FEATURE: Time to redefine

The real estate fund of funds market has been going through a bit of an identity crisis of late. With the vast majority of multi-managers no longer investing purely in newly-launched funds, many seem to be at a loss for how to identify themselves.

“I’m so hesitant to label us a fund of funds,” says Marc Weidner, managing director at Franklin Templeton Real Asset Advisors, a unit of global investment manager Franklin Templeton Investments. He instead prefers to define his firm in more general terms. “The way we are looking at ourselves is that we are providing an extension of the firm’s investment capabilities to our investors,” he adds. 

When it comes to those investment capabilities, however, “there is an expansion of the investment scope beyond primary funds,” Weidner notes. Indeed, co-investments and secondary investments “have become more en vogue today.”

To illustrate the point, consider Franklin Templeton’s current fund of funds vehicle, which has raised about $270 million in capital and has invested about $90 million of that. Of that $90 million, the firm has parked $27 million, or about a third of the invested capital, in co-investments, while the remaining two-thirds have gone to more traditional primary fund investments. That percentage has grown considerably since 2007, when co-investments accounted for just 5 percent to 10 percent of the fund of funds’ investments, according to Weidner.

Don’t call me FoF
“We’ve stopped calling ourselves a fund of funds because technically we will not exclusively be a fund of funds,” says Morag Beers, director of investor relations at Composition Capital, an investment management firm based in Amsterdam and Hong Kong. “We don’t know quite what to call it exactly, perhaps a fund of investments.”

While Franklin Templeton has edged further away from the typical fund of funds model, Composition and a select group of others already have gone whole hog. When Composition rolled out its first two funds of funds in 2005, the firm made the bulk of its investments in underlying funds. Then, for its 2007 vintage fund of funds, Composition evenly split its investments between joint ventures and funds. However, the firm’s two incoming funds, which launched last month, will focus only on joint ventures, club deals and emerging ventures, with no planned investments in primary funds. Composition Capital Europe III and Composition Capital Asia III are said to be targeting €250 million and $400 million in commitments, respectively.

Meanwhile, some multi-managers are seeding their vehicles mid-fundraise with pre-specified deals. The multi-manager platform of Los Angeles-based CBRE Global Investors has raised $250 million for its Asia Alpha Plus II fund from a handful of institutional investors and has completely pre-identified its pipeline of club investments, co-investments and secondaries purchases, PERE has learned. Furthermore, it is not slated to make a single traditional underlying fund investment.

Jeremy Plummer, global head of the platform, would not confirm the fundraising effort, but he notes that CBRE generally is pursuing an investment strategy whereby its investors know exactly what they are getting. “This might be a dangerous claim, but what we are doing is replacing what used to be known as an ‘allocator opportunity fund’ with two key differences – significantly lower leverage and much lower fees,” he says.

In terms of what to call itself, Plummer adds: “It’s no longer fund of funds; it’s multi-manager.”

Split personality
The evolution of multi-managers has not gone unnoticed by real estate’s service providers. “The fund of funds are becoming more sophisticated, and thus they’re looking to do less fund investing, where they feel they add less value” than with co-investments, direct investments and secondaries, according to Roger Singer, a partner at Clifford Chance, a London-based law firm that represents a number of fund of funds sponsors. Such investments also command higher fees because of the greater amount of work and decision-making on the part of the manager.

Multi-managers also have been compelled to look at other types of investments because “the number of primary funds that actually are being raised is much lower than four years ago,” says Weidner, whose firm has focused on co-investment strategies because of “a better alignment of interests.” The slow pace of fundraising for the majority of underlying funds – either because of poor fund performance or difficulty accessing the capital markets – has actually generated more co-investment opportunities, as managers of underlying funds seek partners with which to invest in deals that may be too large for the fund they have raised, he explains. Such investments also can generate better terms, such as reduced performance fees and more tax efficient structures, for an investor than a primary fund investment, he adds.

Meanwhile, “there was a real growth of the secondaries space in 2009 and 2010,” when investors, particularly foundations and endowments, were looking to get out of fund commitments, says Singer. “The growth in that market and the perception of the opportunity led more people to focus on secondaries,” he adds.

One advantage of non-fund investments is that, in many cases, capital can be put to work more quickly. Both co-investments and secondary investments, for example, call for a more compressed decision-making timeframe than an investment in an underlying fund, says Weidner. With a fund, an investor typically would have months to make a decision or even express an interest in an investment, he explains. However, with a co-investment or secondary, an investor has only days to express an interest and weeks to conduct the due diligence, close and fund the transaction.

“The most important point of investors looking at co-investments is that they need resources, and this is probably the highest barrier to entry,” Weidner says. “This is probably why a lot of fund of funds are looking at this as a way to reinvent themselves.”

Growing investor interest
Interest in multi-managers has remained strong, perhaps even grown, partly because “a number of investors reduced their in-house investment staff and increased their interest in monitoring their investments more closely,” says Singer. “The mixture of those two things means you need to outsource some of that function.”

As the real estate portfolios of some institutional investors suffered heavy losses in the wake of the global financial crisis, “the value of diversification across the globe became more readily apparent,” says Ed Casal, chief investment officer of Aviva Investors’ global real estate multi-manager group, which has invested more than $8.72 billion through fund of funds vehicles.  Indeed, limited partners that invested in emerging markets like Brazil and China often fared better than those that didn’t, he notes.

However, some institutions – often managing investment portfolios comprising 30 to 50 underlying funds with a staff of only one or two people – lack “enough firepower and capability in terms of sourcing and analysis,” Casal says. In many cases, those institutions are looking to build a global real estate portfolio via separate accounts, which offers a more customised approach, rather than through commingled funds, he notes. That trend is best demonstrated by the fact that Casal’s group manages six funds of funds and 35 separate accounts.

