SPECIAL REPORT: The white knights of PERE

Fund rescue situations in the private equity real estate industry do not happen regularly but, when they do, they usually create a stir. That is because distress invariably is at the heart of these situations – either within the fund, its sponsor or both – and almost certainly for the investors. 
The opportunity for peers to rubberneck is irresistible. However, while morbid curiosity undeniably is responsible for high levels of interest when these situations arise, so too is another factor – the solutions on the table. More than that, industry players want to know which firms and individuals will attempt to play at white knight and save the day. 
Whether to obtain financial rewards, to demonstrate capabilities to a captive pool of investors or to expand operations into new geographies, private real estate investment managers are quick to pitch for rescue work when it becomes available. 
“People do it for a number of reasons,” says Jos Short, co-founder of Internos Global Investors, a London-based firm that sought rescue opportunities as a way of building its business. Launched in 2008, Internos has grown considerably by turning around problem funds and today has approximately €4.1 billion of property on its books for its efforts. 
It is not only start-ups that are looking to show their white knight credentials. Since the global financial crisis, industry giants including The Blackstone Group and LaSalle Investment Management have taken on rescue mandates as well in an effort to enhance their reputations among potential partners and expand their operations into new markets. “What better way is there of getting investors into your next fund than by being the white knight who has come in and minimized the damage of their old fund,” says John Cahill, a New York-based partner at law firm Paul Hastings and a veteran in the field of fund management changes. 
It is unsurprising that some of the industry’s biggest names have engaged in rescue operations given the high profile of some of the funds that have needed saving as well as the scores of highly influential institutional investors trapped in those funds. Funds raised by Bank of America Merrill Lynch (BoAML), GPT Halverton, Winnington Capital, JER Partners, GE Capital Real Estate and Corestate Capital are just some of those currently in the process of being rescued. BoAML’s fund had 25 of the world’s largest investors committed, JER had 40 investors and Winnington had a remarkable 145 investors.
As such, PERE has put together this special report – examining the catalysts leading to fund rescues, the challenges for those involved in seeking a resolution, the attraction for incoming managers and, indeed, what constitutes a successful rescue – in an effort to shine light on this sensitive but dramatic segment of the private real estate investment market. 
Those key words 
Whether a fund is in need of rescue almost always is determined by its performance. Ken Muller, partner in the San Francisco office of law firm Morrison Foerster (MoFo), says that even in situations where a sponsor has contravened contractual agreements, if its performance is strong, investors often will not seek a replacement. “Many people take the view that if the portfolio performs, then everything is forgiven,” he adds. When performance is poor, however, that can encourage an investigation into a manager’s business practices, and that typically is when the removal of a manager is an option explored. 
That also is when a fund’s documents become important. Before the crisis, most private real estate fund documentation was heavily weighted in favor of protecting the manager. Without being able to satisfy a ‘dismissal for cause’ stipulation for contractual breaches like fraud, willful misconduct or gross negligence, investors were stuck with their manager. “Most LPs felt they had bet on a manager and, if it wasn’t working, they were resigned to putting the fund on the shelf in the hopes of a return one day,” Cahill notes. 
Mark Burton, the former chief investment officer of sovereign wealth funds Abu Dhabi Investment Authority and Abu Dhabi Investment Council (ADIC), says: “Those are the key words: ‘with or without cause’. Very few managers would allow documentation that allows you to terminate them without cause.” 
In 2010, ADIC was one of 25 investors that successfully removed BoAML from the management of its $2.65 billion pan-Asia opportunity fund, Merrill Lynch Asian Real Estate Opportunities Fund. It was the largest change of management for a single opportunistic property fund in recent history.
Although there was no dismissal without cause clause in the fund’s documents, its 25 investors were able to convince BoAML that they could demonstrate it had undertaken certain actions considered to be non-fiduciary. “Otherwise, it would have been nigh on impossible to remove them,” Burton recalls. “You must find a cause that will stand up to pretty strong scrutiny.” 
