BLUEPRINT: The daVinci code

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Looming above the southern exit of Tokyo’s central rail and subway station is the monolithic Pacific Century Place. This 418,000 square foot office block at the epicentre of the city’s Marunouchi commercial district casts a shadow over all those who walk in its proximity.

The 32-storey obelisk has also cast a shadow over the future of Japan’s real estate market and its fate is regarded by many investors as a litmus test for future strategies across the 12 million-strong metropolis. The building represents the first headline-grabbing example of a commercial property repossession in Tokyo after its owner failed to meet its debt requirements. That defaulting owner in question was Japan’s largest private equity real estate fund manager, KK daVinci, which makes the news all the more ominous.

Sam Kaneko
As Japanese real estate market observers ponder the future of Pacific Century Place, for which daVinci paid Chinese billionaire Richard Li a record ¥200 billion (€1.5 billion; $2.2 billion) in September 2006, they also wonder about future of daVinci itself.

It is helpful to understand the impressive rise of daVinci (the KK stands for kabushiki kaishain, meaning joint stock company) in order to fully grasp the situation in which it finds itself today. The firm refused to be interviewed for this article. So to crack the daVinci code, as it were, PERE flew to Tokyo and spoke to advisors, investors, lenders and rivals familiar with its activities to shed light on a company which has, despite its presence on the Osaka Stock Exchange, operated somewhat discreetly to say the least.

daVinci’s story of aggressive investing gone awry, epitomised by its bank-busting outlay for Pacific Century Place, is not unusual in the current market. But its heft in the market means its troubles are widely felt. To give a snapshot of its sizeable presence, daVinci is a firm that has grown to a massive $11.9 billion in assets under management according to its latest stock market filing. It came 17th in May’s PERE 30 rankings for raising $5.2 billion in equity commitments over the last five years alone, and only two years ago became the first Japanese real estate fund manager to launch a ¥1 trillion (€7.4 billion; $11 billion) fund, albeit including leverage.

But the firm became something of “an elephant hunter”, described one rival, as it invested $5.9 billion in four office buildings over a 15-month period which culminated with the global credit crunch in 2007 and subsequent economic downturn a year later. Today it faces a deteriorating Japanese office market riddled with decreasing rents and increasing voids. Against a backdrop of faltering relationships with lenders and tenants, the future of the firm looks laden with challenges.

And yet opinion on daVinci is split. While some in Japan believe its “aggressive” operation was always unsuitable for Japan, others continue to herald the firm for injecting liquidity and transparency into the market as well as for pushing its US-style risk-and-reward tactics into an environment taut with tradition and where making waves above one’s station is not easily tolerated.

At the end of the ‘lost decade’

daVinci was founded by Osamu “Sam” Kaneko, 61, a Japanese-American born in Tokyo but schooled in the US. After graduating from Indiana State University in 1971, Kaneko spent the formative years of his professional life honing real estate and development skills at companies with Japanese heritage but which had expanded to the US, such as Hasegawa Komuten, a Tokyo-based developer and Sunterra Corporation, formerly Signature Resorts, a resorts developer and operator. Sources familiar with Kaneko suggest it was this duel-culture experience which led him to spot an opportunity to bring a new investment culture to the Japanese market and in 1998, Kaneko formed daVinci. Joining him were colleagues from his previous employers, including current co-chief investment officer and former US Navy officer Taylor Bennett.

Pacific
Century
Place,
Tokyo: 
daVinci
handed
back
the keys
The firm’s nascent years in Tokyo, its hunting ground to the present day, came just as Japan was emerging from its well documented “lost decade” of recession. daVinci’s arrival also came just three years before the introduction of J-REITs – a model bringing both transparency to the market and, more importantly, a real estate buyer able to mop up the efforts of opportunistic investors which could locate, buy and add value where others could not. One former investment banker, who lent debt and committed equity to daVinci recalls the view from Kaneko in the firm’s early days: “Sam saw Japan as an inefficient system full of inefficient cronies and in need of a dose of hard logic.”

Within months of setting up shop, daVinci was immediately realising healthy returns for its investors. A firm overview from daVinci last July, viewed by PERE, shows that from March 1998, the firm initially invested $340 million in 63 assets, returning 1.78x equity to investors and an IRR of 24 percent.

“They were doing a lot of things to push the market in the right direction,” the former investment banker says.

Soon other investors wanted in. The firm floated on the Osaka Stock Exchange in December 2001, with JPMorgan snapping up more than 20 percent of its shares, equal to more than half of the freefloat. daVinci soon hit the fundraising trail proper. By November 2002, DJREP, or “Ballista” as it was named, the firm’s first private equity real estate fund, was in buying mode.

