FEATURE: In time of drought

Liquidity, or the lack of it, has been an extremely hot topic over the past six months. From limited partners threatening to default owing to a lack of capital, to the inability of almost anyone to obtain debt, illiquidity has been pushed to the forefront of real estate minds everywhere.

The number of willing lenders has been slashed dramatically in the wake of the credit crisis, with the few lenders focused on deploying capital concentrating firmly on established relationships. Those fund managers able to secure new sources of debt financing are finding the cost of capital much more expensive and with plenty of strings attached, including recourse, lower loan-to-value ratios and much tougher underwriting assumptions. All this significantly diminishes a firm's ability to complete deals.

Such liquidity woes have forced LPs into a holding pattern (see “False reprieve” p. 20), with a dearth of capital calls delaying an inevitable cash crunch once the market picks up.

The problems faced by GP management companies go well beyond bank credit lines. There is growing concern that GPs are facing tough liquidity questions of their own.

Stories about illiquidity issues have been updated again and again since the crisis began. There is one issue, though, that has received much less public attention – that of the liquidity of general partners themselves.

A cash crunch for LPs means less money for the GP, and this may spell budget stress for some. It may even force certain GPs to close up shop.

One budget issue that has dominated the minds of GPs has been the drying up of lines of credit. The lines of credit made available to GPs and secured by the undrawn equity commitments of limited partners, commonly called subscription lines, were used by many managers at the height of the market. These are now proving especially difficult to renew. An Ernst & Young survey notes that 90 percent of respondents believe the renewal of subscription lines at the fund level will be “very difficult” in 2009, with a number of traditional lenders having closed down this portion of their business.

GPs utilised subscription lines to add capital flexibility to their operations. For example, they could use the credit line to fill in for LPs who were tardy with a capital call. That flexibility is becoming scarce, and this may imperil smooth fund administration as a result.

But the problems faced by GP management companies go well beyond bank credit lines. There is growing concern that GPs are facing tough liquidity questions of their own.

As is well known, in the wake of the credit crisis LPs dramatically scaled back on the commitments to new, and follow-on, closed-ended property funds. The denominator effect, declining distributions and pending capital calls combined to force LPs to significantly curtail their investment activity.

And as limited partners reduce the number and size of commitments they make, GPs are finding it increasingly difficult to raise capital for their vehicles.

The inability to raise new funds is having a fundamental impact on revenues. Private equity real estate typically charge management fees of around 1.5 percent, revenues that are vital to help fund day-to-day expenses and management costs. But as the fund grows long in the tooth, fees decline as GPs dispose of properties and make distributions to investors. Fund sponsors unable to go out and raise follow-on vehicles therefore sit on declining revenue streams. The lead partner finds himself or herself at the helm of a firm with an effective expiration date.

Maxwell Rothaus, a principal with New York-based investment firm REMCap, says LP liquidity and fund-level liquidity issues have been widely talked about by investors and general partners. However, when it comes to GP liquidity, the issue has been largely overlooked.

“Given the pressure on GPs in the current environment, and given the fact that the need for asset management is as great as ever, we should expect to see more discussion on this point between general partners and limited partners,” he says.

Many general partners are seeking liquidity in a bid to help expand or sustain their business model. One secondaries market specialist told PERE that the need for capital was an area that could also provide a small, but potentially attractive, investment opportunity for investors with dry powder.

Indeed, PERE has spoken to investment groups who are eyeing GP liquidity constraints as an area in need of greater discussion – and to some who also see an opportunity for investment.

Challenges

For LPs investing with those fund managers, though, the issues can be challenging and numerous. Will the GP be distracted from effectively managing existing assets; will the GP be able to retain its talent; and will the GP be around long-enough to realise some return on investments? Those questions are ones LPs might need to increasingly investigate in order to have a true picture of their own portfolio risk.

Between October and April, 32 opportunistic real estate funds trying to raise more than $23 billion in capital stopped or put their fundraising activities on hold, according to New York-based funds of funds Clerestory Capital.

Given the pressure on GPs in the current environment, and given the fact that the need for asset management is as great as ever, we should expect to see more discussion on this point between general partners and limited partners.

Large funds such as Merrill Lynch and Citi Property Investors are among those affected, both having postponed plans for a second Asia vehicle. CPI recently handed back $400 million of capital commitments to investors, and (as reported on p. 17) Merrill Lynch is now trying to sell the management company of its first vehicle, the $2.65 billion Merrill Lynch Asian Real Estate Opportunity Fund.

For those remaining in the market, many are opting to lower their original fundraising target. Newport Beach, California-based Buchanan Street Partners has reduced the target of its latest value-added fund, Buchanan Fund VI, from $1 billion to $600 million, while Boston's Beacon Capital Partners is reportedly expecting to close its latest office fund on less than $3 billion – against an original target of $6 billion.

When companies on the stock market see their revenue decline by half, the stock tanks as shareholders flee. There is no such instant reaction in the private funds market, but surely there will be repercussions for firms that see their funds under management sharply decline.