There are 37 private equity funds on the books of Wall Street investment banking giant Morgan Stanley. The number is a testament to the decades that the bank has been actively investing in alternative assets. Its emphasis on this area of principal investing has been further demonstrated by the large amounts of balance sheet capital it traditionally has placed in these funds, which range anywhere from 10 percent to more than 20 percent of the total equity.
Morgan Stanley’s approach to alternative investing, however, is changing in the face of incoming regulation. Midway through 2014, the Volcker Rule – part of the incoming US financial institution regulatory changes brought about through the Dodd-Frank Wall Street Reform and Consumer Protection Act – is expected to come into effect, essentially limiting co-investment in private equity funds by the country’s financial institutions to just 3 percent.
With little more than one year to go, it would be easy to suspect panic at Morgan Stanley, but management at the investment bank is calm. The majority of the bank’s 37 funds, by their nature, are self-liquidating and should be wound down before or within a few years after the rule comes into full effect. More than two years since its first draft, the implementation of the rule remains in flux, but the bank is confident its conformance efforts should enable all but one of its funds to wind down in an orderly manner.
The outlier is Morgan Stanley Real Estate Special Situations Fund (SSF) III, an open-ended real estate opportunity fund launched in 2006 through which the bank’s private equity real estate platform, Morgan Stanley Real Estate Investing (MSREI), made non-controlling investments in real estate operating companies, predominantly in emerging markets. At its peak, SSF III held almost $6 billion in equity from institutional investors, high-net-worth individuals and, crucially, the bank’s own balance sheet. If left untouched, SSF III would, by its evergreen nature, perpetually contravene the Volcker Rule.
Formulating a plan
Following an external strategic analysis, commissioned by MSREI in the autumn of 2011 in conjunction with the fund’s advisory committee, the bank has devised a plan it believes would both comply with the Volcker Rule and meet the needs of its investors, as well as the fund’s management team. Late last month, the firm put its plan to a vote, which is expected to last one month, and has embarked on a roadshow to explain the inner workings of the plan to the fund’s investors in an effort to push it through.
If successful – and MSREI is confident it will be – the vote will kickstart an approximately five-year plan to slowly liquidate about 40 investments currently valued at $2.9 billion. A simple majority vote also would effectuate the birth of Proprium Capital Partners, an independent manager spun out by six executives of the fund’s management team, led by chief investment officer Tim Morris and global portfolio manager Jan-Willem de Geus. Initially charged with winding down SSF III, Proprium also would offer investors loyal to its management and strategy a similarly-structured vehicle through which to reinvest their distributions.
Last month, on the cusp of the vote, MSREI’s chief financial and operating officer Michael Levy exclusively walked PERE through the plan for Morgan Stanley to reposition itself in the face of the Volcker Rule – with a view to very much remaining one of the world’s most active private equity real estate players.
MSREI is one platform among a small group of financial institutions not to have deserted the industry as the US government seeks to curtail the more speculative investment activities of the country’s financial institutions – a fact not lost on Levy. “People often say to me, ‘Many other financial institutions are exiting the business, why aren’t you?’ The fact is we have continued to be successful in investing our current funds as well as raising new capital, including almost $2 billion this past year. We are delivering for our investors,” he says.
On the road again
Whether MSREI’s investors want to back funds offered by the bank when it co-invests just 3 percent of the equity is another matter. The platform is coming to the end of the investment period for its Morgan Stanley Real Estate Fund (MSREF) VII Global opportunity fund, and future funds will prove to be the litmus test. In the meantime, MSREI’s efforts will be channelled into its forthcoming roadshow to convince the majority of the 40 or so institutional investors in SSF III to back its plan for the fund.
Levy says there already is support from within the nine-member advisory committee, which includes the California State Teachers’ Retirement System, Washington State Investment Board, the Abu Dhabi Investment Authority and the Abu Dhabi Investment Council. There also are a few hundred high-net-worth individuals invested in SSF III, and they will be offered an opportunity to react to and vote on MSREI’s plans during the voting window as well.
“We will seek to meet with each investor in the fund, whether it is face to face, by webcam or conference call,” says Levy, adding that much of the senior management of MSREI will be involved to one degree or another. “Tim and Willem will take the lead, and Olivier [de Poulpiquet], John [Klopp], Hoke Slaughter [head of Asia], Brian Niles [head of Europe] and I may attend as well. Some investors will understand what we’re doing immediately, while others might require additional education. Investors may be worried about motivation, but it’s their money and they’re entitled to ask any questions they may have.”
