It is a longstanding predicament in the private real estate industry: the optimal time to raise capital and the optimal time to deploy capital are often at odds with each other.
As James Jacobs, head of real estate in the private capital advisory group at investment bank Lazard, puts it: “The easiest time to raise capital is often the most difficult time to invest it, whereas the hardest time to raise capital is often the best time to invest in real estate.”
“The easiest time to raise capital is often the most difficult time to invest it, whereas the hardest time to raise capital is often the best time to invest in real estate.”
-James Jacobs, Lazard
Current private real estate market conditions point to the former scenario. H1 2019 was the most active six-month fundraising period since 2015 and most active H1 since the global financial crisis for real estate funds reaching a final close, amassing an aggregate $75.5 billion, according to PERE data. Contributing to this high capital raising volume were mega-funds, including two which surpassed $5 billion, as well as an additional 17 funds that exceeded $1 billion.
But while real estate fundraising levels have reached new highs, investment activity has dipped by 9 percent year-over-year during H1 2019 to $341 billion – the lowest level since H1 2016, when volumes dipped to $317 billion, according to commercial real estate services firm JLL. “Risk-free rates continue to plummet, lowering financing costs and widening spreads to property at a time when investors are hungrier than ever for yield,” an August JLL report stated.
But with the economic recovery now entering its 11th year, the possibility of a downturn looms larger than ever, even though the actual timing of a correction continues to be difficult to predict. Nonetheless, many real estate managers have factored a potential downturn into their recent fundraises, as reflected by changes with the funds’ terms, structures or investment periods. From interviews with more than a dozen sources in the industry, including placement agents, investors, consultants and managers, PERE has compiled seven ways firms are fundraising for a downturn.
Bringing forward fundraising
Lone Star Funds launched its sixth real estate fund, Lone Star Real Estate Fund VI, in late 2018, even though it still had uncalled capital in the predecessor vehicle, LSREF V. The Dallas-based private equity real estate firm targeted $3 billion for the fund and ultimately held a final close of $4.7 billion, which includes third-party commitments and anticipated co-investments. PERE understands approximately $1.5 billion of the fund’s equity was rolled over from LSREF V. Investors that rolled over capital were reportedly given a reduced management fee.
For one Lone Star investor, LSREF VI was the first rolling-over of fund capital the investor had seen. “I believe the dealflow in the global markets has not made the cut for the targeted returns for the previous fund; hence not deploying the full capital raised a few years ago,” the investor says.
Managers that start raising new funds even when the predecessor vehicles still have significant levels of undeployed capital remaining are “bringing forward fundraising of new fund series or new fund strategies” in anticipation of changing economic conditions, says Priya Nair, global head of product management for private capital services at RBC Investor & Treasury Services. To date, only a handful of managers have adopted this tactic, she says: “It’s uncharted territory.”
Rolling over the capital effectively gives the manager more time to deploy the capital amid market uncertainty. “By rolling over the old, unfunded capital and adding new, Lone Star reset the investment period and now has another few years to deploy the capital,” the investor explains. “Considering the late stage of the cycle, even if nobody truly knows when that may end or how, this gives them continued dry powder to continue sourcing deals or capitalize on any distress that could occur over the next few years.”
Longer investment periods
Meanwhile, managers have been raising funds with longer investment periods than prior funds. Lone Star, for example, set its investment period for LSREF VI at four years instead of the three years that were typical of earlier funds, while Blackstone increased its investment period for its latest fund, the $20.5 billion Blackstone Real Estate Partners IX, to 5.5 years, up from 3.75-4.5 years for the previous three vehicles.
Another manager, Oaktree Capital Management, has taken a variation on this approach by delaying the official start of a fund’s investment period but not charging investors fees in the interim. In its second-quarter earnings results, the firm revealed that as of June 30 it had deployed 35 percent of its $8.9 billion Oaktree Opportunistic Fund Xb, a closed-ended opportunistic distressed debt fund, but had yet to activate the investment period. PERE understands the firm also has delayed the investment periods for some of its real estate funds.
“The idea of delaying the onset of the investment period for fee purposes is a pretty new thing,” said Oaktree co-chairman and co-founder Howard Marks, during the firm’s Q4 2018 earnings call in February. “It happened for the first time sometime within our last few funds. As you know, the purpose is to avoid heavy fees on a fund in the early years when it is only fractionally invested.”
According to Matt Posthuma, a partner at law firm Ropes & Gray, longer investment periods offer managers more flexibility to make investments at lower prices should a downturn occur. Conversely, however, this potentially creates more risk for the investor. “From the investors’ perspective, if there’s a longer investment period, they have to keep that capital ready to go for a longer period of time,” he says. “That money needs to be accessible for a longer period of time, so maybe that means they’re putting more money in cash than they otherwise would in anticipation of the calls.”