Fittingly, the vehicle aggressively outperformed the firm’s prior investments by realising a 2.26x equity multiple and an IRR of 71 percent. Fund two, or “Mikonos”, made its first capital outlay in March 2004 and by last July had returned an equity multiple of 2.35x and an IRR of 73 percent. At the same time fund three, “Mooncoin”, was returning 1.66x and 50 percent and the “one trillion yen fund”, named, “Kadobe”, was returning 1.81x and 28 percent.

Atop a mountain

More than 180 assets across the office, residential, retail and hospitality sector had been amassed by then and daVinci, satisfied with its competence in opportunistic investing, had spread its operation to REIT and core fund management as well as an entry into a new market, Australia. In August 2007, daVinci purchased an 80 percent stake in Quantum Investors, a Sydney-based fund manager which, at the time, Bennett suggested shared a similar investment philosophy to the Japanese firm. Installing Quantum’s managing director Peter Gribble at the helm, the firm launched the daVinci Australia Property & Opportunity Fund targeting A$1 billion (€617 million; $915 million) although to date, the vehicle is yet to hold an equity closing. However, daVinci did buy an office building in Melbourne for A$90 million.

One private placement memorandum obtained by PERE details how the firm also branched out to invest in real estate securities and private companies. By the time daVinci appointed Merrill Lynch to raise $1.2 billion for its daVinci Corporate Opportunity Partners LP fund in September 2007, it had already invested $577 million in corporate level acquisitions including $339 million of equity across 20 companies, four of which had already been exited reflecting an IRR of 36 percent as of July 31, 2007. “The market recognises daVinci as a ‘sure closer’ which is [our] strong competitive edge” daVinci said in its July results, epitomising its confidence at the time.

Tokyo: HQ
to daVinci
The firm, which had grown to 116 staff, adopted the mantra “growing with the investors” such was the alignment between the moves daVinci made and the apparent enthusiasm behind its endeavours from a large and diverse investor pool. Kadobe, for example, attracted pensions, banks, insurers and financial institutions in Japan and pensions, foundations, endowments, government and life insurance among other sources of equity from overseas. In addition to that money, daVinci and its employees were able to contribute 17 percent of the equity themselves to the vehicle.

A glance over daVinci’s fee structure further demonstrates its ability to wield investor appetite and charge a premium in the process. Typical fees for its opportunity funds included: 1.5 percent on committed equity for investment management fees; up to 1.5 percent on committed equity for cost reimbursement fees; a 20 percent fee over the hurdle rate of 10 percent IRR and a fee of 9 percent to 20 percent on capital gains on daVinci co-investments.

daVinci had gone far in a market offering healthy investment yields, particularly in Tokyo offices, but last summer it shifted focus to what it coined a “rent gap” in the market. Investment yields had compressed from 4 percent to 2 percent, but Kaneko and his team argued that, in effect, rents were still not high enough. Conversations with rival firms suggest this could be where daVinci’s problems began as it pushed its tenants to pay more. One lender in Tokyo comments: “daVinci was very aggressive both in acquisitions but also in terms of tenants trying to get market rents. In that sense they overplayed their hand.”

It is argued that was the wrong time to have made such large outlays for some of Tokyo’s largest city centre offices. Pacific Century Place was joined by the 900,000-square-foot Shiba Park Building in Shibakoen, bought for $1.55 billion, and the Akasaka International Building in Akasaka, bought for $1.1 billion among others. But with rents not rising as hoped and voids beginning to

Shiba Park
Building

appear – today Tokyo faces a vacancy level approaching 10 percent – troubled negotiations with tenants spread to stand-offs with lenders. Japan is renowned for its short lease lengths and daVinci had loans of just one to two years in play. With real estate values falling in tandem with rents, anecdotes of rifts between daVinci and its lenders started to surface.

The keys to Pacific Century Place have been handed back and the writing is on the wall for some of daVinci’s other large assets. A rare comment from daVinci’s founder in March only served to cement this: “We have no choice but to default on deals in which the assessed value of the properties falls short of the loans outstanding,” he told Nikkei.

At press time, only Pacific Century Place had been handed back to lenders. Senior lender Shinsei Bank last month appointed Mizuho Trust to market the office for sale. The maturity date for the debt on the Shiba Park Building passed in June but it is thought extensions have since been agreed. One lender comments: “Both cases will ultimately be decided by the subordinated lenders or senior lenders because the equity will certainly have gone.”

