As the old proverb goes, the first step is always the hardest. In the world of private equity real estate, that first step involves reaching a first close during fundraising.
“It’s very, very difficult getting people to commit to a first close,” says Kelly DePonte, managing director at Probitas Partners, a San Francisco-based alternative investments placement agent and advisory firm. Investors may be hesitant to commit because of portfolio issues relating to underperforming funds of prior vintages, or perhaps they would prefer to wait and see what other investors – or investments – come into the fund.
Indeed, fewer commingled real estate funds are reaching their first closes, and those that do are taking longer to get there. According to real estate consulting firm The Townsend Group, less than 20 percent of funds that launched in 2011 achieved a first close after less than one year in market, compared to more than 60 percent in 2005. As a result, more fund managers are offering incentives to prospective investors.
Give me a break
“One of the things that a general partner has to do is generate a strong first close,” says DePonte. “If you have to use fee breaks to get a strong first close, it’s worth it. Otherwise, you can get stale.”
Fee breaks are nothing new, of course, and were offered to investors even in more robust times. Such breaks typically were offered by second-tier managers that had performance issues with prior funds. First-close fee breaks, however, have become more common over the past 18 months to two years, even with GPs that have strong track records.
“In our conversations with GPs, a lot ask about it,” says DePonte. “Even if they don’t go out and offer fee breaks on the first close, they’ve thought long and hard about it.”
Edward Schwartz, co-founder of ORG Portfolio Management, a Cleveland-based real estate consulting firm, has seen a marked increase in first-close fee breaks, estimating that up to 75 percent of general partners currently are offering such reductions. “Just about everyone is challenged,” he says. “You’re getting more and better discounts and from better managers.”
Schwartz points out that all of his firm’s clients – primarily consisting of US pension plans such as the Texas Municipal Retirement System (TMRS) and the Indiana Public Retirement System – have received fee discounts, generally ranging from 25 percent to 40 percent. “We have never been told that a manager didn’t want our clients,” he adds.
In addition, managers have become more upfront about discussing fee breaks rather than waiting for LPs to bring it up, notes Anthony Carpenito, managing director and head of real estate at Credit Suisse Private Fund Group, the private placement arm of the Swiss bank. “It’s truncating this dance,” he says. “Rather than killing six months of time, GPs are going into meetings at early stages with pre-determined fee breaks for large and early investors. That’s wise, given how long these fundraises take.”
More aggressive and creative
Those fee breaks also have become more aggressive and creative. The $500 million commitment to The Blackstone Group’s new Asia-focused fund, Blackstone Real Estate Partners (BREP) Asia, by the New Jersey Division of Investment (NJ DOI) in March is a prime example. The investment, which accounted for 14 percent of the vehicle’s $3.5 billion target, is New Jersey’s largest in real estate to date. In exchange for its early sizeable commitment, the $72.8 billion pension plan received what is said to be one of the most favorable terms that Blackstone has ever granted a limited partner.
The standard fees for BREP Asia are a 1.5 percent annual asset management fee and an 80/20 catch-up over the preferred return of 8 percent. New Jersey, however, negotiated a management fee of approximately 0.76 percent on committed capital during the investment period, based on an eight-month fee waiver, and 1 percent on invested capital thereafter. In addition, Blackstone would be subject to a reduced catch-up rate of 65 percent over the 8 percent preferred return.
“We ask for fee breaks on everything we do,” says NJ DOI director Timothy Walsh. However, he adds with a chuckle, “We don’t always get it.” The pension plan usually writes large checks when it invests in a fund and tries to secure special terms in return – sometimes more favorable than the fee discounts that other limited partners may be getting.
A typical fee break is a 25 basis-point reduction on management fees – similar to the one Blackstone offered to investors committing $200 million or more to its Asia fund. However, “as a general rule, 25 basis points isn’t going to push us over the goal line,” says Walsh. “A third off the standard fee – 1 percent instead of 1.5 percent, for example – that’s something that’s going to get our attention.”
Icing on the cake
The New Jersey commitment isn’t the only recent real estate investment where fee breaks have played a key role. At press time, Ohio Police & Fire Pension Fund was due to consider at its April board meeting a commitment of up to $50 million to a new open-ended core fund managed by USAA Real Estate, with the state expected to receive fee discounts of as much as 50 percent for being a founding investor in the fund.
