Over the summer, the California Public Employees’ Retirement System (CalPERS) made the first investments in its new $200 million real estate emerging manager program. Through the Canyon Catalyst Fund, a joint venture with Canyon Capital Realty Advisors, the $266 billion pension system allocated capital to four early-stage managers, all of which are expected to make between $60 million and $100 million of acquisitions.
By all appearances, it looks like the program is off to a good start. The underlying firms are said to be receiving capital allocations of $30 million to $50 million, which with conservative leverage would appear to be sufficient to meet the $60 million to $100 million investment objective. However, it is said that the fee structure for the program benefits Canyon Capital more than it does the emerging managers.
The issue mirrors something already recognized. That is, being undercapitalized is a common challenge for emerging managers, even when they have a mandate from an institutional investor, as John Baczewski, president of Real Estate Fiduciary Services, noted in a paper released last month. “Often the emerging manager is undercapitalized and the revenue stream from an initial allocation of institutional capital is insufficient to cover required overhead, even if the institutional capital provider agrees to relax some typical requirements,” he wrote.
Emerging managers, moreover, tend to be more undercapitalized than even they realize. “What we do is look at an emerging manager and their operating budget and, quite frankly, it’s usually too short,” said Marc Weidner, managing director at Franklin Templeton Real Asset Advisors, a multi-manager that invests in emerging managers both through funds and joint ventures. “Sometimes they tend to be too optimistic, or they cut corners.”
A failure to provide sufficient capital to an early-stage firm threatens that business’ long-term viability, added Larissa Herczeg, managing partner and chief investment officer of the fund of funds platform at Oak Street Real Estate Capital. “If you’re really pushing too much on fees and they don’t have enough to build out their team, or if you’re taking too big a piece of the economics or structuring their economics in a way that’s going to be a deterrent for other investors coming in, that would hurt them in the long term,” she said. Ultimately, if firms aren’t getting the exposure, investment authority or economics that they need, people will start leaving the firm.
Considering that most real estate emerging manager programs have been in existence for less than 10 years, it’s too early to provide graduation rates for such programs, Weidner noted. “But our expectation is that the graduation rate is relatively small because we are in a difficult fundraising environment for both emerging and emerged real estate managers,” he said.
Indeed, the examples of graduates from real estate emerging manager programs – of which there currently are less than 10 – are few and far between. One is Capri Capital Partners, which was one of three firms that the Los Angeles County Employees Retirement Association (LACERA) hired shortly after it established a real estate emerging manager program back in 2001. Still, it wasn’t until this year that the pension plan said it anticipated moving Capri from an emerging manager – with a capital allocation limit of no more than 10 percent of LACERA’s property portfolio – to a mainstream manager, which has a 35 percent allocation limit. Such a move would make the Chicago-based investment firm the first to graduate from the program.
Meanwhile, one of the managers under the Employees Retirement System (ERS) of Texas’ real estate emerging manager program is expected to graduate to a direct relationship in the near future, when the pension system commits to the firm’s third fund. Previously, ERS had invested in the manager’s second fund through a fund of funds program.
The progress of this manager is notable in that ERS started its program less than three years ago. “You don’t go from infancy to adolescence in a day,” said Herczeg. “If it’s a $50 million first-time fund, it’s going to take two or three or four funds before a large pension fund can invest directly.”
While some emerging managers may be undercapitalized, Herczeg asserted that most programs have sensible allocations to allow firms to meet their investment objectives. Instead, the main challenge affecting emerging manager programs is ensuring that managers are successful not only in raising and investing their first funds, but also the funds that follow. “Some of the programs are just too short-sighted,” she said.
“They’re focusing on getting the best deal you can get today rather than the emerging manager being successful in the long term. Fund II could be a struggle even if everything was done right in Fund I.”
Of course, it’s not easy for a US pension plan to necessarily think of the long term when they have short-term investment objectives that they have to meet on behalf of their constituents. That said, if they are committed to making their emerging manager programs a success, they may have to make some near-term sacrifices – be it larger initial capital allocations or otherwise – in exchange for the longer-term gain of seeing the firms they’re backing hit the big time. If this mindset is more widely adopted, we might see graduation rates finally start to pick up.