A placement agent could be forgiven for feeling worried about the future. In the wake of the global financial crisis what does it mean to be a placement agent and do they still have a role to play? Is the placement agent profession going to face extinction like the fate that befell the dinosaurs or will it rise from its ashes like a phoenix to live another day, albeit evolved?
While many industry commentators have delved volumes on the cause and effect of the credit crunch and its ensuing effects on both markets and investments, we are focused on what it means for placement agents. In short, adapt to the new reality or be extinct.
Hired by fund managers as an external source for raising capital, placement agents have traditionally relied on their relationships with prospective investors to introduce the asset manager of the fund to limited partners.
In the earliest days of private equity partnerships, this was often a simple process, with many investors putting their trust in the results of a fairly quick due diligence process, their relationship with the GPs, the agent’s recommendation (who usually made no or little due diligence on the GP), or a combination of these factors. The result was often an opportunistically assembled LP base for the GP and a poorly informed LP, which created inefficiencies in their portfolios.
Following the global financial crisis, this way of operating changed considerably. Collectively, today’s investors have far more experience with alternative investments in general and in private real estate specifically, as best practices from one asset class were adopted by the other. LPs’ demands in their due diligence, both prior to making the investment decision and during the monitoring of the investment, have grown significantly in their complexity and disclosure. As a result, in order to secure a commitment from an LP, today’s GPs face increasing demands on their time during the fundraising process by way of greater due diligence requests, together with the need for multiple meetings with most investors. Furthermore, after the fund vehicle has been raised, there are ever-increasing requirements on LP communications and investor relations.
GPs use placement agents to raise their funds in a shorter time. However, the widely-held assumption that using a placement agent to ensure a GP reaches its fundraising target is increasingly being refuted. Therefore, the greatest value added is that of relative speed, when agents help GPs to focus on those investors that will invest, as opposed to those that will not.
Combined, these factors have made critical the need for careful GP selection by the placement agent, by conducting thorough due diligence on the GP, for exact planning of the fundraising process and for a sophisticated and diverse investor base. In short, the role of the placement agent has evolved from that of a coach to a tightly pre-selected GP anticipating the demands of the LP.
The going gets tough
The current fundraising market though is having an impact on the real estate – and wider – placement business.
Traditional backers of private equity real estate have decreased allocations across the board for clear reasons, not least including negative funding ratios and denominator effects, as well as greater calls to boost liquidity in fund portfolios. The result is clear, according to market estimates, real estate fundraising dried up in 2009 to an estimated $40 billion, or just 30 percent of what was raised in 2008. INREV, the European Association of Investors in Non-Listed Real Estate Vehicles, estimates that nearly €6 billon was raised for real estate funds in 2009 in Europe, compared to nearly €15 billion and €27 billion in 2007, or close to a 40 percent drop year-on-year.
However, INREV estimates that 64 percent of the capital raised in 2009 was from repeat investors, whereas in 2007 the majority of capital raised came from new investors. This data highlights the collapse of fundraising achieved by first-time funds or by ensuing funds seeking new LPs, both for which placement agents typically make their mark. The general market conditions are negatively impacting placement agents.
In addition, many funds raised prior to the global financial crisis are still awash with unspent cash commitments with estimates suggesting that there is more than $180 billion of dry powder in real estate funds globally, 25 percent of which is made up of European funds. Predictions for capital raising in 2010 and 2011 are grim: INREV estimates it at €10 billion for 2010. Estimates for the following year do not show much growth.
The bottom line
Before the financial crisis most placement agents were active in the opportunistic end of the real estate fund management, which traditionally charged higher fees. Placement agents now need to operate in a lower-fee environment, both in terms of quantum and fee level. After the crisis, the fundraising market has become smaller, with lower total allocations, and thus increasingly competitive in terms of supply and demand of capital. In recent years many investors with mature private real estate fund investment programmes have begun to rationalise their portfolios by reducing the number of private fund relationships. Additionally, those investors with capital to allocate to real estate may opt out of the private equity real estate fund model, instead choosing direct transactions, joint ventures, co-investments, and/or more liquid investment structures, such as open-ended funds or listed real estate investment trusts (REITs).
Today’s situation is further compounded by LPs experiencing notable liquidity issues, having had meagre distributions from their existing commitments. This is translated into limited capital to invest in either new fund relationships or even in re-ups of existing relationships. Also, LPs focus on strategies more reliant on cash distributions and on a drive to lower total expense ratios.
This lower revenue environment has caused numerous placement agents to exit the market or to seek alternative employment.
Before the financial crisis, the private equity real estate industry was lightly regulated. However, recent changes are seeking to force all players in the private equity real estate industry to be closely regulated.
Across the globe, domestic regulators are increasing regulatory oversight of the industry and investments made in illiquid funds. And market participants expect more regulations to come.
Most large-scale placement agents are already regulated in Europe or in the US, even though the activities they undertake are not regulated in the same way in all jurisdictions: the act of selling to institutional investors is a regulated activity in the US, whereas it is not in the EU (advisory services to GPs are). Also, the regulatory constraints imposed on placement agents are relatively light compared to asset managers: little regulatory capital and little reporting to the regulator required. With the prospect of a radical change, meeting the costs both in terms of time and capital will be a severe challenge to the business model.