In addition to criticism on its debt position, daVinci has also been criticised for using too much company equity in acquisitions. One rival recounts: “In this market, you generally invest 1 percent to 5 percent but their co-investments were 20 percent or more.” This will have certainly had an effect on the firm’s bottom line, although a Dow Jones Capital Markets Report on daVinci contextualises this. The report, released in October, highlights that daVinci invested in assets through special purpose vehicles and that asset managers in Japan are required to consolidate special purpose vehicles onto their balance sheets if no single equity holder holds more than 50 percent of the asset.  The report said: “consolidated vehicles can thus be like looking into a fairground mirror when assessing the liabilities an actual asset manager’s capital base is exposed to.”

Split opinion

Some sources believe daVinci will not only lose the equity in some of its most recent investments, but potentially the

If you lose money but you do it doing what you said you would do, people should live with that. In [daVinci's] case, people acted shocked and surprised at what they were doing, buying stuff in Japan, using the same leverage that got everyone into trouble. But daVinci was at fund five. What did they think it was doing in funds one, two, three and four? Japan went on a good run. I think their LPs should have taken responsibility in terms of their due diligence.

A self-proclaimed daVinci apologist
management contracts tied to these investments also. Whether daVinci is removed as asset manager on Shiba Park and its other buildings remains to be seen, but some parties believe the firm and its leader have unfairly become a scapegoat: “If you lose money but you do it doing what you said you would do, people should live with that,” one advisor, who describes himself as a daVinci apologist, says.

“In their case, people acted shocked and surprised at what they were doing, buying stuff in Japan, using the same leverage that got everyone into trouble. But daVinci was at fund five. What did they think it was doing in funds one, two, three and four? Japan went on a good run. I think their LPs should have taken responsibility in terms of their due diligence,” he continued.

Unfortunately for daVinci the positive sentiment from LPs from funds one to four fell short come fund five. Coupled with a general malaise in LP commitments to blind pool, commingled real estate funds, daVinci’s fortunes led to a comparatively paltry $829 million final close for the vehicle, named “Nobile”, somewhat short of its ambitious $4.36 billion target. 

As it presented its 2008 earnings in February, it described the closing as “reflecting current market conditions and the opportunity size”. One LP admitted it had reached the due diligence stage on a commitment to the fund but later pulled out: “We were concerned about their stock price. Their track record is excellent and we liked their strategy but the management of the GP was our main concern,” he said.

At press time, shares in daVinci Holdings, the firm’s listed entity, traded at ¥6,700 (€49; $73) reflecting a market capitalisation of approximately $115 million – a far cry from a high of $2,325 per share in November 2006.

A glance across daVinci’s latest financials for the year to 30 June shows net income was – $300.5 million as a result of a gross loss of $170.6 million, further evidencing the pain being felt at daVinci currently. Despite this, the firms still had $123.1 million in unspent equity and while its total debt was $8.68 billion, the latest valuation of its portfolio was $11.9 billion. In a country which experienced 11 percent growth in corporate bankruptcies in 2008, according to Tokyo Shoko Research, daVinci has remained on it legs. Furthermore, it has taken measures to help stem its liabilities. In addition to selling assets, including the 281-unit residential Lietocourt Arx Tower for $142 million to Kuwait investor St Martins Group in February, daVinci has also sold its REIT manager, DA Office Investment Corp, to Daiwa Securities.

The firm released a report in August named “Future Strategies for Group-Wide Operations” in which it outlined its plans to streamline the business to focus solely on its private real estate funds platform. This should please LPs who want evidence the firm is serious about fixing the entity that manages its funds. Whether daVinci will regain its stature with the lending community and indeed the tenant community is another matter entirely.


DAVINCI AT A GLANCE

Established: 1998 (listed on the Osaka Stock Exchange in 2001)
Headquarters: Tokyo
Senior partners: Osamu Kaneko, Taylor Bennett, Takatsugu Arakawa, Hitoshi Miyashita
Asset under management: $11.9 billion
Staff: 180

Opportunity Funds:                             
Name/Equity raised
Pre-discretionary funds, March 1998 — ¥31.3 billion ($340 million)
Ballista, November 2002 — ¥25.5 billion ($234 million)
Mikonos, March 2004 — ¥12.8 billion ($139 million)
Mooncoin, November 2004 — ¥100.3 billion ($1.09 billion)
Kadobe, March 2006 — ¥320 billion ($3.5 billion)
Nobile, March 2009 — ¥76 billion ($829 billion)
                                               
Total equity raised: ¥565.9 billion ($6.132 billion)