FEATURE: Optical fibre

There is an important psychological barrier to the still-covert nature of trading secondary interests in private partnerships: neither side wants to appear to have given away a big discount or to have paid too much. In financial jargon, parties to secondaries transactions invariably call this the ‘optics’ of a deal.

In an age where there as many types of motivated seller as there are reasons for investors to reduce their fund holdings (see Motivated sellers, opposite page), it seems logical to expect there would be discounts on offer in certain circumstances. Still, when considering a transaction’s terms, all parties are concerned with appearances, even if the gap is closing between buyer and seller aspirations.

With this in mind, PERE spoke to three institutional buyers – Connecticut-based Landmark Partners, New York’s Morgan Stanley Alternative Investment Partners (AIP) and Switzerland’s Partners Group – to discover more about the modern-day approach to trading in secondaries and how to deal with the ‘optics’. What became clear is that the prevailing tactic does not seem to include banging the desk and opening talks by stating a desired discount. 

“This is a market that is driven by optics, more so than most markets,” says Paul Parker, managing director of real estate for Europe and Asia at Landmark Partners, one of the biggest global buyers of secondaries. “Still, people always ask: ‘What are the discounts?’”

Landmark, however, doesn’t seek to refer to discounts. Rather, it talks about ‘pricing’, showing that the firm views a discount as a by-product of its approach to valuation rather than its objective. For secondary buyers, it is an important distinction that they argue is often misconstrued.

Understanding the exit

When considering the subject of ‘pricing’ and the consequential discount, Parker says his firm’s approach is about the prevailing market conditions and the market outlook, but fundamentally it also is about whether Landmark has ‘faith’ in the underlying valuations, reporting and projections of the sponsor. “These items are being looked at by investors more today than ever before,” he adds. “Above all, it is a question of whether the underlying sponsors can deliver on their asset management goals and achieve their exit objectives. Those are the big questions.”

As an example, Parker points to the number of fund partnerships that are approaching their termination dates and/or refinancing obligations while coupled with the challenges of tough markets across Europe, parts of Asia and in certain areas of the US. In some cases, there are managers having to deliver on asset management initiatives without the benefit of carry or alignment of interest to hold onto key personnel.

“Those kinds of factors are what any investor is looking at today,” Parker says. “However, for secondary investors appraising these positions, these issues influence pricing and indirectly drive the determination of the discount in today’s environment.”

That is different than 2008 and 2009, when ‘pricing’ and discounts were driven by the fact that valuations completely lagged activity in the underlying market. According to Parker, a buyer actually had to discount just to get ahead of the time when the re-valuations of the fund came through. Today, valuations reflect what is happening in the underlying markets to a large extent, although there are exceptions.

Explaining further, Parker offers the example of a 2004-vintage fund that projected an exit via the public markets around 2011 or 2012. With a dearth of initial public offerings occurring, the manager is facing a ‘plan B’ scenario of selling individual assets in a market where the economic outlook and real estate markets are weak. If potential buyers of those assets know the fund needs to sell, that naturally will drive down the price offered. “It is essential to consider projected exit strategies, with an understanding that they will be reflected in the pricing and hence the discount,” he adds.

In addition, Parker notes that the spread between the aspiration of the seller and the buyer has been reduced nowadays. When combined with the myriad of reason why there are more motivated sellers, it helps to explain the record volume of real estate secondaries that traded last year.

“It has got to a level where, in my view, any fair, reasonable and willing party can agree to a transaction,” Parker says. “That really explains why last year was a record year and this year probably will be as well.”

Minimising the optics

Marc Weiss, the head of the private real estate secondaries team at Partners Group, says it is “absolutely unhelpful” to talk about the level of discount in a trade, notwithstanding the “natural bias” in the industry to associate high discounts with a great transaction if you are the buyer and low discounts with a lousy one. Instead, the Switzerland-based investment firm approaches sellers in a way that depends upon understanding the seller’s motivation and how it views the market. 

“When it comes to sellers, we say: ‘Do not focus on the discount itself, rather focus on the dollar amount or absolute euro amount of what you may need to realise as a loss – that is more important than the percentage’,” Weiss says. “Obviously, there are other ways around a situation, like structuring a solution to minimise the optics of it, but we find there is a lot of value for us in explaining how we look at values and how we look at the market. By doing that, the seller realises that we are not viewing the market any differently than they are. If the seller agrees with our opinion on value, it therefore should accept our discount. This boils down to how motivated they are to deal with the problem today. Our thesis is always to focus on those institutions that are motivated sellers. If they are not motivated, they are never going to accept our view on pricing.”

Weiss goes on to draw a comparison with the mainstream private equity industry, where valuations are really based on multiples of comparables. He says that, as financial markets improve, multiples will alter for the better. If, however, one takes a more “forward-looking view,” where values are more conservative, then discounts would need to creep up a little.