Taylor Mammen, senior managing director at Los Angeles-based consulting firm RCLCO, agrees: “It basically extends the amount of time for when a manager has a call on fund capital. It’s capital committed that the investor has to take into account, that it can’t necessarily use for other investments. Sometimes that’s advantageous if the investor itself is worried that it won’t have the ability, or stomach, to make investments in a down market—when it might be the best time to do so. For the most part, though, it’s pretty uncomfortable for investors to have too much uncalled capital sitting at the discretion of managers.”
“It’s pretty uncomfortable for investors to have too much uncalled capital sitting at the discretion of managers”
-Taylor Mammen, RCLCO
Lower management fees
With Lone Star and Oaktree, resetting or delaying the start of a fund’s investment period has led to reduced or waived management fees on committed capital.
“We think that is good alignment because if you do believe that the market is very competitive and we are late cycle, especially with the closed-ended vehicles on the value-add side, it certainly makes sense for investors to be paying lower fees on commitments with no guarantees of capital being fully deployed,” says Riaz Kermally, portfolio manager of global real estate at the UK-based Pension Protection Fund.
Whereas a standard management fee on a value-add fund would be 1-1.5 percent on committed capital and 1.75 percent on invested capital, managers are now charging 0.75-0.9 percent on committed capital, which rises to 1.5 percent on invested capital once they begin deployment. “So effectively, the J-curve is not as steep and it also shows if investors’ capital is not deployed, managers are aligned,” says Kermally, whose organization’s panel of approved managers includes CBRE Global Investors and LaSalle Investment Management.
The lower fees are also a reflection of investing in the late cycle, he adds. “We are aware, going forward, performance could be lower. Managers are generally adjusting their targeted returns for the next few years because of the continued competitive environment we have currently,” says Kermally.
Managers that were historically targeting 15 percent returns in 2013-15 have now lowered those targets. “If you don’t think you can generate 15 percent for investors, fund terms should be adjusted to ensure better alignment between investors and managers.” He adds that while he expects returns for more recent vintages will increase if distressed opportunities do arise, there are not many of these opportunities in the market currently.
Meanwhile, managers have become more focused on increasing the amount of reserves in their funds. “They are reserving more capital in their funds for the ‘what if?’,” says Doug Weill, founding partner at New York-based real estate advisory firm Hodes Weill & Associates. “As much as 10 percent of a fund might get reserved to protect the portfolio, and managers are more inclined to do that today than they were three or four years ago. Managers are more cautious at this point in the cycle and they are positioning their portfolios to weather a potential downturn.”
In establishing reserves, a manager would invest or commit up to 90 percent of the fund to transactions, and reserve 10 percent for potential follow-on investments or to protect the portfolio in a downturn.
“A challenge in the last cycle was that many managers fully committed their funds and had no ability to call capital to protect their portfolios,” Weill explains. While PERE has been told of funds adopting 3 percent to 5 percent reserve policies in recent years, Weill believes a higher amount makes better sense for weatherproofing a fund. “With 10 percent, they would be in a much better position and avoid the need to go back to LPs to ask for another round of capital or preferred equity or some additional capital infusion.”
A downside for investors is that they are typically paying management fees on that 10 percent during the fund’s investment period, although fees are not charged on the reserved capital after the investment period ends, he says.
Another approach some managers have taken to amass more dry powder for a potential downturn is to raise additional sidecar capital alongside a main fund, in what are sometimes called ‘rainy-day funds.’ “We’re seeing managers just identify other capital buckets, including sidecar investors to invest alongside the funds, kind of like an accordion feature that allows them to raise more capital if they need it, but not have any obligation to deploy that capital,” says Mammen.
“It comes up in many conversations with managers that they are interested in having a large pool of sidecar capital to call upon, and one of the reasons that’s often given is in the event of significant buying opportunities thanks to an economic slowdown.”
For Paul Jayasingha, global head of real assets at Arlington, Virginia-based advisory firm Willis Towers Watson “the concept of a rainy-day fund is a nice way for a business to secure fund commitments in a time where things could get much harder in the fundraising world.”
But he views such a vehicle as different from typical co-investment capital: “One of the big advantages of a co-investment is you’ve got a lot of clarity on what you’re investing in and the price at which you’re investing in. That’s not how I would interpret a rainy-day fund, where the whole point is that you’re going to take advantage of some distress and there’s going to be opportunities that you can’t foresee now.”
The investor focus on clarity on investments at this point in the cycle has led many managers to pre-seed their funds with assets. One notable example of this is Goldman Sachs’ next private equity real estate fund, expected to materialize before the end of the year. The $2.5 billion-plus fund is expected to be pre-seeded up to 40 percent of total assets from the bank’s balance sheet.
“There’s some very compelling investment opportunities that are available today through offerings with meaningful pre-specification, wherein the de-risking in such portfolios has been material,” says Matt Casper, a partner at advisory and placement firm PJT Park Hill.
Park Hill currently is working on multiple capital raises with managers that are contributing large $1 billion-plus portfolios into new funds and investment vehicles. The assets have been held on balance sheet, in certain cases for multiple years, and are being contributed to the vehicle at cost, or at an attractive basis relative to market, allowing investors to acquire the properties at a discount, Casper says.
