speaking with investors, both were certain that purchasing from their opportunistic or value-add strategies would not play a part in the incoming vehicle’s initial investing thesis. Nonetheless, both conceded there was no industry standard on the issue. And while some managers are determined not to inter-trade between strategies, others are keen on the strategy. Among the latter is LA-based Colony NorthStar. When the firm launched its latest industrial fund, it rolled over a portfolio that seeded a previous closed-end fund.
Drafting a legal document to prohibit trading among entities would be “difficult, if not impossible,” says one New York-based placement agent. If a manager can achieve fair market value and avoid paying a broker’s fee, he thinks such a sale is a positive outcome for investors, he adds.
“The manager has to be a solutions provider, making everyone feel good about the deal,” he says. “There’s never a situation where all the LPs are aligned, so the GP needs to offer optionality.”
In Kayne Anderson’s case, one investor says he had no qualms with the transaction. Ed Cotham, the chief investment officer of the Terry Foundation, says the assets sold from Kayne’s opportunistic fund were “high quality” and “a perfect start for the fund.” The Houston-based foundation has invested in multiple Kayne vehicles.
“Better to start with something the manager and LPs know very well than go out to something that is unknown,” Cotham says.
Because the philosophy on selling among entities varies widely, managers typically maintain a house view on the practice.
Blackstone and Brookfield Asset Management, the two largest real estate managers on 2018’s PERE 50 ranking of private real estate investment managers by capital raised in the last five years, do not trade among their funds – at least not directly.
Last year, Blackstone bought a minority stake through its core-plus fund in European logistics platform Logicor. Months earlier, Blackstone had sold the business – capitalized through two opportunistic funds – to sovereign wealth fund China Investment Corporation. However, because CIC had already agreed to the deal before offering Blackstone a stake, the deal cleared Blackstone’s policy.
Starwood Capital Group, third on the PERE 50 ranking, is understood to be making new investments for its core-plus fund, rather than rolling over assets. Starwood, Blackstone and Brookfield all declined to comment.
One executive at a large, diversified fund manager says some investors have asked the firm to build a fund to roll particular assets into a core vehicle. The firm declined, citing conflicts of interest.
“Our investors, by and large, were happy with that decision. They said they didn’t want to be in funds that would be in the middle of conflicts,” the executive says. “Our rule is we don’t trade between funds. If there’s an exceptional situation, we’ll come to the LP advisory committee.”
Colony’s opposite attitude was exemplified in a deal for its open-ended vehicle, Colony Industrial Fund. In 2015, the investment manager created ColFin Cobalt Partnership, a closed-end fund, to purchase light industrial assets in the US, including a seed portfolio consisting of Cobalt Capital Partners’ 256 assets. In 2016, Colony converted that vehicle to CIF, forming the fund’s seed portfolio with the 256 properties.
A spokeswoman for Colony declined to comment. But a source familiar with the firm told PERE this is a typical way for it to seed a new fund.
Rental housing giant Greystar has not traded between funds to date. Adam Pillay, the Charleston, South Carolina-based firm’s head of investor relations, says its clearly defined strategies – value-add, core-plus and development – by design make trading among entities more difficult.
Pillay adds that recapitalizations of a non-discretionary joint venture may offer less conflict-fraught exits for like-minded investors. In those cases, a third party values the asset, with both sides agreeing to terms through an open, transparent process. Unlike a manager selling among blind-pool funds, it instead facilitates a process decided by its investors.
“When a manager has discretion over two vehicles and decides to trade between them without some form of LP or LPAC approval, things get a little murkier. From an LP’s standpoint, it can be hard to understand how they’re maximizing value for the seller, and buying well for the buyer due to the related party nature of the transaction,” Pillay says. “That being said, there are always going to be unique situations where a manager needs to assess the best exit for their partners.”
London-based Europa Capital is an example in Europe of a value-add manager adopting a traditional route to seeding its first core-plus fund. Last year, it acquired a 237,000 square-foot office property in Munich in a joint venture with Japan’s Mitsubishi Estate from London-based Ekistics Property Advisors. The property was later transferred to the vehicle.
Mid-size manager approach
Smaller managers that lack the ability to invest on behalf of partners, or which cannot warehouse a portfolio on their balance sheets, are still finding other methods to seed new vehicles without rolling assets from one fund to another.
One such manager, Annapolis, Maryland-based Realterm, founded its core-plus fund last year with a “creative anchor investor.” Peter Lesburg, the firm’s director of capital markets, says existing investors’ feedback informed Realterm’s decision not to roll assets over from one of the firm’s value-add funds to the new vehicle.
“The biggest issue is pricing. The investors with whom we spoke wanted to make sure there was a true third-party mark they could rely on,” Lesburg says. “The market is the truest test. Even though it would have been more convenient for us to transfer assets, our capital partners are our most important stakeholders across our strategies. As such, we created a very clear investment allocation policy between our value-add and our core-to-core-plus businesses. We have a rigorous policy that effectively bifurcates investments across those two platforms.”
Asset retention post value-adding strategy is a solution for managers and investors alike at a point in the market cycle when effective deployment is increasingly a fraught exercise. In the absence of a regulatory framework or, for that matter, an industry standard practice, just how many adopt the solution depends on individual perspectives. As PERE has found, there is a spectrum of those.