Cuckoo for co-invests

In what continues to be a challenging capital-raising environment, co-investment programs and vehicles are proving to be a major attraction. Whether it’s fund managers, institutional investors, multi-managers or consultants, almost everyone is looking to get a piece of the action.

“It’s been going on for 12 to 18 months, where co-investments have been more front-and-center of interest,” says Doug Weill, managing partner at Hodes Weill & Associates, a New York-based real estate advisory firm. Driving this trend has been institutional investors, which increasingly have favored co-investments to accomplish various goals, including lowering costs, maintaining greater discretion over investment decisions and achieving portfolio diversification.

“I think you’ll see greater allocations to co-investments over the coming years,” says Weill. “All of these are important factors that I don’t think are going away soon.”

Meanwhile, co-investing has become more prevalent among fund managers partly because of greater liquidity issues for larger transactions. Not only are many firms raising smaller funds than they did prior to the global financial crisis, they also are unable to access as much as debt as they did in prior years and therefore are required to invest more equity per transaction. And for multi-managers and consultants, co-investments are one way to differentiate themselves from competitors that primarily are focused on fund investments.

An edge over funds 

The popularity of co-investments among institutional investors reflects some of the limitations of traditional real estate funds. “We want to be able to source large attractive investments and, when we go through a fund format, our exposure to those large investments is probably not as high,” says Eric Lang, managing director of real assets at the Teacher Retirement System of Texas. “We want to get larger exposure to those types of investments.” Co-investments, which are a subset of what the pension plan calls principal investments, also are accretive on a net-return basis, he notes.

Indeed, Texas Teachers currently has more than 20 percent of its real estate portfolio invested in principal investments, with the remainder of its property investments in commingled funds. Principal investments have generated an overall since-inception return of more than 16 percent for Texas Teachers, with investments across different risk and return profiles. “It’s created alpha within our overall portfolio,” Lang adds. 

Last June, Texas Teachers committed an additional $200 million to LaSalle Investment Management’s Ranger Co-Investment Fund III to invest in real estate co-investment opportunities globally. The pension plan has committed a total of $600 million to the Ranger Co-Investment Fund series since its inception in 2009.

The relationship between co-investments and commingled funds is a complex one. On the one hand, elevated demand for co-investments has had a negative impact on capital raising for traditional real estate funds. “Institutions are much more targeted in their desired investment strategy,” says Weill. “That has taken some of the capital away from commingled funds.”

Nan Leake, partner at Partners Group, agrees. “Institutional investors prefer investing directly in assets, which is why capital raising for closed-ended funds themselves has slowed dramatically,” she says, noting that her firm allocates one-third of its real estate investments to direct acquisitions and co-investments. Indeed, many large investors are opting to build direct real estate portfolios rather than committing to a blind-pool fund that requires investing with other LPs.

On the other hand, co-investments also serve as an incentive for some institutions to invest in funds. General partners, after all, typically only offer such deals to investors that already are limited partners in their commingled funds. “There’s more demand for co-investments than there are co-investment opportunities today,” says Leake. “Lots of investors want co-investments but, if they’re not one of the limited partners in the fund offering the co-investment opportunity, they are handicapped and very rarely are going to get access to it.” 

That said, a fund manager may offer a co-invest opportunity to an investor that is not an LP if the firm is seeking strategic capital or trying to build a long-term relationship with an important investor. 

Co-investment confusion 

Investing alongside a fund is only one of several types of co-investments. “A co-investment means different things for different people,” says Weill. “There’s a little confusion in the market, and I think it needs to be better defined to facilitate capital raising.”

Indeed, Texas Teachers classifies its real estate co-investments as principal investments and, within that category, identifies four different types: one-off co-investments alongside funds; sidecar vehicles, where the pension plan commits a set amount of capital to invest in a particular strategy alongside a fund; single limited partnership funds, or funds of one; and direct investments, where the pension plan executes transactions without the help of an outside manager. In all four scenarios, the principal investment would include either a pre-specified strategy or a pre-specified asset or pool of assets. 

Meanwhile, Partners Group refers to investments done alongside a fund as co-investments, since those are executed through the general partner. However, the firm considers deals done through joint venture partnerships with operators as direct investments, since the firm can source and execute those transactions in-house.

