Achieving the right balance isn’t easy. In recent years, large real estate investors have been pushing for greater control over how their capital is deployed. Unfortunately, such an approach hasn’t always worked out for those investors.
“By and large, when looking at new investments, investors are trying to solve for things that went wrong for them in their most recent experience,” said John Ferguson, partner and co-chair of the real estate private investment funds practice at law firm Goodwin Procter.
Back in 2008 and 2009, during the depths of the downturn, investors found themselves locked into discretionary funds and unable to stop GPs from deploying capital at a time when many institutions were seeking to rebalance their portfolios. “It was a function of having made commitments in a very different environment and time than when the commitments were actually being deployed,” Ferguson explained. “For so many investors, things had changed, so they were seeking a little more flexibility than what the fund model offered them.”
In recent years, many large investors consequently sought to allocate real estate capital through separate accounts and joint ventures that offered them a greater degree of control and influence than they would have through funds. Additionally, these vehicles provided investors with more flexibility to increase or decrease their capital allocations to managers, as well as more advantageous fee structures. The two largest US pension plans, the California Public Employees Retirement System and the California State Teachers’ Retirement System, for example, have invested the bulk of their real estate capital in just this manner.
Some institutions, however, already have expressed buyer’s remorse in forgoing the fund route. Take, for example, the comments of the real estate head of a large foreign institution, as cited in the September market commentary from real estate advisory firm Hodes Weill & Associates: “Organizing JVs and programmatic ventures with quality operators is enormously time consuming and I feel like I’ve missed too much of the market recovery since the financial crisis while I was negotiating JV agreements. Where might my portfolio be today if I had just held my nose and continued to invest in funds?”
Indeed, a major drawback of investing in higher-control vehicles is the time required in structuring them. John McClelland, principal investment officer for real estate at the Los Angeles County Employees Retirement Association, noted in a 2012 interview with PERE, it is a lot easier and faster for a public pension plan to get money committed through a fund than it is to conduct a search and negotiate a separate account. Making a commitment to a commingled fund can take as little as three months – from the first meeting with the sponsor to conducting due diligence on the GP and the fund strategy to negotiating and signing an agreement with the sponsor. By contrast, setting up a separate account easily requires nine to 12 months.
Moreover, vintage 2008 to 2010 funds ended up performing significantly better than they would have if the LPs had greater control over investments and forced the GPs to sell at the bottom of the market. It’s no surprise then that Korean institutions and sovereign wealth funds have been turning their attention to funds, while US public pension plans have been returning to funds after a period of inactivity in real estate, according to the Hodes Weill report.
Of course, if those funds hadn’t performed well, there might not be the renewed interest in discretionary funds there is today, suggested Timothy Walsh, president and chief operating officer of Gaw Capital Partners USA and former director of the New Jersey Division of Investment. “If you made an investment in funds or JVs in 2009 or 2010, it was hard to lose money,” he said. “It’s really where you are in the cycle.”
That said, with more investors coming into the funds, the balance of power between LPs and GPs is shifting once again. Prior to the global financial crisis, GPs were in the driver’s seat, with many funds oversubscribed and LPs clamoring to get into the vehicles; post-crisis, the exact reverse happened. “The tide is going to continue to ebb and change with the market in terms of the GPs being in control and the LPs being in control,” said Walsh. Currently, on a scale of 1 to 10, with 10 being most favorable to LPs, the market is at about a five right now, he noted.
Despite the growing popularity of funds at the moment, separate accounts and programmatic joint ventures aren’t going away. “There’s a reasonably healthy pipeline of all three,” said Ferguson. “My sense is that on both the GP and the LP side, you’re seeing people being a lot more thoughtful about what vehicles make the most sense for them.”
Indeed, it appears that both GPs and LPs have learned sobering lessons since the crash. Therefore, we wouldn’t expect the pendulum between GPs and LPs to swing from one extreme to the other again; rather, it should remain in relative equilibrium for the foreseeable future. Considering all of the ups and downs of the past several years, that could be just what the market needs.