Imagine trying to sell your house and after months of dealing with prospective buyers traipsing their dirty shoes over your prized Oriental rug, you finally get a bite. Weeks of staging your property are over. At last, the time has come to finally move on to your new dream home.
Despite the fact that contracts haven't been signed, most sellers will have started the process of moving their life from one home to another. They are already emotionally detaching themselves from the property. Imagine then, that the buyers suddenly pull out.
The trauma of losing a prospective buyer is not just a reality of the residential market, but it is also something facing private equity real estate managers as LPs start to renege on planned commitments to closed-ended property funds.
Fund managers can spend months on the road, touring pension funds, endowments and foundations to try to successfully persuade LPs that yes, their fund is an ideal play pool for investment dollars.
Imagine that tantalising moment when, after visiting possibly hundreds of LPs, a fund manager gets a bite. Hooray, the real estate investment officer is going to recommend a commitment to his investment board. The recommendation is approved, everyone is happy and the GP goes back to the office with a smile on his face. He also calls up all the other LPs on the fence to inform them that prestigious institution X has just agreed to commit.
Of course, just like the home seller, contracts have yet to be signed. Sadly, faced with an overweighted real estate allocation, declining distributions and the fear of default on existing fund commitments, the soft circle LP has to make an extremely tough choice of withdrawing its planned commitment.
New Jersey Division of Investment and the Pennsylvania Public School Employees Retirement System (PSERS) are two pensions that have been forced down this road in the past few months, primarily owing to the denominator effect.
In January, the $62.8 billion New Jersey fund pulled back on plans to commit $150 million to Morgan Stanley's latest global real estate vehicle, Morgan Stanley Real Estate Fund VII Global, despite approving the investment at a June 2008 board meeting.
New Jersey is overweighted to the alternative asset class, including real estate, by more than 50 percent. As of the end of 2008, New Jersey had an actual allocation to alternatives of 15.1 percent compared to a target allocation of 10.3 percent. According to documents from the pension fund's January board meeting, the fund said it was planning not close on the investment owing to declining real estate prices but also because of increasing opportunities in the property debt market.
Now PSERS has followed suit, revealing it will no longer fund almost $1 billion of planned commitments to five GPs, including Beacon Capital, Stockbridge Capital Partners, Mesa West, The Carlyle Group and Strategic Capital Partners.
The commitments were proposed and provisionally approved between May and September last year and included $100 million to Strategic Partners Value Enhancement II, $200 million to Beacon Capital Strategic Partners VI (and $200 million for co-investment purposes), $150 million to Stockbridge Value Fund, $125 million to Mesa West Real Estate Income Fund II and $150 million to Carlyle Asia Real Estate Partners II.
PSERS told PERE it was not trying to get out of its existing commitments or contracts, but owing to the denominator effect – and the fact that PSERS' real estate allocation broke through its 12.5 percent target at the end of the year – hard choices needed to be made.
“These were deals which were never executed or finalised and we decided to not fund them at this time due to the fact that our allocation to this asset class has increased due to the denominator effect,” a spokeswoman said. It had nothing to do with fund quality, she added, and if things improved the situation could be revisited.
Few LPs would dare to consider such a move during the good times, however the past 12 months have proved to be anything but good.
GPs are recognising the brutal reality many of their LPs are facing, and are working eagerly to find a solution, including allowing investors to reduce the size of their commitments, as was seen when Westbrook Partners let LPs in its $2.5 billion Westbrook Real Estate Fund 8 lower their commitments by up to 10 percent – without penalty.
For some LPs, however, such measures don't go far enough and trimming the fat of the soft circled commitment is one way of providing some much-needed breathing space.