FEATURE: Waiting for the tide

Nobody would debate that the private equity real estate market has weathered a brutal storm over the past two years, and while the worst may have already passed, many investors are finding their patience wearing thin while they wait for the return of opportunities to brighten up the skies. 

With all the distress, many expected a flood of fund interests to hit the secondaries market, as limited partners scrambled for liquidity. While there is evidence that many institutional investors dipped their toes in the secondaries waters over the past year and a half, the actual deals completed failed to constitute a “tidal wave” – or even a tidal pool. 

While Switzerland-based investment manager Partners Group logged roughly $19 billion of potential secondaries opportunities globally in 2009, nowhere near that amount of money ultimately exchanged hands as a result of secondary deals. In fact, according to private equity and real estate investment firm Landmark Partners, only $1.2 billion of secondary transactions were completed last year. 

Still, investors who specialise in the secondaries space continue to be optimistic about a “rising tide” of deal activity, with more volume on the horizon. They note that the $1.2 billion in real estate partnership secondaries deals was actually a record amount, albeit from a very low base, and an increase from $855 million of deals counted by Landmark in 2008. The question of when a substantial uptick in deal flow will finally materialise – and how much of an increase can be expected – has to do with why there is currently such a dearth of secondary closings relative to opportunities in the pipeline.

As buyer-seller dynamics in the secondaries market evolve away from what took place during the economic crisis, things can only get better. Declining valuations of funds and underlying assets over the past two years resulted in such substantial discounts to NAV – as high as 60 percent to 90 percent in many cases, according to Partners Group  –  that there was very little price agreement between sellers and buyers. In the midst of the credit crisis, potential buyers, attempting to take the most conservative pricing positions they could, in many cases insisted on valuing seller assets at zero. In fact, some sellers themselves were so pessimistic about the future of their investments that they were offering to pay potential third party buyers to take over their interests, just to get out of meeting the commitments.

The head of private real estate secondaries at Partners Group, Marc Weiss, explains that such aggressive write-downs were necessary to factor in possible further value deterioration. “As a secondary buyer, you need to take a very forward-looking view on pricing,” he says. “Nobody necessarily wants to be the first in the game to take a large write down. You want to price in the risk that property fundamentals and values could continue to deteriorate.” 

But the deep discounts did not spur transactions. In fact, they had the opposite effect. Faced with the free option of selling or holding on to interests in limited partnerships, many LPs found themselves asking, “Why sell now?” 

As a result, on one side of the bid-ask gap were sellers not willing to take a big hit, while on the other were buyers not willing to take a big risk. 

“Absent more clarity in the capital markets on when [prices] are going to come back and when fundamentals will return, that bid-ask gap is big enough that very few deals are transacting,” says president of San Francisco-based placement agent Probitas Partners Michael Hoffmann. “Having said that, we still see a lot of folks making positions available because they’re still under liquidity constraints.” 

Not all LPs looking to sell on the secondaries market, however, are as distressed as previously thought, which could have accounted for some larger than anticipated bid-ask spreads. “A lot of the LPs are now in much better shape, because other parts of their portfolio have improved,” an unnamed market professional told PERE. 

Optimism and patience 

Despite the substantial bid-ask gaps that have been observed during the past two years, the consensus, looking into 2010 and beyond, among major players in the secondaries space is generally optimistic. That optimism, however, can require almost excruciating amounts of patience. 

“Our experience has shown us that selling actually occurs on a lag timeframe from the dislocation, so you find not a tidal wave but rather a rising tide of deal activity,” says Chad Alfeld, a partner at Landmark Partners. “Those that were considering secondary sales last year have not necessarily gone away,” he adds. “They still exist as potential sellers.” 

While the “rising tide” in 2009 represented an increase of $366 million in secondary deal closings on 2008 levels, new entrants in the secondaries market have been popping up sporadically, which could account for another increase in deal flow year-on-year.