Despite his confidence in a positive resolution, Levy nonetheless knows there is plenty of hard work to come. “Trying to develop a consensus view on this unique situation among nine LPs with different perspectives and geographies has been one of the more challenging things I’ve done,” he says.
Issues and solutions
MSREI will talk investors through the main takeaways from the strategic analysis that SSF III’s advisory committee commissioned to boutique advisory firm Evercore Partners and law firm Schulte Roth & Zabel back in 2011. First, working off an initial legislative framework (mindful that the Volcker Rule is not yet crystallized) coupled with what Levy describes as regular, recurring dialogue with the Federal Reserve, MSREI has determined that its funds need to comply with the rule’s 3 percent equity limitation. Second, most of the investors on the advisory committee want to continue their investment in a real estate investment vehicle with a strategy like SSF III and want to stick with the same management team, he adds. Lastly, the investors want an alignment of interests. “For this fund, the alignment was through the capital,” he says, noting that MSREI’s 24 percent stake in SSF III equates to about $700 million – in other words, plenty of ‘skin in the game’.
Levy believes the chosen course of action reconciles these needs. If approved, SSF III would become a closed-ended fund. Distributions arising from sales would not be reinvested as per the fund’s current charter but distributed back to investors. There currently is approximately $600 million in distributions in the fund, but half of this is expected to remain as reserves or for contingencies. The initial distribution therefore would be limited to approximately $250 million. Then, as each quarter passes, the intention is to continue returning distributions until the last investment is exited.
In case any MSREI competitor is planning a raid on SSF III’s assets, Levy stresses that there will be no fire sale. “Over the next five years, this portfolio will monetise. The majority of the investments may monetise before then. It’s not a contractual limit but the business plan for the underlying investments, so there will be no fire sale. We have no contractual or regulatory pressure to do that.”
That deals with MSREI’s path to compliance with the Volcker Rule, but what about meeting investors’ objectives? Securities and Exchange Commission rules prevent Levy from talking about it, but PERE understands that investors of SSF III wishing to continue investing in the strategy would have the opportunity to reinvest their distributions with another similarly-structured fund to be run by Proprium.
Before then, however, Proprium’s primary responsibility will be to wind down SSF III and, to that end, MSREI has awarded to it a sub-advisory mandate to do the job as an independent business.
Levy will say that Proprium would be supported by MSREI during the transition process and that MSREI already has invested “thousands of man hours and millions of dollars” in legal and other restructuring costs to get the firm ready in anticipation of a nod from investors. Proprium will not fundraise from day one but, should early distributions from SSF III become early commitments to the new firm, expect it to make investments of its own before too long.
Making the most of it
Of course, the situation is not ideal for MSREI, which has, aside from the 2007 vintage of its better-known MSREF fund series, made opportunistic returns from its private equity real estate investments. Nor is it ideal for the investors of SSF III, which committed their capital immediately prior to the start of the global financial crisis and want to ride the recovering property markets with as little disruption as possible in order to make at least some profit from their outlays.
For some investors, switching from one platform to another, regardless of personnel continuity, might be too hard to swallow. How investors ultimately feel is likely to be a function of how well the fund ultimately performs, but PERE has heard forecasts that the fund is projected to return all of the original equity once all of its assets are exited – and that could smooth things over. Levy declined to comment on the fund’s performance.
Though the final outcome is still not crystal clear, more visible is Morgan Stanley’s need to conform to a rule likely to come into force midway through next year. As such, a positive vote from its investors would signal its next chapter in private equity real estate – a chapter in which it is a 3 percent investor in its funds and not a 10 percent to more than 20 percent investor. Whether that is good enough for its investors remains to be seen.
Morgan Stanley Real Estate Special Situations Fund III
Launched: 2006
Led by: Chief investment officer Tim Morris and global portfolio manager Willem de Geus
Initial capital: $2.24 billion
Highest capital: $5.9 billion (third closing, 2008)
Current capital: $2.9 billion
Current co-investment: 24%
Strategy: Non-controlling investments of between $30 million and $100 million in the securities of real estate companies globally, but predominantly in emerging markets.
Representative investments: Investa Property Group, an office investment firm in Australia; RosEuro Development, a multi-sector developer in Russia; Oberoi Construction, a multi-sector developer in India; Callahan Capital Partners, a US private equity real estate firm.
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