Life after Lehman

Shock, astonishment. These were the emotions that gripped observers of the world's financial system over the course of five days last month when Lehman Brothers filed for bankruptcy, Bank of America acquired Merrill Lynch and the US government took effective control of American International Group (AIG).

Watching the events unfold, professionals in the private equity real estate said they could only feel shell-shocked by what was happening. “People are reeling, honestly. This is a calamity in the multitudes of what happened in the RTC days,” says one industry executive.

It is the bankruptcy of the 158-year Lehman Brothers, though, that has most stunned observers. September 15 marked the day that Lehman Brothers, after a failed attempt to sell off its assets, including its $30 billion commercial real estate portfolio and a controlling stake in its profitable investment management arm, finally conceded defeat and filed for bankruptcy.

The bankruptcy does not spell the end of Lehman's investment management unit – which includes Lehman Brothers Real Estate (LBRE), its private equity business Lehman Brothers Merchant Banking, and groups managing venture capital, infrastructure, credit and funds of funds – but it does raise fundamental questions about its future.

Broke parent, new fund
In contrast to the fortunes of its parent, LBRE is doing better than ever. LBRE has just closed its third global vehicle, Lehman Brothers Real Estate Partners III, on $3.2 billion. Its previous fund raised $2.5 billion in 2005. Ranked sixth in the PERE 30, PERE magazine's proprietary list of the top 30 private equity real estate firms in the world according to capital raised over the past five years, LBRE has raised more than $17 billion since its inception in 2001.

Led by global head of real estate Mark Walsh, LBRE has secured some of the biggest real estate deals in history, including last year's joint venture with New York-based Tishman Speyer to acquire the Archstone-Smith apartment REIT for $22.2 billion.

People familiar with the situation say it's business as usual at LBRE, however for investors the bankruptcy of its parent company does raise questions, not least surrounding Lehman's commitments to its own funds and the possible spin-out of the private equity real estate arm.

Typically, Lehman Brothers commits capital to its own alternative investment funds equal to around 20 percent of total commitments. A person close to the events said that Lehman's commitments are “ring fenced” and there was every expectation that capital calls will continue to be honored by the bank postbankruptcy.

However a secondaries specialist said many investors were waiting cautiously for information on how the bank's bankruptcy would be accounted for. The fear – no matter how remote – is that a default could trigger a winding down of the fund. “Anyone who buys the [LBRE] business will have to meet those liabilities and obligations. Investors are watching this space carefully. No one fully understands what exactly is happening yet [as of press time, September 19] but there is a lot of uncertainty,” he said.

One obvious path for Lehman Brothers Real Estate – and every other Lehman investment management group – would be a management buyout, certainly not unheard of in private equity, which is filled with independent former divisions of investment banks. Although one New York-based lawyer said investors were primarily concerned about the “stability” of the LBRE team, according to the head of a major private equity firm that was among the potential bidders for Lehman assets, the fact that the parent company is now in bankruptcy court could work to the advantage of the fund GPs themselves. The court could be persuaded that the best offer for the division would indeed come from the managers, who would threaten to walk out the door in the event that an unacceptable suiter bid for the business. At press time, Bloomberg was reporting that Bain Capital and Hellman & Friedman were negotiating to buy Lehman Brothers' investment management unit.

A buyout would probably be facilitated with the capital of an institutional backer, many of whom would jump at the chance to be a part owner of a newly independent, experienced private equity real estate group with a big, fresh fund and a wasteland of value lying before it.

Although one source said that Lehman Brothers investment management professionals are eager to continue working under the Lehman banner, that may now not be possible as the bankruptcy process parcels out assets.

Deals and steals
Indeed, the demise of Lehman Brothers means different things to different parties.

Some of LBRE's external partners are adopting a wait-and-see approach, with Mike Flax, executive director of Madison Property Fund Managers telling realestateweb.com it was “business as usual” regarding their South African joint venture with Lehman. Flax said a decision was expected soon on whether to carry on investing in the ZAR4 billion ($486 million; €338 million) Annandale Farm mixed-use residential project, which has yet to transfer land ownership. LBRE had invested “quite a few million already,” he said, but if the fund did not continue, “we'll look to replace them.”

Along with its parent company, LBRE has plenty of assets for sale. In the run-up to the bankruptcy proceedings, LBRE was seeking to exit real estate assets and investments, according to people familiar with the matter. One GP says one of the bank's investments around the Washington DC-ballpark area was offered up for sale – but that Lehman couldn't achieve a price it was looking for. The bank, he says, invested around $580 million but offers at the time were around $280 million.

“A number of office and apartment deals done in and around the [Washington DC area] happened because Lehman provided the equity in the deal,” Chris Smith, president of the Washington DC Building Industry Association, told the Washington Business Journal.

According to the website of Monument Realty, one of Washington DC's largest development firms, Lehman has invested around $620 million in 15 fifteen real estate transactions with the firm. Since May, it sold more than 20 properties valued at roughly $1.5 billion, according to sales data from Real Capital Analytics, including a portfolio of six Hyatt hotels to RLJ Development's RLJ Real Estate Fund III, and at least seven apartment blocks from the Archstone deal. In the five months leading up to June, Lehman sold around 11 properties.

Real estate, of course, was part of the reason for Lehman's ultimate demise after the bank overexposed itself to commercial property and mortgage securities. And as the firm works through its bankruptcy, Lehman's balance-sheet real estate assets will prove to be prime opportunities for investors. At the time of press, Lehman Brothers had asked the bankrupcy court to give the bank extra time to provide a full list disclosing all its assets.

“No one fully understands what exactly is happening yet, but there is a lot of uncertainty.”

The bank's 575-foot-high global headquarters on New York's Seventh Avenue (along with two data centers) has already been snapped up by UK bank Barclays for around $1.5 billion as part of its deal to acquire Lehman's North American investment banking and capital market business.

In a further harbinger of motivated selling, the US REIT Boston Properties reveals it has created a $13.2 million “reserve” in the event Lehman breaks its lease for the 436,723 square feet of office space it rents at 399 Park Avenue, while London's Canary Wharf Group says it is insured for the 875,000 square feet of space leased by Lehman at 25 Bank Street.

Canary Wharf, however, adds that the insurance is primarily through AIG, illustrating how the meltdown of Wall Street really has had global implications.