“Today, you have some additional capital formation occurring from groups that had not previously done secondaries real estate transactions,” says Alfeld. “The fact that you see capital formation means that those participants view that there is an opportunity.” 

Partners Group’s Weiss states that some discounts to NAV have emerged in the 25 percent to 50 percent range, as opposed to the 60 percent to 90 percent ballpark, which could translate into more price agreement going forward. “Those institutions that are still in search of liquidity are now more serious than ever before about conducting a transaction,” he says. “We think the trend is going to continue, particularly now that the required discounts to NAV are much more palatable to a seller. Year to date, we’re well on track to meeting and maybe even exceeding, who knows, that $19 billion figure.” 

In terms of who will be looking to sell in the near future, Alfeld submits that virtually all types of investors have been considering sales, from financial institutions to insurance companies to public pension plans to endowments. “It’s a very viable market,” he says, adding that he considers it a clear possibility that secondaries transactions will continue to increase in 2010. “We generally believe that 2 percent to 5 percent of the commitments will turnover based upon turnover rates experienced in private equity funds, and therefore one can predict future turnover volume of real estate funds,” he says.

At Liquid Realty Partners, a firm dedicated exclusively to real estate private equity secondaries, chief executive officer Scott Landress sees “continual improvement” in terms of secondary deal closings. While he admits that current conditions are “far from optimal” he notes that “the trend is positive.”

Regarding new participants taking an interest in the secondaries space, large university endowments have emerged as one of the parties testing the water. “We’re still seeing a lot of financial institutions as sellers,” says Weiss, “but more recently we’ve seen a significant trend towards the endowment community exploring the secondaries market. We’ve been approached by several endowments just recently as a matter of fact to look at their entire portfolio and just kind of give them our views on pricing.”

Harvard University and Stanford University’s endowments both declined to be interviewed for this article, but a spokesperson at Stanford says the university’s endowment decided against selling its interests on the secondaries market last October, noting that returns were improving and that the endowment’s liquidity had improved.

Management matters

As is the case with all investments, the decision on whether to buy, sell or hold one’s interests relies heavily on price, but there is another major factor that carries weight with market participants – the quality, real or perceived, of the fund manager. 

For example, one issue that might influence whether an LP wants to sell positions on the secondaries market could have to do with a shuffle in the management team. As Landmark’s Alfeld points out, when high-level executives – chief investment officers, heads of private equity or heads of real estate – leave firms, and new teams are put in place, those new groups are no longer beholden to the pre-existing assets, and may even want to divorce themselves from such holdings to reinvent portfolios. 

Conversely, the perceived quality of particular managers can be what attracts secondaries buyers in the first place. “Rather than people who are [seeking to buy] secondary positions for purely economic return, shooting for 25 percent to 30 percent returns given the risk, some of the most sophisticated buyers that we’re speaking with are looking at acquiring strategic positions in the managers they’ve concluded are going to be survivors and thrivers instead of people that are going to be hurt,” says Probitas’ Hoffmann.

One reason why the quality of mangers can trump the quality of underlying assets, at least pertaining to secondaries, is due to the highly specific nature of the asset class and the specialised knowledge required to manage interests successfully. 

“I think a lot of people come to the secondary real estate market thinking they can underwrite it like a private equity deal, where you buy the position and you passively manage it and hope to get your return,” Hoffmann says. “What they find is very different. If you’re not a fundamental real estate professional from an investment standpoint, so that you understand the bricks and mortar, you understand operations of the assets and you understand the submarkets and the inherent risks there, you’re kidding yourself if you think you can underwrite it.”

While investors in the secondaries market wait for the tide to come in, bringing with it the opportunities that many have all but written off, an important element might be knowing who to trust, rather than which deals look the best. “Figuring out who the survivors are is going to be the ultimate way to play the market,” says Hoffmann. “If you’re willing to form conviction around managers today, I think you can find some extraordinary buys.”