Private real estate is a field increasingly dominated by big firms. Fundraises in the multi-hundred millions were considered sizeable but now funds are surpassing the billion-dollar mark frequently. And now three-comma funds have outraised all smaller vehicles in four of the past five years, according to PERE research.
Most striking is the proliferation of the mega-funds, those closing on $3 billion or more, and their influence on the space. Fund closings totaled $78.8 billion in the first half of 2019, a record. This highwater mark was achieved despite sub-billion-dollar funds making their lowest cumulative raise in more than a decade. Credit for the historic haul belongs chiefly to four firms – Brookfield, Lone Star, Cerberus and TPG – whose five closings combined for $37.5 billion
Not to be outdone, Blackstone held a record-setting final close on its Real Estate Partners IX fund as PERE went to press. At $20.5 billion, the firm added more than $3 billion in retail capital to last year’s $17.3 billion institutional close.
These fundraising magnets of the private real estate sector have been the biggest deployers too. Through the first half of 2019, 11 firms bought at least $1 billion of institutional-grade assets, according to Real Capital Analytics. They accounted for $39 billion of acquisitions, equivalent to more than 65 percent of the market. The top four buyers, Blackstone ($13.5 billion), Gaw Capital ($5.1 billion), Starwood ($2.7 billion) and Carlyle ($2 billion), accounted for 39 percent of the market.
Though more pronounced in early 2019, this concentration of capital has been in the works since the global financial crisis. It sits at the confluence of three post-crisis trends for investors: fewer manager relationships, more non-fund investing and a gravitation toward safety. It has been amplified by a surge of new investors and increased allocations for the asset class.
And yet not all investors yearn for multibillion-dollar offerings. For some, scale is appreciated when it brings access to unique deal opportunities, but others complain they do not see the benefits.
“The limited partners often don’t see the economies of scale brought to these large structures,” Mike DiRe, head of real estate for the California State Teachers’ Retirement System, one of the biggest US pensions, says. “I certainly think that should be a question to the managers: where’s the economy of scale for the partner when the fund gets this large?”
Others feel resigned to mega-manager growth. “It’s been an evolution of many of the fund managers getting larger and us just going along with them,” Anthony Breault, senior real estate investment officer for the Oregon State Treasury tells PERE. “You either maintain an ongoing relationship or you don’t, that’s the decision you have to make.”
Through interviews with more than a dozen investors, managers and capital advisors, PERE has found rising fund sizes are a mixed bag for institutional investors. On one hand, bigger funds are a necessity. Bigger allocation targets mean investors must invest more capital and most prefer to do so through as few managers as possible.
“I’ve had investors say, ‘don’t even talk to us until the fund is over a billion’ because they can’t be more than 10 percent of a fund and they can’t write a ticket for less than $100 million,” one executive at a manager, who requested anonymity to discuss fundraising, says.
Are you being served?
Big, diversified-strategy managers offer extensive networks with exposures to a variety of asset classes. Large pools of capital, in turn, allow them to build platforms from scratch, or acquire them wholesale through portfolio purchases and take-privates, all of which is alluring to institutions.
And yet, it is unclear how much individual investors benefit from each additional billion dollars raised. In mega-funds, many have less ability to negotiate discounts and less sway in limited partner advisory committees. Investment strategies, meanwhile, have shifted to accommodate bigger commitments and, consequently, more capital is tied up in funds increasingly challenged by chasing outsized returns through niche acquisitions.
This has led some investors to wonder if fund increases serve them or their managers, even if they are willing to look past such concerns and forego more favorable structures.
“These funds may not have the highest returns. But they’ve been very decent returners over the past decade and if you’re an underfunded public pension plan, the one thing you can’t afford is to lose money,” Kelly DePonte, managing director and head of research for Probitas Partners, an advisory firm, says. “If you take a lot of risk to generate a high return and you lose money, you could get fired. If you do it and make a lot of money, you get a pat on the back. It’s all downside risk with no upside benefit.”
Blackstone and Brookfield, the largest fundraisers in the market, have earned the trust of investors by delivering notably reliable opportunistic returns at scale. Blackstone’s Real Estate Partners series has achieved a 15 percent net internal rate of return since inception, according to the firm’s second quarter disclosure. Brookfield’s Strategic Real Estate Partners strategy, meanwhile, has hit its 20 percent gross IRR target since 2013. Both marks are well above the 9.36 percent rolling five-year total returns registered by the Global Real Estate Fund Index – a joint database tracked by INREV, ANREV and NCREIF.
Subsequently, most investors are content to keep their fund commitments with these managers going. Some supplement their commitments with joint ventures, separately managed accounts or club deals, while others round out their portfolios with direct acquisitions. These outlays are often supplementary. Mega-funds have been accepted as the new normal.
But uncertainty abounds as the private real estate landscape evolves into the land of the giants. Investors have watched fund sizes swell over the years. For example, the New York State Common Retirement Fund began investing in Blackstone’s Real Estate Partners series in 1996, in its second fund, which was closed on $1.2 billion. That total increased to $1.5 billion for Fund III, then $2.2 billion for Fund IV and so on, with New York State re-upping each time. Last year, BREP IX‘s institutional fundraise closed on $17.3 billion. New York State committed $500 million.