With BoAML conceding, the investors secured both a transfer of the fund’s management to industry titan Blackstone as well as a settlement valued at $650 million. 
Eric Piesner, managing partner of MoFo’s Singapore office, notes that, with a greater choice of funds available to investors nowadays and many managers willing to cede more ground than before when negotiating documentation to ensure capital commitments, ‘no fault divorce rights’ are becoming more common. “Then it just becomes a question of what the voting threshold for that is,” he adds. 
According to Cahill, the threshold typically is 75 percent or another pre-defined ‘super majority’. However, he points out how corralling a large pool of international investors is a challenging task in itself. “Trying to get LPs together as a group when they are not naturally a group is a practical impediment,” he explains. “They need to create their own steering committee like they are creditors in a bankruptcy.” 
In the case of BoAML’s fund, the LP advisory committee was described as “probably the most active advisory committee in private equity.” It was an exception rather than the norm. 
A contentious situation 
There also was no dismissal without cause clause in the fund documentation of Hong Kong hedge fund manager Winnington Capital’s Trophy Property Development fund, once China’s largest private equity real estate vehicle. Paul Hastings was one of three law firms hired last year to advise on a resolution for the firm, its 145 investors and its operating partner, Hong Kong developer Shui On Land, after it become apparent the fund’s investments could not be exited and a stand-off had ensued between its principals. 
Cahill recalls how, despite the fund’s dire outlook, technically there was little cause for investors to remove the sponsor. “It was a prime example of poor investment decisions being made and the LPs wanting a change, but frankly they didn’t really have good grounds,” he says.
The Trophy Property fund eventually was resolved via a complicated asset swap between Winnington and Shui On, with a senior team extricated from Winnington as its new manager. It too involved a majority vote, but from a wider array of investors ranging from US pensions to individual investment bankers.
Nick Wong, principal at Cleveland-based investment and advisory firm The Townsend Group, one of the Trophy Property fund’s investors, says: “The relationships had become so bad the LPs needed to step in to salvage value.” Referencing the absence of a dismissal without cause clause in the fund’s documents, he notes that Townsend today would not commit its discretionary capital to funds not offering the clause – even if Townsend’s advisory clients still might consider such vehicles. 
One important factor in replacing managers is their co-operation. For a significant time, Winnington was reluctant to relinquish its position given that the Trophy Property fund represented the majority of its business, which made its handover challenging for all concerned. It was different for BoAML because the bank was keen to preserve relationships with the investors since they also were active across its other business lines. 
The opposite was the case with Virginia-based JER, which relinquished its JER Europe Fund to LaSalle in 2012. Indeed, JER even helped to select a replacement for the €850 million vehicle. A “very transparent and collaborative process,” LaSalle’s European head Simon Marrison says JER “was very professional about it, as were the investors.”
A lengthy but smooth process involving a two-thirds majority vote by the investors effectuated the handover, and JER even remained an LP in the fund. Marrison notes that there were “not a lot of great stories” in the vehicle and no carried interest left to pursue, indicating that JER had little financial incentive to help. Despite that, JER’s cooperation enabled the firm to withdraw with minimal clamor. “More often than not, it’s in everyone’s interest to settle the matter in a way that isn’t going to generate a lot of attention,” adds MoFo’s Muller.
Multiple motivations 
The motivations for investment managers to become embroiled in fund rescues can vary. The opportunity to demonstrate management capabilities for an investor pool that has low expectations at the point of handover is one common attraction. For example, Venator Capital Real Estate Partners, the team spun out from Winnington to manage the Trophy Property fund, is hoping it will land future funding from investors by improving on the 50 percent initial write-down in the value of the fund’s capital. 
LaSalle had little or no exposure to the investors in JER’s fund, “so we saw this as an opportunity to show what we could do,” explains Marrison. For LaSalle, there was another attraction as well. The Chicago-based firm was strong in Western Europe but had little exposure to Central Europe, and a takeover of JER’s platform meant inheriting six staff and offices in the Czech Republic, Poland and Luxembourg. 
