FEATURE: Down for the count

“I never knew it would be this bad,” has become the perpetual refrain of investors worldwide. Many US private equity real estate firms fought against significant write-downs during the first three quarters of 2008 hoping the market would recover.

However, reality has set in during the fourth quarter, according to research by PERE magazine, with GPs on average writing down their portfolios by 25 percent for the fourth quarter alone.

Speaking to dozens of investors and fund managers, 25 percent was the tragic number heard time and time again, but some place the loss even greater.

“When you look at the average you're going to get a number for a value-added or opportunistic fund of, let's call it 35 or 40 percent, but that could be zero to 90,” says Edward Casal, chief investment officer of the global real estate multi-manager group at Aviva Investors.

The numbers become even grimmer when leverage comes into play since write-downs on equity are amplified by the fund's leverage levels. Leverage levels went as high as 90 percent at the peak of the real estate bubble circa 2007, leaving funds investing at that time vulnerable.

Among GPs hit particularly hard has been Goldman Sachs' Real Estate Principal Investment Area. At year-end 2008, its Whitehall Street Global Real Estate 2007 Fund wrote down $2.1 billion of the $3.7 billion it had invested between May 2007 and August 2008, according to The Wall Street Journal. Based on market trends, it is reasonable to expect that the majority of the write-down occurred in the fourth quarter.

“The more leverage obviously the higher write-downs you're going to have against the equity and if you're 80 percent or 90 percent leveraged you're really wiped out,” according to president and chief executive officer of BPG Properties Daniel DiLella.

The equity invested by the Whitehall fund in certain investments is now worth next to nothing or, in some cases, less than nothing. Whitehall invested $372 million into timeshare company ASNY in June 2007. That equity was valued at zero at the end of 2008. The fund also invested $103 million in New York's Helmsley Building at 230 Park Avenue, which is now $58 million in the red. Whitehall's investment in the Stratosphere Hotel and Casino on the Las Vegas Strip also saw its $326 million in equity reduced to $5 million.

“There's no way of recovering and there's no way anyone is going to refinance your position to help you recover so those portfolios are really gone,” adds DiLella

PERE has also uncovered documents showing that Beacon Capital Partners' value-added fund Beacon Capital Strategic Partners V, which closed on $4 billion in 2007, marked down the value of its invested equity by 25.5 percent. This brings the total drop in the value of the fund's equity to 35.9 percent (see table below). Beacon declined to comment.

Investor perceptions

LPs see write-downs from a variety of perspectives. The prevailing assumption is that investors want to get write-downs out of the way quickly. “My deep sense is that investors would like values corrected quickly and don't want a slow painful death,” says Jack Foster, managing director and head of funds of funds Franklin Templeton Real Estate Advisors. However, this isn't necessarily the case across the board.

Aviva's Casal adds that, although there are exceptions, very few investors have complained about GPs not marking down assets enough. “A few of the LPs are saying mark me down because you've created a huge denominator problem, I want to buy more real estate and if you guys don't mark me down I can't buy more,” says Casal. However, most are not incentivised to want larger write-downs.

Conceptually, LPs want to see the write-downs earlier rather than later. However, expectations that write-downs would range from about 10 percent to 15 percent have been proved optimistic. According to one investment official, who left a large US institutional investment firm this year, some LPs changed their mind once they saw the magnitude of the losses at hand.

Large write-downs can create a whole host of issues for LPs, including impacting funding ratios and asset allocations. But most importantly it also raises questions about a fund's performance. “They started saying if you can take your time and spread it out over a couple quarters that'd be nice,” the former institutional investment professional adds.

That desire by LPs to see write-downs spread out over a longer period of time may become reality though, because, although the fourth quarter was painful enough, there is no doubt that there is more pain to come.