“I would argue that the pricing of companies in private equity probably has outpaced expectations from a public market perspective,” says Weiss. “For real estate, if one examines cap rates, they are back to historic highs. In a world where it is more likely that borrowing costs will rise rather than fall, I think one needs to be very careful. If one wants to be forward looking at a time when values are improving faster than they should, then that is going to drive up your discount.”

A bottom-up approach

According to David Boyle, who heads up the real estate programme within Morgan Stanley’s AIP division, the business focuses on small and medium-sized funds, typically with 10 to 15 assets. “For secondary trades, we focus on what the right risk-adjusted return is and underwrite from the bottom up, visiting all the properties for an asset-by-asset analysis,” he explains.

With this approach, the investment bank’s secondaries business can find itself buying interests close to net asset value (NAV) one day and at a wide discount the next. “We want to make a commitment on a secondary basis that we would have committed to on a primary basis – so the quality of the GP and the underlying assets is very important to us,” Boyle adds.

Boyle provides a recent example of where the manager had, if anything, been conservative in writing-up values. In certain cases, the firm had even bought at discounts of 35 percent to NAV.

“There is no right or wrong answer,” says Boyle. “We do our work and figure out what we think the right risk-adjusted return is. That translates back into what the discount to NAV is.”

At times, AIP has bid at discounts to NAV where it thought it still was bidding pretty strongly, but the seller didn’t transact because the price didn’t reach NAV. “A lot of sellers have the ‘psychology of NAV’ and not wanting to take a discount or a big hit,” Boyle says. “That certainly affects whether the seller is going to sell in the first place.”

Obviously, it all comes back to perception. If the optics are wrong, the seller won’t trade.

BOX: Motivated sellers
There are many reasons why particular holders of fund interests might sell today. Here is a pooled list from Landmark Partners, Partners Group and Morgan Stanley Alternative Investment Partners on typical sellers of secondary interests and/or motivations for transacting secondaries

Liquidity management: “More than ever, firms are using sales receipts to pay down debts.”

Anaemic distributions: “Few and/or meagre distributions are being paid, causing many investors to ask: ‘What is the point of my being here?’”

Management changes: “When people leave, that invariably leads to directional change, and that leads to transactions.”

High-net-worth individuals and hedge funds: “We have bought from groups that over-extended themselves and needed liquidity and/or those that shouldn’t have been investing in private equity real estate funds in the first place.”

Banks and insurance companies: “Big regulatory issues such as Basel III and Solvency II are leading to increased deal flow.”

Endowments and foundations: “Some over-allocated to alternatives in the last cycle, and they are now reducing their allocations to illiquid assets.”

Headline risk: “Some institutional investors are migrating back to safety, selling the non-core assets with which they are less comfortable.”

A banner year
Deal volume for real estate secondary transactions is estimated to have peaked at $2.2 billion last year, which would be a record figure for the sector

The measurement of total real estate secondary trades may not be an exact science, but most studies suggest 2011 was a record year. Indeed, just a few weeks ago, Landmark Partners’ annual tally of transactional activity showed that volumes had reached $2.2 billion.

That $2.2 billion figure is an estimate of net asset value at the time of sale and represents a 20 percent increase over 2010 volume of $1.8 billion, according to Landmark. Approximately 41 percent of the volume was concentrated in US real estate partnerships, 32 percent in Asian partnerships and 25 percent in European partnerships.

The actual figure is probably much larger still, as Landmark noted that the data did not include the entire volume of ‘LP-to-LP’ trades that typically go unreported in the marketplace. In addition, Landmark’s dataset excludes transactions involving interests in single-asset real estate joint venture partnerships and other private non-fund vehicles. It also excludes smaller trades in UK unlisted funds on various exchanges, which would add greater volume still.

Landmark said banking institutions and other financial conglomerates were active sellers in 2011, as these institutions looked to the secondary market to meet balance sheet and regulatory objectives. In addition, several transactions were prompted by the sale or spinout of real estate fund sponsors by larger financial companies looking to shed non-core businesses.

Interestingly, mainstream private equity is reporting record secondary activity as well. Private equity intermediary NYPPEX said total deal volume in 2011 stood at a record $27.5 billion, up 24 percent from $22 billion in 2010. NYPPEX also is estimating that deal flow will rise to $35 billion this year, based partly on regulations continuing to drive activity by banks and insurance companies.

Indeed, in the private equity world, German banks are offloading considerable amounts of their private equity positions. Real estate secondary buyers are wondering when those institutions will begin addressing their property interests.

King of the secondaries
The apparent raincheck on Liquid Realty Partner’s latest fundraising begs the question: who is the mightiest real estate secondary player of them all?

In 2006, it seemed that Liquid Realty Partners could lay claim to being king of the real estate secondaries market. That was the year that the San Francisco-based firm raised a jumbo fund that put its rivals in the shade. The firm, founded by Scott Landress, scooped the record for a single dedicated real estate secondaries fund by raising $720 million for Liquid Realty Partners (LRP) III. 