Similarly, Blackstone’s takeover of BoAML’s Asia fund saw 25 new hires to bolster a bench of just 15 staff at the time. When Internos assumed control of the European fund management arm of GPT Group in 2009, it inherited 100 staff along with the €1.7 billion of assets held in its funds. The Australian REIT even kicked in €7 million to meet the costs of managing such a sizeable platform. 
On the remuneration front, funds in need of rescue rarely offer much carried interest for the incoming manager. So, partly to retain transferring staff, new management fees regularly are negotiated – often more lucrative than the original fees but less attractive than carried interest. However, Short warns that fees often are “rebased downwards” when a rescue mandate becomes too competitive. Marrison recalls how, in addition to reworking the fund’s fee system, LaSalle also ensured that JER’s staff had careers with LaSalle beyond the life of the fund. 
Venator’s fees for managing the Trophy Property fund also were re-set and now are based on a more “conservative and realistic basis,” but one that nonetheless will introduce carried interest should the firm outperform its base forecast, Wong notes. Currently, the fund is expected to produce a 0.7x equity multiple. “If they outperform that, then we’ll share some upside with them,” he says. 
Oftentimes, investors do not equate a successful rescue with the return of all of a fund’s equity, particularly as a rebasing of its strategy regularly means a lower financial outcome anyway. As with the Trophy Property fund, Blackstone is understood to have been asked to return 70 cents on the dollar when first approached and, similarly, the firm has been offered a promote if that is bettered. 
Still, sometimes no extra value is required. “Sometimes you are working hard just to preserve value,” Short says.
Warning bells 
Widely agreed is that there is a period of grace for incoming managers. Similar to politicians, problems initially can be blamed on the previous administration. “For the first couple of years, it’s someone else’s problem,” remarks Marrison. “Then, ultimately, you take responsibility and there is a risk associated with that.” 
Piesner warns that managers thinking about fund rescues need to consider potential liabilities. MoFo advised on ING Real Estate Investment Management’s takeover of New City Asia Fund Management’s Asian opportunity fund in 2009 after the Tokyo-based firm fell into financial difficulties, sparking investor concerns about management. Indeed, indemnities were an important part of the takeover negotiations. 
“We were concerned about liabilities that could arise from the platform,” Piesner says. “As the new manager, you must ensure you’re not putting yourselves in a position of being found liable for conduct that occurred before you took over.” 
The structural complexion of a takeover is crucial. “Managers need to be careful about buying a manager out of his stock,” explains Cahill. “Instead, they want to take on contractual rights and, if they must take the GP position, doing so via a special-purpose vehicle enables them to insulate themselves from potential liability.” 
In the case of BoAML’s fund, Blackstone took over both the management and GP positions, but not before ensuring litigation threats from its investors were nullified. In other situations, only the fund management has been adopted by the incoming manager via a sub-advisory role, but not the GP responsibility. 
Some funds, however, are beyond rescue and usually the reason is related to debt. In some instances, Short says, a fund’s debt might be owned by an aggressive nonperforming loan investor, in which case it is likely the assets would be foreclosed. Even if the original lender still is ‘in situ’, a rescue attempt is futile if the leverage ratio on the assets is too extreme.  “When the debt situation is so bad, you know it’s not worth the gamble,” he adds.
Just as incoming managers must consider potential impediments when pursuing a rescue, investors in a problem fund also should consider the pitfalls of replacing the manager. Indeed, sometimes the best rescues are achieved by the same manager that caused the issues or even a team from within that manager, as with the Trophy Property fund. 
“The most important feature of the restructure was the asset swap, and we needed the cooperation of Shui On,” Wong says. “That’s why we backed an internal team. Without a team able to work with Shui On, there would have been very limited alternatives for us.”
