FEATURE: The right diversification

The real estate fund of funds market is going through something of a metamorphosis at the moment. Today, its major protagonists are more comfortable being referenced as multi-managers – the inference being they do much more than allocate capital to a series of underlying funds. That has been evidenced by their increasing participation in other types of transactions, such as joint ventures, secondaries and co-investments stakes.

However, that’s not the only change happening. The investment thesis centring on the theme of diversification in the portfolio is evolving as well.

Diversification for the sake of diversification was the objective, with a goal of checking the box for each of the allocations
Jerome Gates. Hamilton Lane

According to Jerome Gates, global head of real estate at independent financial services firm Hamilton Lane, investors previously targeted allocations to global regions and property sectors with little in the way of supporting data or reasoning to justify their allocations. “Diversification for the sake of diversification was the objective, with a goal of checking the box for each of the allocations,” he says.

For Gates, that approach has proven shallow. “The question investors should be asking today is whether or not maximising diversification is the correct approach in this uncertain economic environment,” he says. “Or should the objective be highly focused strategies?”

PERE spoke with senior executives of Franklin Templeton Real Asset Advisors and Aberdeen Asset Management – the only two multi-manager platforms to close on meaningful amounts of equity for commingled funds in 2012 – to understand their thoughts on the subject. While they agree that diversification is still of critical importance, its evaluation is a moveable feast and warrants the consideration of many more factors than before.

Elimination of correlation

Franklin Templeton regards achieving diversification a perennial task, with managing director Marc Weidner maintaining that diversification is “the ultimate risk mitigator.” Still, achieving true diversification is not a “one-step box checked.” It is more a constant and active elimination of correlation in the portfolio.

“The obvious starting points are fund vintage, fund manager, asset class and strategy diversifications,” Weidner says. “But there are forces in today’s market environment that are trans-national and trans-product, and there are many others in the capital markets too. You need to think about these as well.”

Franklin Templeton is less than half-way invested on the $319.2 million of equity it closed on in May for its Franklin Templeton Private Real Estate Fund, a global fund loosely intended to invest one-third of its capital in each of the US, Europe and Asia. However, within these thirds, Weidner says the firm is taking a far more granular approach to its underlying investments to ensure it avoids situations of ‘false diversification’.

It shouldn’t be part of our discussions because it’s a core deal, but the reason it is not core is because of a complicated situation between the bank and the owner

Marc Weidner, Franklin Templeton

“We know of a fund investing in 2000 that was geographically diversified in continental Europe but focused solely on suburban offices,” Weidner recounts. “The manager didn’t want to take a lot of repositioning and development risk, so they bought ‘vacancy’. That had huge correlation because the tenant base for suburban offices in continental Europe is pretty much the same in Spain, Italy, Germany and France. To have the same tenants competing in the same marketplace was counterproductive.”

So how has Franklin Templeton avoided correlation and achieved diversification for the approximately $160 million of capital it has committed so far? Weidner says the firm is taking a cautious approach to Europe in light of the current Eurozone crisis, which is precipitating a long-term structural downturn on the back of conflicting political agendas. As such, investments have only been made in economies on the fringes of the Continent to avoid investments in countries too negatively correlated to one another.

For example, Franklin Templeton has invested just under $50 million in the UK and the Nordics. In the UK, the firm co-invested alongside a fund suffering from a “scarcity of capital,” while the Nordics investment was into a fund focused on the somewhat insulated markets of Finland and Sweden.

These markets are not immune to the Eurozone crisis, but they are relatively distant from its epicentre. At the same time, they offer capital and structural inefficiencies, enabling Franklin Templeton to take sizable and controlling (or at least influencing) positions in investments that, in healthier times, the firm would be nowhere near. Today, they need “re-equitisation,” as Weidner termed it.

In the US, Franklin Templeton is achieving access to similar assets. “We’re looking at an asset in midtown Manhattan,” Weidner says. “It shouldn’t be part of our discussions because it’s a core deal, but the reason it is not core is because of a complicated situation between the bank and the owner.” In his experience, prevalent equity gaps “can be called at a premium,” and his firm intends to add to the $45 million already invested.

