FEATURE: Operations, in or out of house

There is no right way to do private equity real estate. Ultimately the returns tell limited partners whether a fund has performed or not.

So, whether a fund manager uses an internal or external operating partner to execute an investment strategy shouldn't matter. But it does, and for a number of reasons.

Take the example of Athens-based Dolphin Capital Partners' largest fund, Dolphin Capital Investors, which owns around 65 million square metres of coastal development sites in Greece, Cyprus, Turkey, Croatia, Panama and the Dominican Republic.

Even when things are going well, “an operating partner may not be aligned with the fund sponsor. When things are going poorly, they are certainly not aligned with you.

Dolphin partner Pierre Charalambides says the fund had to choose between outsourcing the development process to local or international developers and building an internal development platform. “We chose the latter,” he says, for four reasons.

The first was to have a bigger say in the project from the initial concept stages through the later stages, such as sales and marketing. Second, Charalambides argues, is that developers tend to take a “very high portion” of the profits for themselves, decreasing returns to investors. He adds that large-scale residential projects are traditionally a long and difficult process. By building the knowhow internally, the firm says it can gain a competitive edge and cross-fertilise knowledge to other projects and countries.

Lastly, Dolphin finds that, regardless of location, the number of suitable partners has been thin. “We have found external developers, especially in emerging markets, to be either nonexistent, unreliable or inexperienced,” says Charalambides.

Time is money

It is something Daniel DiLella, president and chief executive of US private equity real estate firm BPG Properties, agrees with.

BPG, he adds, moved away from the external operating partner model to ensure alignment of interest. Even when things are going well, “an operating partner may not be aligned with the fund sponsor,” DiLella explains. “When things are going poorly, they are certainly not aligned with you.”

In today's declining market, that alignment of interest is vital. Local developers without the benefit of economies of scale are all coming under greater pressure from lenders to meet interest payments. It can put a great strain on fund manager relationships, with sometimes unwelcome results.

We have found external developers, especially in emerging markets, to be either non-existent, unreliable or inexperienced.

DiLella says external operating partners could feel the need to ask for a new economic structure with a fund sponsor owing to their own financial pressures. There is little economic interest for a developer who is out of money to stay on with a project. But if a fund doesn't want to cut a new deal with its partner, it faces some daunting options: either paying off the partner to avoid litigation; replacing him with a new partner, which will cost more money; or bring everything in-house and hire somebody.

The biggest problem of all is that every option is time consuming when you need flexibility, says DiLella.

Time is one thing, but watering down returns to investors is another. According to analysis BPG carried out for investors, adopting a fund/operating partner model can affect returns significantly.

Once an external operating partner is paid his fees or a share of the carry, and the fund takes its fee and carry, investors, who were initially looking at investment level returns of around 15 percent, are now looking at returns in the region of 10 percent or 11 percent.

Add to all that growing calls for greater transparency in reporting from private equity real estate funds (a common challenge is getting partners to provide the requisite information in a timely fashion), and some managers will conclude the external operating partner is an added layer of complexity they can do without.

No right answer

Of course, that's not to say having your operational expertise all under one roof is the right answer either.

Some of the brightest and biggest funds are more than happy to operate with external partners they feel are the “best-in-class” in any given country, region or sector, including Morgan Stanley Real Estate Investing and RREEF. For one thing, such a model can relieve the burden of overhead and the amount of time consumed by operating in a country outside the fund's established local teams.

RREEF, the alternative investment management arm of Deutsche Bank, has a number of agreements with operating partners across Europe.

Without trust then there is no point in doing it.

Chris Papachristophorou, RREEF Global Opportunistic Investments

Chris Papachristophorou, chief executive officer of Global Opportunistic Investments, says RREEF has been able to enter new markets where others have not previously gone owing to the local operating partner model. The most important issue, he says, is trust. “Without trust then there is no point in doing it.”

For hotels and retail investments such as department stores, RREEF has not only teamed up with a partner; in some cases, it has also looked with a partner to hire an independent management team. For larger investments with a big operating business, Papachristophorou says a firm needs a strong management team wholly dedicated to that project.

A classic example of the external operating approach is RREEF's 2005 acquisition of Italian department store chain La Rinascente. RREEF was part of an investor consortium that hired former chief executive of Selfridges, Vittorio Radice, as chief executive. The appointment brought in specialised expertise and became a time-saving device.

RREEF also has operating partners that look after the management of a range of investment assets, such as Pirelli Real Estate, with whom it has worked on several occasions in Italy.

Papachristophorou explains the fees Pirelli would charge are for services the fund would pay for anyway, including agent and property management fees. Pirelli, of course, also puts in sizeable equity as a co-investment. “Is it better to outsource and have a pure service provider, or is it better to outsource to someone that has equity in the investments?” asks Papachristophorou.

“In my view, as long as the partner has the same skill set as the pure service provider, which is an important prerequisite, it is better to work with your equity partner as he has greater vested interest in the transaction. That is the rationale behind it but it is also important to maintain some flexibility or intervention rights,” Papachristophorou adds.

Skin in the game

The theory is straightforward; if the operating partner has a lot at stake, he will fight to make the investment successful. The trick, though, is to structure the right deal in the first place.

We would never agree to a deal that gave our partner a share of the profits from day one if they were getting development management fees but had not put any equity into the deal.

Mosaic Property's Stephen Rees

Mosaic Property, which invests in Central and Eastern Europe, tends to do deals on its own, but works with external local partners on development projects. Chief executive Stephen Rees says the one thing it works extremely hard on is “making sure everyone understands the risks and rewards of entering into a development together. We would never agree to a deal that gave our partner a share of the profits from day one if they were getting development management fees but had not put any equity into the deal.”

In Mosaic's experience, a partner might sometimes want to inject a site into the deal in lieu of equity. When it comes to assessing the value of that land, rather than accept the partner's valuation as an equity contribution, Mosaic would only judge the value once the development was complete. It often means the site is injected at cost.

Once a development achieves a particular performance level, Mosaic says it will look back and revisit the value of the land at the time of the deal and pay bonuses accordingly. “The right people to deal with are the people who understand that they will be rewarded somewhere in the process, but that is not necessarily the first year,” says Rees.

Sometimes, though, the best method of executing a strategy is not to partner or organically grow an internal operating partner model, but to simply buy a company outright – the ultimate in-sourcing method. It may be a more complex method of investment, but in a sense you get the management team for free.

Morgan Stanley has formed many joint ventures across Europe where it feels it has found a best-in-class operator. Deutsche Immobilien Chancen (DIC) in Germany was one example. Morgan Stanley however also acquired pan-European developer Multi Corporation in 2006 – not just for its development pipeline but also its people and management. Likewise, Dolphin acquired Aristo Developments in Cyprus for the same reason in 2007.

In some instances, it can therefore work to have a big operating staff on the payroll of a fund. Equally, it can work to build a platform from scratch or outsource skills to an asset transformer or asset manager. So long as returns to the investor meet those promised by the opportunity fund in the first place, either method is satisfactory. Like all things in private equity real estate, it just has to be executed well.