A need for speed 

Real estate co-investing also has its pitfalls, such as requiring investors to act quickly on opportunities. “You have to be prepared to make an investment decision in a short timeframe,” says Lang. 

That timeframe can range anywhere from two weeks to 60 days, but Texas Teachers has set up processes to enable it to meet those timelines. “It’s always hard to meet those timeframes, but you have to do it if you want to be able to live up to the mantra of trying to be a top source for capital,” Lang adds.

Others in the industry also have recognized the need for speed in co-investments. In March, Harrison Street Real Estate Capital wrapped up its first co-investment vehicle, raising $100 million in a single close from institutions such as the San Francisco Employees Retirement System, Liberty Mutual and Perella Weinberg. 

“There’s a lot of interest from investors for co-investments,” says Chris Merrill, president and chief executive of the Chicago-based real estate investment firm. “I think a number of investors are finding ways to increase their ability to execute on that.”

Harrison Street, which began making co-investments alongside its second fund seven years ago, previously raised and deployed co-investment capital on a deal-by-deal basis. However, having already identified a pipeline of co-investment opportunities, the firm decided to collect a dedicated pool of capital to invest in development projects alongside its fourth opportunistic fund, Harrison Street Real Estate Partners IV. 

“It’s much more efficient to have this type of structure,” says Merrill. “A lot of times, response times need to be faster. Participating in a sidecar co-investment fund is one way for investors to participate in co-investments and not have to worry about reacting on a deal-by-deal basis.”

More popular, less attractive 

Meanwhile, increased demand from other LPs, as well as the increased sizes of some funds, has lessened the appeal of co-investments for investors that came to the space early. 

Texas Teachers, for example, began making principal real estate investments in 2008, with one of its early successes being the recapitalization of General Growth Properties, in which it made a $250 million investment in exchange for equity in the reorganized company. The pension plan has since exited that investment, on which it earned more than a 50 percent return. 

“More and more LPs are doing them, so it’s getting harder and harder to find attractive transactions,” says Lang. Given the abundance of capital in the market today, investments are much more competitive and valuations are not as favorable as they have been in the past, he explains. Meanwhile, the resurgence of mega-funds in the market has enabled some GPs to make more large investments within those funds, rather than splitting the deal between the main fund and a co-investment vehicle.

Such circumstances have somewhat curtailed Texas Teachers’ co-investment activities in real estate. “We have not done as many transactions as we had in the 2009-2012 timeframe,” says Lang. “Deal flow has increased, but execution has moderated due to current valuations.”

Lang stresses, however, that the pension plan maintains a positive outlook on its principal real estate investments and expects that the institution will continue to target 20 percent or more of its new real estate commitments in principal investments for the foreseeable future. The only change brought on by current market conditions is that it is harder to find attractive returns, he notes.
“We’re a value investor, and we always want to make sure we price risk appropriately,” says Lang. “Sometimes, the market in our view might not be doing that. We’re willing to take risk; we just want to get paid for the risk we’re taking.” 

PE versus RE  

While the Teacher Retirement System of Texas has earned strong returns through real estate co-investments, that hasn’t always been the case. Rather, recent research indicates that co-investment portfolios can be poor performers. 

According to a study released last month by Altius Associates, a private equity and real assets advisory firm, private equity co-investment programs have a high probability of generating sub-zero returns. Among the inherent risks of co-investments, according to the report, is that GPs may be incentivized to keep the investments with the highest expected returns entirely within the fund, while investments that exceed the fund’s capacity may put the manager in a market segment where it does not have a track record.

Real estate co-investments also may be similarly construed as being higher risk and potentially delivering more lumpy returns. Co-investment vehicles, after all, typically hold a smaller number of investments than the fund itself and therefore are less diversified. Such vehicles typically include portions of the fund’s larger investments that the fund cannot acquire in its entirety because of diversification requirements. 

As with private equity co-investments, institutions typically pay lower fees with real estate co-investments than they would through funds. However, while private equity co-investments typically involve no fee and no carry, concessions are not as significant with real estate co-invests, where terms may include a half fee and half carry.