Diversified in itself

The remainder of Franklin Templeton’s active capital from its global fund is invested in Asia, where it has invested in a traditional pan-Asia commingled fund as well as a Japan fund with a predominately nonperforming and sub-performing loan strategy. It is in the East that the firm believes there is enough diversification to warrant a bespoke Asia fund of funds.

Indeed, in March 2010, Franklin Templeton launched its second Asia effort, Franklin Templeton Asian Real Estate Fund II. However, in more than two years since, the firm has yet to announce a capital closing. Nonetheless, Weidner contends that the thesis for the vehicle remains sound.

“Asia is a universe to itself,” Weidner says, pointing to developed countries like Japan and Australia, which sit near to developing countries such as China. “In Asia, when you start getting more granular, you can find a lot of diversification and a lot of inefficiencies to take advantage of.”

While Franklin Templeton has not announced closings for its Asia effort, Aberdeen Asset Management certainly has. In April, Aberdeen held a first closing on $242 million for its Aberdeen Asia Fund of Funds III and an almost equal amount for a side-car co-investment programme.

Jon Lekander, Aberdeen’s global head of indirect investments, agrees with Weidner’s depiction of Asia as the one region that can offer standalone diversification. “The reason is because Asia as an economy and as a geography is much more segmented,” he offers. “You don’t have the trade agreements that Europeans or North Americans have, and there’s actually competition between various countries.”

Asia as an economy and as a geography is much more segmented. You don’t have the trade agreements that Europeans or North Americans have, and there’s actually competition between various countries
Jon Lekander, Aberdeen Asset Management

However, Lekander perceives Asia becoming gradually less diverse over time, and the notion that an investor can achieve true diversification in the region could erode. On the other hand, he sees the Eurozone crisis and its potential unravelling as offering a level of diversification in the region not seen since the formation of the European Union almost two decades ago. When asked when Europe might become more of a multi-jurisdiction play, he adds: “Frankly, I see those tendencies already.”

While the diversification potential might improve for real estate fund of funds, Lekander is not rubbing his hands with anticipation, as he sees it as a “double-edged sword.” That  is because the majority of the firm’s investors come from Europe and Lekander would rather Aberdeen’s armoury of expertise in the region was not subjected to “more of a level playing field” as non-direct fund managers take to creating pan-European vehicles.  “The more complex it becomes, the more it makes sense to wrap a fund of funds around it,” he admits.

Still, that is hypothetical talk. As things stand, Franklin Templeton is skirting around Europe’s edges and Aberdeen’s only live multi-manager product in Europe right now is an €85 million separate account on behalf of the Employees Retirement System of Texas, which was won in February and is focused on value-added and opportunistic funds.

Voices of the disaffected

According to PERE’s Capital Watch, roughly $2 billion was raised for commingled multi-manager vehicles last year and, despite $7.03 billion currently being sought for such strategies, the fact that half the year has passed and just Franklin Templeton and Aberdeen have closed on significant capital has led various advisors to question the need to seek diversification through such a model in the first place.

Ted Leary, an advisor of US institutions at Crosswater Realty Advisors, says: “I personally haven’t seen any so-called increased benefits such as diversification that off-set what I believe are very serious weaknesses in the model, such as higher total fees and watered-down governance, controls and LP rights. The market must be reflecting that reality.”

Another disaffected advisor, Kelly DePonte, partner at Probitas Partners, says investor antipathy towards multi-manager products has deterred his firm from focusing on the sector. “Especially since fewer investors are focused on opportunistic (real estate investing), and the additional level of fees and expenses of a fund of funds really knocks returns.”

Still, for those that have kept faith with the commingled multi-manager model and with groups like Franklin Templeton and Aberdeen – and evidently there are a few investors that have – they will be pleased to hear that diversification for diversification’s sake is an acute concern for these firms. They are all about ensuring that true diversification and not correlation remains of paramount importance.