In addition, Muller notes that most managers would rather continue managing a fund on less attractive terms than suffer the embarrassment of being removed. Furthermore, he says it is the existing team that is best acquainted with a fund’s assets and, on a value preservation basis, is more likely to succeed than a new firm un-familiar with them.
Few damsels stateside  
While the highest-profile private equity real estate fund rescues have happened in Europe and Asia, few such occurrences have happened stateside. Cahill puts it down to two reasons: a quicker commercial real estate recovery after the crisis and watertight legal protection for managers. 
“Other than sporadic pockets in the South, not much actually went wrong,” Cahill says. “Where people lost their shirts was in the residential community, where loads of no income loans were issued.” Those deals, he points out, generally were conducted by private families or residential REITs and not by private equity funds. “Most US funds never invested in residential property because the returns weren’t high enough and there was lots of competition,” he adds.
Short has another theory. He believes the US market actually has many “dead men walking” – private equity real estate firms kept alive by their investors and financiers, even if their portfolios are in distress and their resources depleted. “That is a market that desperately needs consolidating, but the US system won’t turn the life support off,” he says. 
Acknowledging that robust legal documentation may be responsible for this predicament, Short believes the world’s biggest private real estate market is considerably under-resourced in spite of a veritable army of would-be white knights around the planet baying for the opportunity to get in there and start rescuing. In the meantime, the industry’s salvation army will continue to rectify messes in Europe and Asia. 
GPT Halverton 
White Knight: Internos Global Investors
Rescue started: 2009
What happened: The European property fund management arm of Australia’s GPT Group was bought by Internos for just €2. However, such was the loss-making and necessary funding position of the platform – comprising some €1.7 billion in gross assets spread across Germany and The Netherlands – that 100 staff were transferred to Internos gift-wrapped with an extra €7 million in working capital. Jonathan Johnstone, GPT’s head of Europe, portrayed the transaction as the “full property investment solution going forward,” while Internos co-founder Jos Short described the transaction as providing his firm with a “substantial and established European platform with an exceptional client base.” Observers say this deal did more than anything to establish Internos as a white knight of the industry.
Merrill Lynch Asian Real Estate Opportunities Fund 
White knight: The Blackstone Group
Rescue started: 2010
What happened: Investment bank Merrill Lynch already was seeking to offload its Real Estate Principal Investments division, the largest holdings of which were in its $2.65 billion Merrill Lynch Asian Real Estate Opportunities Fund, ahead of its merger with Bank of America in 2008. However, a shortlist of potential suitors for the division dissipated when it become apparent that the bank took actions considered non-fiduciary by the fund’s 25 investors and they threatened litigation. The bank responded by halting the process and engaging with the investors’ advisory committee for a solution. That resulted in an approximately $650 million settlement and the transfer of the fund’s management to Blackstone.
JER Europe Fund 
White knight: LaSalle Investment Management
Rescue started: 2012
What happened: US private equity real estate firm JER Partners labelled the transfer of its 13 European property portfolios, much of them held in its €850 million pan-European opportunity fund, as part of a strategic shift in focus towards its core capabilities in the US. However, it was widely understood that many of the assets within those portfolios were performing poorly. Not a hostile situation, JER was understood to have fully collaborated with advisors as a successor manager was selected. Following an extensive beauty parade, the fund’s approximately 40 investors selected LaSalle. The job? Retain JER’s European team and manage out the assets, preserving as much value as possible along the way.
Trophy Property Development   
White Knight: Venator Real Estate Capital Partners
Rescue started: 2013
What happened: Hedge fund management firm Winnington Capital raised $1 billion from approximately 145 investors for investments in minority stakes in five developments across China in 2008. Misjudgements related to development timelines, personnel and funding led to disagreements with its operating partner, Hong Kong developer Shui On Land. Following a period of recriminations between Winnington, Shui On and the investors, a settlement was brokered by external advisors, leading to the swap of the five minority stakes for a majority stake in one development. As part of the solution, Venator, a start-up led by former Winnington executives, was mandated to manage the development and return as much capital to the investors as possible.