Mapping the universe

In September, Stockholm-based Aberdeen Property Investors closed its first Asian property fund of funds, AIPP Asia, on $600 million (€422 million) and, at the same time, launched its second Asian fund of funds vehicle, AIPP Asia Select. The pan-Asia Pacific funds aim to give investors a net annual internal rate of return of 13 to 17 percent.

A month later, the firm raised €121 million in the first closing of its second European property fund of funds, Aberdeen Indirect Property Partners II (AIPP II) with a target size of €600 million. The follow-on fund comes two years after AIPP, which was established in 2005 as the first and largest pooled fund of funds focused on Europe. The vehicle raised €624 million.

Aberdeen's rapid expansion is part of a broader trend in private equity real estate funds of funds. The private equity real estate landscape is changing. Investors are increasingly looking to diversify their portfolios as well as expand abroad with an eye toward the burgeoning emerging markets. The fund of funds route offers easy portfolio diversification and a onestop option to investing in risky, yet potentially outperforming emerging markets.

“You're seeing a proliferation of investors, the inclusion of some of these really big players.”

“In a private asset class there are inherent risks and volatility on a property by property basis,” says Kenneth Wisdom, senior vice president at Connecticut-based Portfolio Advisors. “But when you introduce diversification across funds, across managers, and thereby across numerous properties in various markets, even on a global basis, you are able to manage some of that inherent risk.”

Clearly, funds of funds have emerged as an increasingly popular diversifying tool. The real estate fund of funds market has recently experienced unprecedented growth—much of which is directed abroad in Europe and Asia. According to PERE's own data, more than $4.8 billion of funds of funds are currently in market or coming to market. US-focused funds comprise $950 million, or 19.7 percent of the total. Europe-focused fund of funds constitute more than $1 billion, Asia-focused funds total $1 billion, and global fund of funds tops off with $1.8 billion.

In 2007 year to date, approximately $2.3 billion in fund of funds have closed, the majority of which are global funds. This number is twice the amount raised in 2006 (see chart).

Big players
In the recent past, market observers often wondered why the private equity real estate world had so few funds of funds assets, whereas in the private equity market, funds of funds had become a major source of capital. “In 2003, when we started in this space, there was hardly anybody out there,” says Edward Casal, chief executive of New York-based Madison Harbor Capital.

Casal notes that at the time of his firm's founding, roughly 10 percent to 20 percent of limited partner capital came from funds of funds in the mainstream private equity space. But in private equity real estate, something like one percent of the capital was formed in funds of funds.

Since then, the private equity real estate fund of funds market has experienced a dramatic awakening. An underlying reason for the growth is the shift from smaller investors to larger investors in the space. “You're seeing a proliferation of investors, the inclusion of some of these really big players,” Casal says. “Historically, funds of funds were for smaller institutions and high net worth investors. The big guys didn't need funds of funds to do their investments. The market is seeing interest from larger investors unable to reach their [real estate] investment target.”

The shift has had a viral effect, Casal adds. Increased interest from larger investors is, in turn, prompting more activity from smaller investors, who now find funds of funds to be a more acceptable option. As an investment approach, private equity real estate funds of funds have had a more established tradition in Europe than in the US. Institutions in the UK and Europe are much more accustomed to fund of funds investments, says Mike Clarke, head of property distribution at Schroders. The majority of interest in the UK and Europe has come from larger investors such as pension funds. Banks and insurance companies are also active investors.

The fund of funds market has grown as a means for investors to diversify outside of their domestic holdings. “A lot of investors have been looking at diversifying their exposure,” says Bart Coenraads, head of real estate at Amsterdam-based Fortis Investments.

One reason for going abroad is the need to balance out the effects of an unstable market at home (see Intellectual Property, p. 10).

“A lot of institutions, quite naturally, begin investing in real estate locally,” Wisdom says. “When you have some frothiness or volatility in the market, investors will look towards what they view as international markets to help balance out and diversify their portfolios. So there's a lot of the ‘not in my backyard’ investment objectives going on. Europeans are looking at US and Asia, and the US is looking at Europe and Asia. There's a strong global push.”

“We see some of the larger pension funds committing to fund of funds and that's basically whenever they want to enter into a new region.”

Larger investors are also using funds of funds as a way of accessing managers as well as information about manager performance. Fund of funds make available the experience and knowledge of a broad range of fund managers in a relatively data-deprived industry.