In recent years, several large investors have committed significant amounts of capital to the fund of funds market. They include Germany’s largest pension fund, Bayerische Versorgungskammer, which last month awarded a €500 million global real estate multi-manager mandate to UBS Global Asset Management to invest in core, value-added and opportunistic real estate funds, and the State Universities Retirement System of Illinois, the Illinois Municipal Retirement Fund and the Chicago Teachers Pension Fund, which jointly committed up to $190 million to the Franklin Templeton Emerging Manager Real Estate Fund of Funds in 2009.

Elsewhere, the Employees Retirement System (ERS) of Texas is targeting a commitment of $75 million to $100 million to its first international fund of funds, through which it is looking to make private real estate investments in Europe and Asia. The $23 billion pension plan would make this commitment using a ‘hub and spoke’ approach, where the hub portion would constitute capital allocated to small- and mid-sized investment managers in those markets through a still-to-be-determined fund of funds vehicle and the spoke portion would consist of capital allocated to larger international real estate funds. ERS made its first fund of funds investment in December 2010, when it agreed to commit $50 million to an emerging manager fund of funds sponsored by Morgan Creek Capital Management.

“The local presence of the manager reduces the underwriting risk of dealing with smaller, more niche-focused strategies,” an ERS spokeswoman tells PERE. “Additionally, utilising a fund of funds increases diversification, which also reduces risk.”

Whereas ERS may only be able to invest in two to three real estate funds on its own, the pension plan could invest in as many as eight to 12 funds through a fund of funds, the spokeswoman explains. ERS is expected to close on its investment to the international fund of funds by the first quarter of next year.

Scouting deals abroad
Although many investors have been able to manage real estate investments in their home markets, they have turned to multi-managers to help source deals abroad, according to Beers. In many parts of the world, “opportunities have become very much more localised,” she says. “You really need to go looking for them and, when you get into those markets, you generally need to be hooked up with the local players.”
Additionally, “there are a lot of opportunities that do not present themselves in a fund format,” notes Beers. “They’re perfectly legitimate opportunities with very good real estate firms that, for a variety of reasons, do not happen to be structured as a fund.”

Composition, for example, recently closed on an urban redevelopment deal in Taiwan that was structured as a joint venture with a local developer. While large-scale development projects in Taiwan are closed to overseas investors, smaller ventures are possible with the involvement of a local partner, Beers says.

Sowing the seeds
As multi-manager firms increasingly look beyond primary fund investments, however, investments have become more difficult to underwrite. Co-investments and secondary investments, for example, “are not as straightforward to source as primary funds,” Weidner says. “It’s going to take you a little bit more time. In addition, you will need more resources and connections.”

Plummer suggests that not all multi-manager firms can make such an adjustment from the previously popular model. “There’s quite a big difference in skill sets required to do it,” he says. “We need to be able to assess the actual real estate assets we are investing in and get comfortable with that as opposed to the fund of funds model of three of four years ago, which was more about passively committing capital to a fund and letting the manager do what it likes.”

CBRE’s strategy of pre-seeding its funds, or lining up investments for a fund while capital is being raised, is gradually gaining traction with some multi-managers that continue to back underlying funds.  Franklin Templeton, for example, invested two months ago in a small US real estate fund with a portfolio that was 60 percent pre-specified. “It’s putting money to work immediately,” says Weidner.

A solid deal pipeline is becoming more and more of a requirement for investors to seriously consider a fund, adds Beers. Indeed, about three-quarters of the investments that Composition has lined up for its new Europe and Asia funds can be rolled out within 12 months.

“Investors are far more critical as to ‘when does my money start working?’” Beers says. “Therefore, you need to get the deals, or a certain number of deals, lined up beforehand.”

Other multi-managers point to the difficulties of pre-seeding, despite its desirability. “It’s good to do, but I know what the capital markets look like and it’s harder to do,” says Joseph Stecher, managing director at Morgan Stanley Alternative Investment Partners’ real estate fund of funds group. Because financing – whether from a bank or a parent company – has become more challenging for a fund sponsor to obtain, “the trend for pre-seeding is generally going to be down,” he notes.

Primary colors
While many multi-managers have shifted away from investing in funds, some managers maintain that primary funds will remain a key part of the fund of funds investment strategy. “It’s much easier to raise money for co-investments and secondaries than for primaries,” says Stecher, whose group invests in primary funds, secondaries and co-investments. However, “there’s definitely a missed opportunity” if primary fund investments are overlooked, he adds.

Stecher sees primary funds becoming more interesting to LPs because he believes the best way to access “close-to-the-ground” opportunistic managers globally is through primary commitments to small- to mid-sized funds, generally ranging from $400 million to $800 million in size.

“In a fund, we can get immediate property diversification,” with 10 to 30 different properties in that particular fund, says Casal. While a joint venture or co-investment offers more direct control over an asset, “the downside is you’ve got money concentrated in a single asset, as opposed to diversified across a pool.” Although Aviva’s fund of funds group has broadened its investment mix to include more club deals, primary funds still account for 80 percent of its investment activity. 

Still, the increase in non-fund investments by the industry potentially signals “a tremendous change in the fund of funds market,” Weidner says. He believes the industry will continue to grow, both in terms of the percentage of private real estate transactions being funded by multi-managers and the dollar amount invested by fund of funds, provided that “the fund of funds industry can demonstrate they add value to their clients’ portfolios.” If they can, “these are going to be good years for fund of funds managers,” he adds.
In the meantime, with non-primary fund investments currently en vogue, many fund of funds firms would rather call themselves something else.