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When a fund manager like Lone Star aims lower

Targeting a smaller vehicle goes against the trend of firms able to raise successively larger funds. There are benefits – and risks – in doing so.

On the same day in late January, two of the largest real estate investment managers announced their largest ever fund closes – setting new industry records in the process.

On January 31, Toronto-based Brookfield Asset Management announced it had captured $15 billion for its largest-ever global property fund, Brookfield Strategic Real Estate Partners III. A few hours later, New York-based Blackstone disclosed during an investor call it had completed the $17.3 billion institutional close for its own record-breaking fund, Blackstone Real Estate Partners IX. The alternative asset manager anticipated gathering a total of $20 billion after completing the retail close for the fund by the end of the year.

Both Blackstone and Brookfield have raised successively larger funds: BREP IX and its $15.8 billion predecessor BREP VIII, are the largest ever closed-ended real estate funds, while BSREP III comes in third. The firm’s fund targets, meanwhile, have also increased exponentially: Brookfield, for example, had targeted $3.5 billion for its first global property vehicle, which ultimately collected $4.4 billion in 2013; it subsequently set a $7 billion target for BSREP II and went on to corral $9 billion. For BSREP III, the firm captured 50 percent more than its original $10 billion equity goal.

The firms are not alone in targeting bigger and bigger funds. The average target size for a private real estate fund reached a 10-year high in 2018 at $640 million, up 60 percent from $400 million in 2017 and an increase of 33 percent from the previous peak of $480 million in 2008, according to PERE data.

“Generally speaking, we’re only continuing to see fund sizes increase,” says Christy Gahr, principal at Meketa Investment Group, an investment consulting and advisory firm. “Why you can continue to raise bigger funds is because real estate fundamentals haven’t changed in a negative way. Real estate fundamentals are actually incredibly supportive of continuing to invest in real estate, despite pricing.”

Gahr: successively larger funds have been driven by investor demand

Institutional investors have therefore continued to back ever-larger funds. “Most institutional investors have only increased their allocations to real estate,” she says. “That supports potentially greater commitments, either by number or by value.”

Industry anomaly

It is therefore an anomaly that one of the other industry big guns, Lone Star Funds, is targeting a $3 billion fundraise for its latest commercial property vehicle, Lone Star Real Estate Fund VI, according to a filing with the US Securities and Exchange Commission. That target is about approximately half of what the Dallas-based private real estate equity firm had raised for the two previous funds in the series, LSREF V and IV, both of which had targeted $5 billion and amassed $5.8 billion. Lone Star had lowered its target fundraise in the series once before: the biggest fund in the series, LSREF III, which attracted $7 billion in 2013, had an equity goal of $6 billion.

Smaller target sizes often follow the poor performance of a predecessor vehicle in a fund series. Lone Star, however, has maintained a strong track record over its last several property funds. While LSREF IV and V were considered too new to have meaningful results, LSREF III was generating a multiple of 1.34x and internal rate of return of 15.95 percent as of June 30, while LSREF II was producing a 1.49x multiple and 26.26 percent IRR, according to a document from the Oregon Public Employees’ Retirement Fund.

In August, California State Teachers’ Retirement System reported a since-inception net IRR of 11.8 percent for its Lone Star real estate investments – the second highest such IRR among the pension plan’s top 15 real estate managers by net asset value. The highest-performing manager on the list, Blackstone, had a since-inception of IRR of 12.6 percent.

Lone Star declined to comment on the smaller target size for LSREF III, but PERE understands the reduction reflects the opportunity set that Lone Star is now seeing in the market. Because the firm’s investment pacing had been slower when deploying the previous fund, LSREF V, as a result of fewer distressed situations and opportunistic volume, the firm scaled back the equity goal for LSREF VI, one Lone Star limited partner tells PERE.

“I view the smaller target raise recognition from Lone Star in a favorable light, as the team appears to be balancing an efficient fundraise process against the realities of market deal flow, and late stage market cycle, regardless of time left before – or if – a correction occurs,” the investor says.

Paul Jayasingha, global head of real assets manager research at advisory company Willis Towers Watson, has a similar perspective. “We view it very positively when a manager lowers their target fundraise relative to their previous funds from a position of strength; in other words, their track record is still very strong and they’re a credible manager in the marketplace and there hasn’t been significant turnover,” he says.