This is also the case with the Oregon State Treasury, a long-time subscriber to Blackstone and Lone Star vehicles. When the state investment council entered those relationships, the firms were smaller and better suited to take risks, Breault said. Since then, Blackstone and Lone Star have become mega-fundraisers, closing 10 and 11 vehicles respectively on $3 billion or more since 2008.
Like other large pensions, Oregon has benefited from these increases as an investor that prefers writing tickets between $100 million and $200 million – it typical needs to commit to funds that are at least within striking distance of $1 billion. The more capital entrusted to one of these funds, the fewer total relationships it needs to manage.
But what investors gain in convenience can come at the expense of continuity. For instance, managers regularly change strategies and personnel to deploy bigger chunks of capital. For the most part, this evolution has been gradual among the mega-fund managers, Breault says. But it is a reality each investor must grapple with when it is time to recommit.
“The inherent challenge is the DNA of a firm changes as they grow larger, as they get more AUM, more complexity with counterparties and more LPs,” Breault says. “They’ll buy different assets than what you had originally invested and underwritten the team for. You either go with that, or you find another group that you like, perhaps a smaller, nimbler group that can do more tactical, one-off deals.”
During an April earnings call, Blackstone chief executive Jon Gray was asked how the strategy for BREP IX, the sector’s biggest fund with $18 billion of institutional capital, will compare with previous, smaller funds. He pointed to the firm’s historical success with large deals, such as the acquisitions of the Equities Office Property Trust and Hilton Worldwide Holdings in 2007 and the General Electric multifamily portfolio in 2013. Gray said during the call: “We use our scale and global reach to win deals others cannot.” During Brookfield’s investor day last fall, chief executive Bruce Flatt also touted the benefits of added capital. “Our advantage is scale and we believe that’s an enormous advantage in the very specific things we do because it gets rid of the competition on many of the things that we do.”
Blackstone, Brookfield and the rest of the top five mega-fund managers either declined to comment for this article or were not available.
Safety in (big) numbers
Managers may argue their investment principles have held steady, but a rash of multibillion- dollar transactions suggests a new method of execution. And loath to walk from managers producing consistent returns, investors will tolerate it, even if it means reshuffling other parts of their portfolio to meet their exposures. There also is safety in numbers for risk-averse investment officers. “Nobody gets fired for buying Blackstone,” has become a common mantra, just as it was an axiom for buying shares in technology company IBM.
Doug Weill, co-founder and managing partner of Hodes Weill & Associates, a New York-based advisory firm, says some vehicles are such large forces in the market that, without exposure to them, investors risk falling short of their benchmarks. “The mega-funds have gotten so large that they’re dominating the indices from a weighting standpoint. So, investors that don’t have an allocation to mega funds run the risk of their portfolios performing at a significant variance to the index,” he says.
Remaining with a long-time manager can help investors secure more favorable fees, Angela Miller-May, chief investment officer for the Chicago Teachers’ Pension Fund, tells PERE. Though mega-managers have few incentives to grant discounts, Miller-May says the desire for continuity can provide leverage. If nothing else, a recommitment saves investors from venturing into a difficult investment market.
Since the GFC, many new investors have flocked to private real estate, including sovereign wealth funds, high-net-worth individuals and large North American pensions that previously did not have allocations. Newcomers tend to favor ‘name-brand’ managers, PERE understands, putting pensions such as Chicago Teachers at a disadvantage. With more investors clamoring for these funds, retirement systems have smaller windows to work new commitments through their investment boards. An example of this is Blackstone’s Real Estate Partners Europe VI, which launched at the start of this year targeting €10 billion. It has already attracted more than €12 billion.
“If it’s a large manager, they generally don’t need our money. They’ll sometimes close without us because we can’t move as fast as they need us to move,” Miller-May says. “There’s so much capital out there that managers are not taking a whole year from first to final close to close out a fund. Some are one-and-done, they’ve raised all the money in that one close. So, we have some challenges in investing in those types of funds and we really have no leverage to negotiate much of anything.”
But as fund sizes climb, questions arise about deal pipelines and deployment capacities. Style drift is also a danger, especially when asset values peak and deals are become scarce. Jerome Berenz, head of indirect investments at German insurance platform Allianz Real Estate, tells PERE he is wary of arbitrary fund increases. While demand among investors can support higher targets from one vehicle to the next, that alone is insufficient validation for a substantial increase. When it comes to the largest funds, he says it is difficult to know how much each additional billion dollars benefits investors.
“Primarily, it has to fit with the sourcing capability and the market conditions,” Berenz says. “It’s difficult to appreciate what is the right size for these mega-funds. What’s the difference between a fund of $10 billion and $15 billion? Does this extra $5 billion create anything more for the investors? Is it a competitive advantage? It’s hard to tell.”