However, instead of serving as the start of an unrivalled and long run as king of real estate secondaries, Liquid Realty’s achievement turned out to be the coronation of a short-lived reign. One year after the record fundraising, the firm did find additional success when it returned to the market and raised $570 million for LRP IV, exceeding the vehicle’s original $400 million target by more than 43 percent. 

In 2009, however, director of business development Josh Cleveland and director of acquisitions Brendan McDonald left Liquid Realty. Chief investment officer Jeff Giller also left after more than four years at the firm, triggering a key-man clause in LRP IV. More recent personnel exits include Tracey Luke, director of portfolio management, who left earlier this year to join Invesco Real Estate in a similar role.

The steady flow of departures hasn’t helped Liquid Realty with its recent capital-raising efforts. The result has been that the firm has put fundraising on hold for its latest vehicle, which was targeting $800 million in commitments.

PERE understands that Liquid Realty has informed several investors that it has stopped marketing the vehicle and currently is exploring a number of options, including a potential change in focus. The firm is expected to announce any decision regarding its strategy later this year.

In the meantime, others have caught up in terms of fund size. In 2010, Swiss-based Partners Group raised €750 million for the Partners Group Real Estate Secondary (Euro) programme and Landmark Partners raised $718 million for Landmark Real Estate Fund VI in 2011. If Liquid Realty can return in the fall and resume its quest for $800 million in equity, the achievement would go some way in helping the firm to recapture its crown.

The Madison way
Madison International Realty is not a traditional secondaries firm in that it buys direct interests in buildings rather than fund interests. In an interview with PERE, president and founder Ronald Dickerman explains the latest trends helping his business

Madison International Realty, a New York-based firm with offices in Frankfurt and London, is not regarded by other secondaries investors as a traditional player. Rather than acquire fund interests, it focuses on buying direct interests in buildings on a secondary basis.

On the fundraising front, it is a niche that has curried favour with investors. In 2010 and 2011, Madison’s senior management went on the road to collect commitments from investors for its latest offering, Madison International Real Estate Liquidity Fund IV, and succeeded in closing on $520 million in equity – an amount that represents an oversubscription level of more than 20 percent.

Perhaps Madison’s most notable deal arrived in 2008, when it bought a 38.5 percent stake in New York’s iconic Chrysler Building for $10 million and increased its stake to 48.9 percent in 2010. In total, it has invested $55 million in the skyscraper, acquiring its ownership interest from a number of German investors that invested through Commerzbank, which held the building in a joint venture with Tishman Speyer.

Since then, there have been further eye-catching deals involving landmark offices, the latest of which arrived just last month when Madison announced the purchase of a 56.95 percent stake in the Trianon complex in Frankfurt from Morgan Stanley. It bought the interest from Morgan Stanley’s P2 Value fund, an open-ended property fund for German investors that the German financial regulator BaFin ordered liquidated. Although Madison declined to disclose the price, sources familiar with the situation have revealed that the firm acquired the stake for €92 million.

Completed in 1993 and featuring a roof in the form of an upside-down pyramid, the Trianon complex is considered one of the most prominent buildings comprising the Frankfurt skyline. It measures some 46 stories and 700,000 square feet, with the property’s main tenant, DekaBank, under lease until 2024.

In an interview with PERE, Ronald Dickerman, Madison’s president and founder, explains that there are three trends helping his business model.  The first is a reluctance by property owners to sell, even though underlying investors may be looking for an exit.

“Many property owners don’t want to sell their properties because, although cap rates are low, rental rates have not recovered. So their view is to hold it for three, four or five more years to participate in rental rate recovery and then think about selling,” Dickerman says. “What is happening is a lot of asset sales have been delayed and a lot of underlying investors are looking for alternative exit strategies. We are being approached by a tremendous number of investors – the building isn’t going to be sold, but they want to sell their interest.”

The second trend, Dickerman explains, is that a lot of fund sponsors were willing to execute partial interest sales in their core assets. They do not want to sell everything or lose control, but they need liquidity. “We view it as a direct secondary interest,” he says. “The owner takes some chips off the table now and hopes to play some part in rental recovery later.”

The third angle stems from the way banks no longer seem to be ‘extending and pretending’, Dickerman notes. “We are finding that banks are saying: ‘I want my money back now, and you are going to need to make an amortisation payment of 20 percent to 30 percent of the principal in order to pay down the loan’,” he says. “We just executed a transaction in the US where we bought a 49 percent interest in the building, the proceeds of which were used to redeem a mezzanine loan at 40 cents on the dollar.”

Obviously, Madison has a very differentiated business model. “It has allowed us to be much more discerning about the buildings in which we invest,” Dickerman says. “We are looking for core assets with stability of cash flow, whereas equity investors are looking for an alternative or early exit strategy.”