Jayasingha: a manager lowering a target fundraise from a position of strength is ‘very rare’

However, he says such instances are “very rare,” and the managers which have done so are typically not raising large funds.

“Unfortunately, we really haven’t seen any other funds going to market with smaller fund targets right now,” the Lone Star investor agrees. “Our belief is that this would be the appropriate time to do so, but there appears to be enough capital in the system that GPs are able to raise the capital and do not have the incentives to lower the target raises.”

Big fund, lower returns?

Smaller funds also make sense at this stage of the real estate cycle, Jayasingha notes: “The two big issues with raising big funds at the peak of the market are you’re likely to pay higher prices for those assets, and the second issue is that there’s likely to be a big J-curve impact from typically a slower deployment rate in terms of the percentage of assets that are drawn down, because you have got a bigger fund to put to work and that J-curve impact has a direct impact on the net returns that an investor gets.”

The $10.9 billion BREP VI and $13.3 billion BREP VII, for example, had investment periods of 4.5 years and 3.75 years, respectively, while the $15.8 billion BREP VIII’s investment period stretched to 5.5 years, according to the firm’s full-year 2018 earnings report.

That said, most managers are unlikely to lower their fund targets, because it may not be commercially viable for them to do so, he says. As managers raise larger funds, they consequently manage more assets and typically hire more people. A firm could have twice as many staff involved with its third fund compared with its first. “If you’ve got twice as many people, you can have twice the cost basis,” Jayasingha says. “To them, going half the target size of the fund from the previous size, that means accepting a much-reduced profit margin.”

A firm may therefore have to pay lower salaries to its investment professionals, which in turn puts the manager at risk of losing some of its key staff to its competitors, he adds: “By going for smaller fundraises, commercially, it could be riskier for a manager because they’re risking attrition to their firm and they’re able to pay their staff less.”

One mega-fund manager maintains the size of its funds is dictated by dealflow and types of deals the firm can source. “What your capabilities are and the nature of the kinds of investments you’re trying to target absolutely impact it,” the manager says. “For us, our strength has been the scale of our team, and our capital and our ability to compete for things larger than most other folks are able to compete for. So that informs how we think about sizing our funds.”

The manager adds: “There’s really no more upside to taking more capital than you think you can invest. You don’t want a situation where you feel some degree of pressure, either real or perceived, from the investors to deploy it, and you put it into investments that don’t work out. No one wants to do that. Likewise, it’s not great from a relationship standpoint to take a bunch of money that is then an outstanding commitment for LPs, and then not being able to invest it.”

Despite the potential J-curve impact, raising one very large fund with an extended investment period may also be preferable to raising a smaller fund with a shorter investment period and then going back out to market, the executive adds: “Generally speaking, LPs don’t want to be processing new commitments to the same managers and the same strategies constantly. If you reasonably believe that there’s going to be an interesting moment in the relatively near future, they’d rather give you the capital now so you’re positioned to take advantage of it.”

The trend of successively larger target fundraises is not expected to end soon. “We’re going only to see significant change in the marketplace where the LP base can put up a united front and signal their views and their attentions to the manager,” says Jayasingha. “The problem is not all the LPs have the same views. Some are under pressure to put money to work. You can have the situation where, they’re actually giving the message to the GPs that they’re very keen to put money to work and therefore they will be committing to the next fund regardless of size.”

Change driver

That investor appetite is likely to continue unabated until there is a correction, says Gahr. “When investors pull back is when markets change, and they might have more hesitation and more caution, and be more skeptical about private markets, they might have concerns about liquidity,” she says.

But while there is no shortage of investors piling into ever-larger mega-funds, some consultants have opted to steer their clients elsewhere. Meketa, for example, is skeptical of managers that have not lived through multiple real estate cycles. “Where I see discipline is with very long, established real estate managers that have gone through likely multiple market downturns,” Gahr says. “Because they’ve lived it, because they’ve had to work through troubled assets, because they’ve had to have very difficult conversations with their limited partners, they are approaching today’s marketplace with a sense of caution, and not trying to raise a record-breaking fund or raise a headliner, because they know what it feels like to have to deploy that and live with that when market conditions are not as positive.“

Jayasingha is similarly cautious: “At a time when there’s a lot of interest in real assets and managers are raising bigger funds that are raising their capital quicker, actually it’s better to sit back from the crowd and say, we’re going to sit this game out. We’re not in a race to be the first to get into the bigger funds, because we know how that story ended last time.”