“Institutional real estate is by and large, taking REITS out of it, a private asset class and by its very nature is information starved,” Wisdom says. “Having information on the marketplace, having a vantage point to see the broader market is imperative. There are very few folks who actually have access to tangible information that can be used in that manner.”

Uncharted territory
Going from investing at home to investing abroad and delving into the riskier emerging market countries is an intimidating feat—not only are investors at an information disadvantage but many don't have the surplus staff or resources to do the necessary due diligence.

“There are some sophisticated institutions who have the wherewithal to invest in some of the proven markets like Western Europe or the United States and North America, but don't have the resources to extend themselves to doing the due diligence to invest in Asia and some of the emerging markets,” Wisdom says. “When they look at the number of dollars that they are going to put in those markets in comparison to everything else, it probably doesn't make sense for them to dedicate resources to making those investments. In those instances, a fund of funds—providing a diversified exposure to those specific markets—makes sense.”

The emergence of fund of funds as a viable option for accessing emerging markets is an attractive option for more mature investors, who may have little or no experience in those markets, says Bart Coenraads, head of Fortis' real estate team. This is especially true for larger investors who are investing in those markets for the first time; many will seek to make their debut venture through a fund of funds.

“We see some of the larger pension funds committing to fund of funds and that's basically whenever they want to enter into a new region,” Coenraads says. “Especially the case in, let's say, Asian funds of funds, we see that some of the larger institutional pension funds have been committing to funds of funds because it's their first investment. Through the fund of funds they more or less put themselves on the learning curve on investing into a new region.”

Though the possibilities are appetizing, investing in emerging markets requires a more complicated recipe for success. Good underlying fund managers are essential, says Wisdom, who points to the lack of experienced managers on the ground in many emerging market countries: “Looking at India, there is a lot of hype on India real estate. But if you actually look at the experience of the managers—it is quite limited. Many of the bigger players are struggling to find people to lead their efforts in India and put together a strong enough team. Some have succeeded, some are still in the process but having the right people on the ground is critical to success in these markets.”

A global view
Given its current pace, the fund of funds market is projected to grow in the next few years with a trend towards increasing product segmentation into emerging market fund of funds, European fund of funds and Asian fund of funds.

There has been much growth in the European market, says Clarke, property distribution head at Schroders. “We reckon the European [fund of funds] market could easily get to 30 to 35 billion euros of equity within the next three to five years. We're nowhere near that yet. There is more and more capital being bought into the international arena and I can't see how many funds will do it in any way other than through fund of funds.”

The past few years have also seen a growth in Asia-focused fund of funds, with the search for ever higher returns, as well as a rapid movement toward global fund of funds, Clarke says.

As an investment tool, real estate funds of funds have come forth as the be-all and end-all for investors looking to cover all their bases. The vehicles offer a broad range of diversification: manager diversification, geographic diversification, sector diversification and also vintage diversification, says Russell Bates, managing director at Madison Harbor.

The level of diversification from fund of funds is hard to match: “Even though you only invest 5 billion euros, you get 7 or 8 billion of assets in exposure,” says Clarke, “which you could never get by just going into one big fund.”

Of course, growth may not always be smooth. One challenge fund managers are facing is finding opportunities to invest the outsized amount of available capital. “There is a lack of product in most of these emerging markets,” says Schroders' Clarke. “You don't have the breadth of opportunities at this stage that you have in some of the more core markets.”

This disequilibrium will continue into the near future, says Fortis' Coenraads. “A lot of managers, underlying managers, are raising a lot of capital and that will be a challenge going forward. Some managers will struggle to put that equity to work.”

Broader market challenges aside, successfully managing a fund of funds—especially with a mind toward investing globally—is almost like managing a think tank. “With direct investing, you tend to be very good at a lot of detail about a building,” Casal says. “The execution of a fund of funds, however, particularly when investing internationally, is a much more intellectual exercise. Suddenly we have to be globalists, experts on world trade and macroeconomics.”

The difficulties of a cross-border strategy underscore the value of a strong network of local partners, a sentiment shared by many managers. “There are many places you want to be but it's difficult to find local partners,” says Erwin Stouthamer, managing director and founder of Amsterdam-based Composition Capital Partners. Having a global view of the world, or having a network of people who can provide a bird's eye view, will be a recurrent theme as the real estate fund of funds market continues to grow and evolve toward less-familiar, higher-risk, and possibly higher-yielding markets. “You have to map the universe,” says Stouthamer.