FEATURE: Grappling for control

Over the past four years more than $250 billion has been raised in closed-ended, commingled funds for value-added and opportunistic real estate strategies, according to PERE data. A third of that capital was raised in 2007 alone.

GPs and LPs are engaged in a fund-level tug of war

Those capital-raising highs are unlikely to be achieved anytime soon, as investors retrench their activities in the face of declining distributions and falling portfolio values. Indeed, fundraising in the second half of 2008 slowed to such an extent that the volume of funds closed for the whole of last year topped just $67.5 billion. That was well off the peak of $84.2 billion in 2007 and only $8.5 billion more than the total for 2005.

However, as investors aggressively reassess their portfolios in the light of write-downs, talk is emerging of a new trend in private equity real estate: that of a move away from the commingled, blindpool fund structure.

A trend in that direction would be significant, because until now the opportunity funds business has been all but defined by commingled limited partnerships, which give general partners full discretion over deals and investment management.

During the US Pension Real Estate Association spring conference in Washington DC at the end of March, a survey of delegates revealed that 55 percent believed there would be fewer commingled property funds in the future and a greater call for separate accounts. Even off-stage, talk among professionals was dominated by this issue. A private session between plan sponsors and GPs at the conference was focused on just this topic, according to one delegate.

Power is key. LPs are licking their wounds following a year in which investments in every single asset class were battered. Most are upset and frustrated, even angry. The majority are asking: what went wrong, whose fault was it and how could things have been different?

Unequal LPs

Many fingers can be pointed in trying to answer these questions. However, two overriding themes have emerged from the ensuing debate about the future of private equity real estate: that of LP-to-LP alignment of interests and the level of discretion that should ultimately be given to GPs post-2008.

Ted Leary, founder of Los Angeles-based advisory firm Crosswater Realty Advisors and the former chairman of Lowe Enterprises Investment Management for 22 years, has come out of retirement to help LPs work through their portfolios in the wake of real estate's performance in 2008. One of the issues he has repeatedly heard spoken about among LPs is that of alignment of interests among investors themselves.

In a commingled real estate fund, LPs can be teamed up with a vast number of investors, depending on the size of the fund. Each investor can commit vastly different sums of capital, thereby producing vastly different alignment of interests among LPs in the vehicle. Over the past six months, as LPs struggled to balance the denominator effect against declining distributions and pending capital calls, there were real fears about the potential for LP defaults. That threat brought into high relief the lack of alignment between LPs themselves.

“Some LPs are keeping a list – not just a poor managers list but also a second list of other LPs that they don't want to invest with ever again,” says Leary. When one LP is unwilling to act to rectify problems within a fund, or simply cannot act when issues arise, there is an automatic tension between the LPs. “Some LPs just don't want to go through the pain they've experienced again.”

It is this lack of alignment that is adding fuel to another concern among LPs: that of control over their investments. Speaking to more than a dozen industry professionals, PERE was told that there has been a significant increase in the number of investors asking to use investment vehicles other than the commingled fund, primarily because it gives them greater control over the underlying assets, and thereby their capital investment.

Dan Vene, senior vice president at Rowayton, Connecticut-based placement agent CP Eaton, says club deals (similar to separate accounts but with a few investors rather than just one) and JVs are becoming more prevalent as LPs and GPs debate what the right fund structure is for the industry in the current capital strained environment.

CalPERS control

“The negotiating leverage has shifted towards LPs with liquidity,” Vene says, particularly among the larger players. “Whereas the largest LPs would have traditionally represented a significant percentage of a commingled fund (often between 10 percent to 25 percent of total commitments), these larger players may opt for a team with similar pedigree but in a smaller, more focused format.” The move, he says, allows LPs to benefit with a lower fee structure and more control.

The California Public Employees' Retirement System (CalPERS) is one pension fund that is looking to restructure its manager relationships to achieve better alignment of interests, more control over assets and enhanced transparency. In March, CalPERS announced it would reassess its entire hedge fund portfolio and move away from “commingled accounts” and more towards “customised vehicles, managed accounts and other methods to improve control of its assets”.

A spokesman for the $165 billion fund says the pension was still assessing its real estate programme, but adds: “We are looking for better alignment across the board in all the asset classes and alignment of interests for hedge funds is the first part of that. We want better alignment than what we have had.”

And with fundraising expected to slow to pre-2005 levels, and perhaps even lower, GPs are more than willing to discuss alternative structures if they are unable to raise capital for a traditional, commingled real estate fund.

But while many LPs claim to want more control over asset selection and management, not all are equipped for these tasks. As Vene notes: “These structures are only appropriate for LPs with sophisticated internal teams to benefit from the increased control provisions incumbent in this structure.”

The rising prominence of club deals and joint ventures, together with separate accounts, is therefore unlikely to result in the death of the commingled fund.

“Unless you are a large plan sponsor of significant size it's extremely difficult to run separate accounts or do club deals and get the proper diversification that you need,” says Joanne Douvas, founding principal at New York-based funds of funds manager, Clerestory Capital. To achieve a diversified portfolio of assets, most professionals PERE spoke with, say an LP needs to invest between $250 million and $500 million with one manager spread across dozens of properties. Handing out $500 million cheques, however, is something only a few LPs can do, particularly in the wake of the past year's events.

Although few managers like to run separate accounts and other investment structures without full discretion, that could change as LPs start asking for greater control over a fund's underlying assets.

“When you invest in a commingled fund you have a dedicated manager who will take control and make the decisions for that fund,” says Ed Casal, chief investment officer of Aviva Investors' multi-manager real estate group. Those LPs wanting to take back more control, particularly majority control, need to be prepared for a much more “management intensive” vehicle, he adds.

“Do you have enough knowledge to discuss the leasing options for the properties you've bought? What about the footings; when do you break ground?” Casal says. “These are all questions that are part of the process of getting a real estate deal done and for many LPs they simply don't have the staffing levels to handle these sorts of accounts.”

Bradley Stelzer, real estate portfolio manager of the $2 billion Montgomery County Employees' Retirement System, says the Maryland-based pension will continue to focus on commingled property funds because “limited resources” and staffing levels would pose an impediment to investing through other structures.

However, even given Montgomery's small size, Stelzer stresses fund managers looking to raise commingled funds will need to work harder to attract LP capital in the future, otherwise there could be a shift to alternatives. “GPs that survive [the current downturn] will likely have unique relationships, unique structuring capabilities or unique operational proficiencies. Overall investor interest in [commingled] funds may decline as investors search for alternative structures or reduce the pace of their real estate programmes.”