Following a pay-to-play scandal in the US, some states, including New York and California, have discussed banning the use of placement agents altogether or requiring agents are paid a flat fee. In September, California’s state assembly passed legislation that would require placements agents working with the state’s public pension funds to register as lobbying, putting an end to fees based on the success of a fundraising.
In June, the US Securities and Exchange Commission announced it had also decided to prohibit unregistered placement agents from soliciting public pensions on behalf of private investment firms, despite concerns of greater restrictions placed on the industry.
The challenging market and regulatory conditions are forcing the role of the placement agent to change. So what can a placement agent do today to survive?
An institutional world: The make-up of LPs is likely to remain institutional, that is, those investors looking to match assets with their long-term liabilities rather than made up of private wealth investors (where the desire to have instruments with apparent liquidity, such as hedge funds or open-ended funds, still matters). The agents that can effectively navigate the institutional field will be the winners.
The days of the controlling LP: As in most times of crisis, LPs currently have a tendency to seek control of their managers or of their assets, increasingly taking an active role in the investment committee. LP investment committees, co-investments, club deals, joint ventures and direct deals have made a comeback. However, as the crisis recedes and capital becomes more plentiful, the discretion within a box is likely to return, but will probably be adapted to the new reality of control. Agents then become invaluable to GPs seeking to counterbalance the controlling LP when negotiating terms, as an agent would understand the terms achieved with other funds and what level of discretion the LP can live with.
The days of the evolving GP: With a business model that has recently produced negative results both for themselves and their LPs, a number of GPs are now trying to figure out where the next big wave of capital will come from and for which strategy. For GPs, survival may mean a change of style of investment into another (for example, opportunistic to core, US to Europe). Agents will need to pick the true alpha producers from the rest, as not every GP can be transformed successfully.
Challenging the economics: LPs are taking a more aggressive stance on the economics of the manager. Except for a golden circle of GPs, the balance of power has shifted toward LPs and will predictably remain so for a while, until the fundraising market heats up once again. Agents will maintain an intrinsic value when it comes to fee discussions.
A transparent world: Hidden fees, late or incomplete reporting, style drift, lack of proper fund administration or governance, hidden leverage (at GP, fund, or investment level) are being revised. LPs are now more vigilant than ever. The role of the placement agent is to advise a GP to be upfront in disclosing these issues to LPs, as the GP will be found out sooner or later.
Alignment of interests – revisited: This fine catch-all idea was meant to prevent managers from investing in foolish deals. Evidently, it did not. Interestingly, the basic principle of the carried interest is not being questioned. Advising the GP and brokering a deal with the LP on the right level of alignment, through team and GP co-investment, the right level of carried interest and fund governance will be a major challenge for the agents in the coming months.
No legacy deals please! Legacy assets dating from before the financial crisis have proven to be a huge issue with LPs. GPs will need either to sell them in the market at a loss or park them in special purpose vehicles to be sold at a later stage, if and when property values recover. In exceptional circumstances, LPs have accepted legacy deals to be transferred at mark-to-market valuations to new funds. This will assume that a GP could accept potential losses and that the assets do not face significant refinancing risks. Placement agents are now required to place extra care in their due diligence of these legacy deals.
New valuation methodologies: The financial crisis has laid bare some of the pitfalls of mark-to-market valuations. Long-term investors seem punished by short-term volatility on assets they intend to hold on to for the long term. Long-term investors are out of allocations when markets are cheaper, hence preventing them from the benefits of these lower valuations. New, possibly more realistic, valuation methodologies are being thought through for private equity, but their application will take years. The agents should keep the LPs informed for best practices across jurisdictions, although regulators tend to decide ultimately as to how assets are valued.
The beauty of core funds: Confidence in complex private equity real estate transactions has been severely eroded. LP boards are still facing the fear of further losses and the likelihood of accepting aggressive or complex strategies is low for the foreseeable future. Core funds are in most demand today. The agent’s role is clear to help GPs focus on making their fund strategies simple. However, as markets recover, investor confidence is expected to be restored, and it is a matter of time before opportunistic funds return to successful fundraise.
Placement agents will need to operate in a lower-revenue environment which will still be fiercely competitive, due to the lower available capital from LPs. However with tougher regulations and numerous competitor exits, placement agents – currently active and with proven track records – should enjoy the barriers to entry these regulations effectively raise and thus still command revenue levels high enough to find it rewarding to stay in the business.
Successful agents should be able to pick the wining GPs that will achieve top-quartile or top-decile performer status. They should also be able to convince a global audience of LPs which is highly sceptical of the benefits of private equity real estate funds, but still need them. These challenges will require a large investment by placement agents in due diligence processes and market analysis to provide the arguments and intelligence needed to convince LPs. Those agents that will survive the current crisis will be tend to be leaner, fitter and more agile and thus should not meet the fate of the dinosaurs.
Extract taken from The Definitive Guide to Real Estate Fundraising, published by PEI Media in July 2010.