FEATURE: The situation with special situations

Not too long ago, near Union Station in Washington DC, there was a Class A office building in need of refinancing. The loan backing the property was fast approaching maturity, and the landlord needed to repay some old debt. 

Refinancing was the obvious option, but there was just one snag: the top three floors were intentionally being left vacant because the owner wanted to wait for rental rates to rise. Since the property wasn’t fully leased, this meant that the cash flow the property was expected to generate was lower than normal. As a result, conventional refinancing for the asset wasn’t going to be an option. Fortunately for the borrower, a special situations fund came to the rescue to provide higher leverage financing for the property.

Given the preponderance of situations like these, it is little surprise that a number fund managers and investors are finding such investments – and others in which liquidity may be a problem – so attractive. Indeed, real estate-focused special situations funds have been gaining in popularity among managers and investors alike since the global financial crisis of 2008.

In a market where there’s more distressed debt, increased dislocation and a continued need for the restructuring of deals, a number of fund managers have experienced considerable success with special situations funds. In addition, with the US and European real estate markets continuing to show volatility and inefficiency, the need for flexibility and freedom within the private equity real estate sector is growing, and many such managers believe that investor appetite for these types of funds will only grow going into 2012 and beyond.

What’s in a name? 

Part of the reason why special situations funds are so popular may be as simple as the fact that they refer to such a wide array of fund and asset types. The term ‘special situations’ doesn’t just refer to one thing: it has a broad range of connotations in the market and changes from year to year. 

“Special situations mean different things to different people,” says Michael Zerda, a director within LaSalle Investment Management’s Special Situations Group in London. “In the past, we’ve seen special situations mean more loan-to-own strategies or buying distressed commercial mortgage-backed securities.” 

Nowadays, however, special situations funds could refer to anything from senior, mezzanine or corporate debt to large- or small-cap equities to opportunistic purchases and everything in between. 

“Special situations is just a name,” says Mike Nash, senior managing director and chief investment officer of The Blackstone Group’s real estate debt strategies. Nash, who heads up the New York-based private equity giant’s real estate special situations fund, notes that, even though its investment vehicle is indeed called a special situations fund, it would be more accurate to say that it specialises in high-yield debt opportunities. 

Kevin Traenkle, a principal at Los Angeles-based Colony Capital, adds: “Special situations is simply a catch-all for what doesn’t fit into the classic asset classes. Usually it’s around some kind of distress, and a lot of times it’s around restructuring.”

Special advantages

Indeed, during the past year, the real estate market has seen not only a considerable amount of distressed debt, but also a great deal of interest from investors in buying distressed assets. Recent examples include Anglo Irish Bank’s sale of its $9.5 billion US loan portfolio to Lone Star Funds, JPMorgan Chase and Wells Fargo in August and Bank of America’s sale of an $880 million commercial mortgage portfolio to a venture between Square Mile Capital Management, Invesco Real Estate and a fund managed by Canyon Capital Realty Advisors in September. 

As Craig Solomon, managing principal at Square Mile, said at the PERE Forum in New York last month: “2011 demonstrated tremendous opportunities for distressed-style investing.” This, of course, is where special situations funds come into play, as many of them specialise specifically in distressed debt and distressed assets. 

The two biggest advantages of special situations funds to investors are their ability to offer high risk-adjusted returns and to provide liquidity where the conventional market cannot. Because inefficiencies still exist in the real estate sector, there’s an appetite in the investor community for smart fund managers with proven platforms in this space. 

Another big perk that special situations funds can offer is the ability to engage in long-term investments and enter into transactions that don’t require an immediate turnaround. For example, the Blackstone Real Estate Special Situations Fund II, which was launched in 2008 and held a final close in February of this year, is rather similar to the firm’s Blackstone Real Estate Partners (BREP) VII vehicle. One crucial difference between the special situations fund and BREP VII, however, is that the special situations vehicle enables a five-year lending cycle, which therefore allows Blackstone and its investment partners to make less liquid investments that require more patience. 

Prior to the global financial crisis in 2008, the world was seemingly awash in cash. With high values and low structural problems, interest in capital and liquidity was rather low within the investor community. Now, in the current – and considerably different – economic environment, the rules have changed, with the need for capital and liquidity having risen. 

“In hindsight, as values increase and structure diminishes, you don’t get paid for the risk,” says Nash. “The situation is almost completely different now, as there are fewer participants. The risk we all thought we were taking [prior to 2008] wasn’t as high as we thought.”

Big in Europe

The phenomenon of needing special situations funds for distressed deals or transactions requiring restructuring isn’t merely restricted to the US; it also is widespread throughout Europe. Indeed, primarily because of the European debt crisis, special situations funds increasingly are becoming relevant to the European real estate market. 

According to Amy Aznar, head of special situations at LaSalle Investment Management in London, as regional real estate owners and banks look for ways to deleverage and recapitalise, special situations funds give investors a great deal of flexibility in both where to invest and in which part of the structure to invest. “The mezzanine debt gap continues to be very pronounced and very attractive to special situations,” she says. “The European debt crisis has only accentuated the need for filling debt gaps.”

Indeed, the investment opportunities for these types of funds in Europe are becoming more pronounced as regulatory pressure increases. In particular, LaSalle has been seeing increased opportunities in the constrained senior lending space because it’s an area in which banks will no longer lend.  

Since deleveraging needs to occur across the board within European real estate, Aznar says she believes that investment opportunities in special situations will be even more pronounced in 2012. 

Especially flexible

Ultimately, the future for special situations funds in both the US and Europe is looking particularly bright. Simply put, with more distress, more dislocation and more overleveraged companies and assets, there are more special situations from which to choose. Wherever restructuring needs to take place, special situations funds are a handy source of capital. 

Not only that, but special situations funds also provide investors and fund managers with increased flexibility in where – and how – to invest. In a volatile market, flexibility is [increasingly] important to investors. “The flexibility gives a lot more ways to invest,” says Aznar. “The ability to choose is a really key tool.”

In addition, special situations funds currently are in vogue and growing in popularity with investors in the real estate space because they typically cover investment opportunities in which there’s debt that needs restructuring. “And right now,” says Traenkle, “that’s just about everything.”