Meanwhile, at its March board meeting, TMRS committed a total of $250 million to three real estate funds – Invesco Real Estate’s Invesco US Core Income Fund, Abacus Capital Group’s AbaCore I and Lubert-Adler Partners’ Lubert-Adler Fund VII. In all three vehicles, the $20.4 billion pension plan will be a founding investor and receive meaningful fee breaks. For example, as a first-close investor in the new Lubert-Adler fund, TMRS will pay reduced management fees, consisting of a 1.25 percent fee on the total commitment during the commitment period and 1 percent of the total equity in unsold assets after the commitment period.
Schwartz, however, asserts that “there’s no particular emphasis” on first-close fee breaks when ORG is evaluating new managers for clients. “We feel like we pick the best managers, irrespective of fees,” he says. “We have a scoring matrix, and a low percentage of that score goes into fees.”
For New Jersey, “the fee break is the icing on the cake,” says Walsh. “The important part is the quality of the manager and the quality of opportunity.” Such was the case with Blackstone’s new offering, which is the firm’s first real estate fund focusing on Asia, a region where the state pension also is seeking to increase its overall portfolio exposure. Blackstone – a top-quartile manager in anyone’s book – is said to have a need for fresh capital for investments in Asia, given its pipeline in the region and the pace at which it is investing its latest global real estate fund, BREP VII, hence the urgency for building momentum for BREP Asia with a strong first close.
While a first-close fee break may not necessarily have an impact on an investor’s decision to commit to a fund, it does influence the timing of the investment. If NJ DOI hadn’t received a significant fee break on its BREP Asia commitment, “we probably would not have been a first-closer,” says Walsh. “We probably still would have invested; we just don’t think we would have invested in the first close.”
As Walsh points out, the pension plan at any given time is considering multiple investment opportunities across various asset classes, including real estate, private equity, energy and hedge funds. Meanwhile, it has limited time with its board, which holds meetings only six times per year. “There’s a balancing in terms of who’s going to come first,” he says. “If we’re trying to make a decision to go with a real estate fund or a private equity fund or a hedge fund, we’ll often give precedence to a fee break at first close.”
Advantages and risks
Of course, the benefits of being in a first close extend beyond just fee reductions. “If we’re going to be involved in a fund, we like to be involved early” to help set terms such as catch-ups and preferred returns, says Walsh, noting that NJ DOI has been a first-close investor in about one-third of the real estate funds to which it has committed capital over the past two-and-a-half years. “I think being involved early on the general terms is important, more important than just straight fees.”
For this reason, Schwartz says it’s important as a consultant to be on top of both current and future fund offerings, which includes discussing with managers the possibility of clients being seed investors in funds that still are in the idea stage. “When you start something from ground zero, you can craft it in a manner that’s more advantageous and more investor-friendly than a multi-million dollar fund that’s ready for the last close,” he explains.
At the same time, being a first-closer has its risks. Being an early investor often entitles that party to a fee break, but the investor is subject to substantial blind-pool risk.
“There’s a major trade-off here,” says Carpenito. “If you think you can drive a meaningful fee break and trust that the GP will build a portfolio to your liking, then it’s important to be in that first close. If the fee break is not as large as you would hope or you need to see more evidence that this is a manager to which you truly want to commit capital, then being in the first close is not that important.”
The dilemma is more pronounced with smaller investors, which only can drive fee breaks by being early, rather than size of commitment, and need to rely on a credible lead investor or investors to make a first closing a reality. As a result, smaller investors typically won’t engage with a manager until there already is at least one large investor leading the first close and, by then, there may not be enough time for that investor to complete due diligence in time to participate in the first close. “There’s a tension within smaller investors on how they prioritize things,” Carpenito adds.
Meanwhile, general investor skepticism about a GP’s ability to source and execute deals remains an issue, notes Carpenito. “What LPs continue to worry about are commitments to a vehicle that cannot deploy capital at a quick enough rate, lengthening the amount of time where an unfunded liability is out there and increasing the chances of not getting all their capital to work,” he explains.
For that reason, “we think first-close fee breaks will continue to be prevalent because a lot of people don’t want to take that chance and move forward,” says Schwartz. “We think it’s going to continue for the next several years.”