Some view the growth of fund sizes as a natural progression of the private real estate universe. But that is only part of the story. While the top fundraisers are finding new ways to deploy capital, investors are also seeking to consolidate the number of managers in their portfolios. This is a widespread reaction to a pre-GFC trend toward piling up managers by the dozens or even hundreds. When the downturn hit, many struggled with the distress that ensued.
“Most of the pension funds have been on a slow campaign of reducing the number of managers because portfolios became quite unwieldy heading into the downturn after a lot of fundraising in 04, 05, 06,” Breault says. “We learned that portfolio management and construction is vitally important.”
The results of that shift have been on display in early 2019. Only 76 funds closed during the first two quarters of the year, on pace for a historic lull. A repeat performance in the second half would put the final count well below even the doldrums of 2009 and 2010, which saw 212 and 215 closings.
Mega-funds are sold on managers’ abilities to use them to transact at scale, access otherwise unattainable deals and outbid their rivals. Blackstone displayed that earlier this year when it acquired GLP’s US industrial portfolio for close to $19 billion.
Although the New York-base firm tapped BREIT, its non-traded investment trust, to help finance the deal, it would not have been able to make a bid on the 179 million square foot portfolio without its mega-fund capital. Blackstone’s sole competition would likely have been a public market offering.
Similarly, Brookfield acquired GGP, a mall REIT, last year in a deal valued at $15.3 billion then quickly began liquidating parts of the portfolio. Later in the year, the Toronto-based manager took Forest City Realty Trust private for $11.4 billion.
If real estate fundraising has become the land of the giants, Blackstone and Brookfield are the biggest among them. Together, they have accounted for the eight top fund closings since 2012, including the only vehicles to gather $10 billion or more. As such, they have become prototypes for what mega-funds can do. “Blackstone raises funds that are essentially two times the next largest manager, so they have a pretty powerful angle,” one capital raiser tells PERE. “The deals they do are so large that their competition is a consortium of others. They see things that others don’t.”
But questions remain about how many large portfolio deals exist in the market to justify these mega-hauls. There are even concerns top managers can simply volley assets between one another, such as in Blackstone’s recent logistics play, where it re-acquired properties sold to GLP for $8 billion in 2014.
Still, some industry observers, such as Joshua Harris, a professor and researcher at New York University’s Schack Institute of Real Estate, see plenty of runway for the sector. He points to the myriad properties owned by local families and operating companies that have so far been untouched by private equity. “Real estate still has years to go until it reaches a saturation from an investment standpoint,” he says.
Others believe the fact that only one firm – or maybe two – can execute on the sector’s mega-transactions, does not bode well for competition. A healthier market would feature more managers in the $10 billion-plus fund space to keep pricing viable, Kelly Ryan, a partner at the law firm Kirkland & Ellis, tells PERE, adding that he believes the industry is moving in that direction. “The growth in size of private real estate funds and their sponsors corresponds to the historic growth of bulge-bracket [leveraged buyout] funds,” Ryan says.
“This is a direct result of real estate becoming a fundamental part of the alternatives portfolio for institutional investors. The addition of new bulge-bracket real estate funds should enlarge the roster of buyers focused on deals that require a significant equity check.”
Raising on the rise
Mega-fundraising has reached a new high in 2019, but it is a continuation of a decade-long trend
In the past decade, only two full years saw as much mega-fundraising activity as 2019 has during its first six months. In 2015, vehicles over $3 billion accounted for $55 billion and last year they totaled $43.8 billion, according to PERE data.
This is also just the third year since 2008 in which large funds have outpaced medium funds, those closing between $1 billion and $3 billion. In 2011, large funds closed on $14.3 billion compared with $13.6 billion for their midsize peers. The other instance was last year, with a $43.8 billion-$38.9 billion split. Medium-size funds have accounted for $22.4 billion so far in 2019.
More striking, however, is the degree to which small funds – those below $1 billion – have lagged. Historically, these have been the engine for the market, accounting for 90 percent of closings and attracting more than 50 percent of its capital. This year, those rates plummeted to 73 percent and 24 percent, respectively. With just 56 funds closed on $18.9 billion, this segment is on pace to be at, or near, its lowest point since before the GFC.
Since 2012, a typical first half would have seen two or three large fund closings, nine in the middle tier and 130 below the billion-dollar mark. In 2019, there were five mega-funds, 15 medium vehicles and 56 sub-billion-dollar closings.
There is no guarantee the second half of the year will follow the blueprint of the first. But it would take a substantial shift to bring 2019 in line with full-year trends. The average fund closing has been more than $1 billion, nearly two and a half times the previous 10-year average of $416 million. Brookfield’s $15 billion closing on Strategic Real Estate Partners III boosted the average, but the dominance of large funds is clear even without it. The median fund closed on $450 million.
The number of funds in the market has declined every year since 2014, when it peaked at 377. The amount of capital being invested, however, has not followed suit. While commitments hit a $167 billion zenith in 2015, most years have fluctuated with between $134 billion and $146 billion, according to PERE data. Considering more vehicles tend to close after July 1, it is likely 2019 will meet or beat the post-GFC average, suggesting that fund appetite has not dried up but has instead homogenized around larger vehicles.