“Many investors would rather take that bet versus a blind-pool commitment. They say, ‘I have certainty in deploying capital into this now, I have managed down risk at a high point in the cycle, and I have less exposure to the J-curve’,” he notes.
Posthuma, however, says pre-specification carries its own risks: “While that does provide more certainty as to the existing portfolio, it also increases your exposure in the event of a downturn that might affect assets generally. In some ways, you can argue that it’s better not to buy a lot of assets upfront or at least in the first year or so of the fund, but rather give the manager more time to decide what’s the right time to be buying new investments.”
Slower deployment pace
Indeed, in Asia, Gaw Capital Partners is taking a more measured investment pace with its latest real estate opportunistic fund, the $2.2 billion Gaw Capital Real Estate Fund VI, for which it is expected to hold a final close imminently.
“When distress actually comes, people don’t necessarily give out capital. They sit on it,” Christina Gaw, managing partner and head of capital markets at the Hong Kong-based private equity real estate firm explains, recalling the difficult fundraising environment the firm faced in 2009.
With Fund VI, “we want to make sure that we deploy it at the right pace, such that if distress does come, we would still have a good amount of dry powder to deploy, rather than have to raise fresh capital during times of distress,” she says.
Gaw Capital previously had deployed its funds in approximately two-and-a-half to three years, ahead of their designated four-year investment periods. With Fund VI, the firm may “maximize” the investment time to three-and-a-half years, she says: “If you see uncertainty, you’re going to slow down a bit. You still have to invest, but you’re not going to try to invest in two-and-a-half years. So if within that four years, the downturn does come, you still have sizable capital to take part in that.”
To do so, Gaw Capital will be more selective to build a more diversified portfolio for Fund VI, says Gaw: “During a time when we would want to slow down deployment, that’s what we would think more about: do we have it in the portfolio? Do we have the exposure already? If we want to slow down deployment, then we should look at things that are more diversified for the portfolio to avoid concentration risk.”
Impact on fundraising
For investors such as Tony Breault, senior real estate investment officer at Oregon State Treasury, fundraising tactics such as longer investment periods or establishing reserves are viewed as positives: “We have been supportive of both, as I’d rather see prudent investment discipline apply through a longer investment horizon, and we’ve seen what can happen when a fund does not have adequate capital reserves available to recap a project, or refinance at a lower valuation, or simply needed to finish a business plan over an extended hold period.” In fact, the pension would likely not invest in a fund that had an investment period of less than three years or did not have a reserve.
Raising capital around a potential downturn, however, is not always an easy sell. “An LP will wait for the distress to happen and that’s the challenge for the managers,” says Weill. “They like the capital ready and standing to commit to deals for when that distress occurs.”
He notes that with Hodes Weill’s opportunistic and distressed-focused mandates, investors frequently ask why they need to commit now. “It’s not easy to have money committed to something that sits there as a dry commitment and they don’t know how quickly it’s going to get drawn,” he says.
Mammen adds that downturn-related fundraising practices have not all been well-received by investors: “It is fair to say that at least some institutional investors are finding policies and practices like those to be part of a large set of reasons for why they find commingled funds to be unattractive.”
PERE data bears this out. The California State Teachers’ Retirement System, for example, was a repeat investor in Lone Star Real Estate Fund III, IV and V, but did not re-up with LSREF VI. Arizona State Retirement System, meanwhile, had committed to Oaktree Real Estate Opportunities Fund V and VI, but did not back REOF VII.
Some managers consequently have had more difficulty securing large commitments from large investors. “It’s keeping fundraising challenging,” says Mammen. “It requires managers of particularly large commingled funds to go to more and more investors in order to expand their investor universe or accumulate smaller checks. They can’t rely on the same mega-investors, whether domestic or international, to commit a few hundred million dollars to the fund. So it’s taking more work.”
Is the downturn-related opportunity overblown?
While some managers are fundraising for a downturn, others are skeptical that significant opportunities could arise from a correction.
“From my perspective, I’m somewhat wary about it. I do fear that a lot of investors and managers are preparing to wage the last war, preparing to wage the Great Recession when the next downturn might be materially different, particularly for real estate. The chances that real estate causes the next economic downturn are very low,” says Mammen.
“The opportunity fund business in real estate was largely built on significant downturns that enabled managers to acquire assets really cheaply, turn them around in a short amount of time, take advantage of significant valuation increases and then get out and get their promotes. I would say there’s a good chance that isn’t going to happen next time. I worry about investors relying on opportunity fund managers to find quick hits. I think the opportunity set is going to be limited.”
He concedes that more capital is being raised for opportunistic strategies than there are potential to earn opportunistic returns. In fact, returns may be muted even relative to the reduced return targets in the mid-teens, Mammen says.
“We’re not going to see a significant downturn,” agrees one manager that invests in distressed opportunities. “Could prices correct? They could. But with interest rates so low, we don’t see a ton of distress and we don’t see a massive distress cycle coming. I don’t think we’ll get a repeat of 2007.”