SPECIAL REPORT: Back from the brink

Morgan Stanley Real Estate Investing (MSREI), the principal real estate investment platform of New York investment banking behemoth Morgan Stanley, has just made a remarkable comeback.
That was the narrow yet prevailing opinion of around 110 readers who took part in a poll on perenews.com this summer posted following our report that the firm had collected approximately $1 billion in a first closing for its latest global opportunistic investment fund (see pie chart).
The closing of Morgan Stanley Real Estate Fund (MSREF) VIII Global, or G8 as it is colloquially known, is a long way from the fund series’ record-breaking G6 which attracted $8.8 billion in 2007. But after the dire performance of that fund prompted certain big investors in MSREI’s next fund, G7, to rescind their commitments before it closed, the platform’s ability to garner more capital has been widely questioned.
Investor attrition meant G7 shrank from $6 billion to $4.7 billion by the time MSREI held its final closing for that fund in 2010. And, against a backdrop of rival investment banks either dismantling or selling off their platforms, the writing seemed to be on the wall for a firm that had once been the darling of institutional investors that in total have ploughed more than $25 billion into MSREF funds since the bank began them in 1991.
But thanks to recent backing from one of Morgan Stanley’s largest shareholders, Chinese sovereign wealth fund, China Investment Corporation (CIC), and Future Fund of Australia, a renaissance appears to be taking shape.
It began with the appointments of Frenchman Olivier de Poulpiquet and John Klopp to lead the platform in 2010. And now, having defied the malaise amongst its investment bank peers, MSREI is once again looking to reinstate itself as one of the largest names in the opportunistic real estate sector. As one former senior executive of an institution that backed MSREF in the past, put it: “I think investors feel ready to give them another chance.” A consultant to institutional investors added: “The slate has been cleaned.”
In the balance 
A second chance is enough to make this a comeback story because at the end of 2011, the future of the MSREF funds hanged in the balance after it became apparent MSREI required more time to invest $2 billion of G7’s capital. 
Fortunately, the first deals of de Poulpiquet and Klopp’s reign already were generating target-beating returns, enabling the bank to convince the fund’s investors to vote in favor of an extension.  “There would be no scenario where they would be closing on money (now) if they hadn’t got that vote,” said a former MSREI staffer. “It was really important to get that.”
The investors in G7, including US car manufacturer General Motors, sovereign wealth funds CIC, GIC Private and Canadian pension manager Canada Pension Plan Investment Board (CPPIB), have been rewarded for their faith. PERE understands that MSREI already has returned $1.6 billion to limited partners and is generating IRRs of more than 20 percent from that fund. “It is now a different proposition,” the consultant noted.
One source with knowledge of the firm said the investing strategy of de Poulpiquet and Klopp had chimed with some investors, enticing them to commit more money. Describing it as ‘cash flow defensive’, the strategy revolves around acquiring properties generating core-like incomes and/or with other attributes in place such as lengthy rent guarantees, all the while deploying far lower leverage than it used to pre-crisis.
An example of assets acquired under this strategy is a €635 million, 15-strong portfolio of Auchan malls and retail parks in Italy from French retail property developer Immochan last October. The deal took a year to negotiate but ultimately provided MSREI with a fully-let collection of properties benefiting from a guarantee on 10 years of rent.
Even its $1.2 billion acquisition of the Galleria mall in St Petersburg in 2012 and its $1.1 billion purchase of Moscow’s Metropolis mall a year later, which have met with skepticism from rivals, have similar defensive characteristics. Critics of these deals questioned the motives for putting so much of G7’s equity into a market that traditionally has been beset with political and liquidity issues. But PERE’s source said they were purchased on net operating income yields (NOI) of 8.5 percent, that look more like NOI yields of 10.5 percent today, and that is significant risk mitigation.  “That is huge cash on cash in what effectively is a low-performing economy,” he said.
First show of hands


Now that G8 has been capitalized, the identity of CIC as an early backer has surprised few. Besides historically being a notable shareholder in the parent bank, it has been a regular investor in the MSREF series as well. One source familiar with the state fund said it favors, where appropriate, repeatedly backing fewer managers over forming multiple relationships on a deal by deal basis. “CIC likes to leverage existing relationships,” he said, adding that its investments with MSREI had also facilitated co-investment opportunities and also exposed the CIC real estate team to Morgan Stanley’s infrastructure. He said:  “An investment means lots of market intelligence and on-site support, a compliment to the limited staff of CIC in Beijing.”
Less predictable was a sizeable commitment made by Australia’s Future Fund. Not especially known for writing passive equity checks to funds, the A$100 billion (€69.5 billion; $93 million) state investor usually invests in direct partnerships. As with CIC, it has various conditions attached to its fund commitment. PERE understands Future Fund’s commitment to the fund in fact is more than matched by its sidecar co-investment fund. PERE’s source said: “[Future Fund] also has a small bench and will be looking to have its eyes in all the different markets.”
Such comments resonate with the words of Barry Brakey, the state fund’s head of real estate, who told PERE in a Blueprint interview in May: “The team works hard to find good entry points to quality property and to seek partners to actively manage our portfolios.
Besides CIC and Future Fund, there are certain smaller institutional investors that have committed equity as well as Morgan Stanley related entities and staff.  MSREI declined to comment about its fundraising.
The boo brigade 
Despite this early support, however, onlookers argue MSREI still has work to do before it can truly be considered a serious rival to the sector’s biggest investment houses like Blackstone or Lone Star Funds. “You cannot compare MSREI with Blackstone anymore. Today Blackstone steals the limelight,” said one person. 
That view was one of a spectrum of responses to MSREI’s capital raising gleaned by PERE. Others were more cutting. “It’s a sign the world has gone nuts,” one rival fund manager said aggressively. “These guys shouldn’t be able to raise another penny after their prior performance. They were the poster child of everything wrong in 2006/2007.”
A former MSREI executive, however, was more nuanced in his view. “I actually think they have done a good job for the last couple of years, refining their strategy, figuring out what they needed to do,” he opined. But he too felt the platform needed to generate more positive results before it could reclaim former glories.
“They spend too much time benchmarking themselves with Blackstone, but the reality is they are now more of a Westbrook or Rockpoint.” On raising a fraction of the money of the fund’s zenith G6 vehicle, he said: “Doesn’t matter, it’s a start.”
In a similar vein, the consultant has figuratively elevated MSREI’s opportunistic offering from negative to neutral. “We remain neutral on the product. Do we think it is investible? Yes. But is it the best investment idea out there? Perhaps not at the moment. The new management still has to prove itself and that takes time.” Nonetheless, the consultant said he might approve a commitment to G8 should MSREI be able to demonstrate early exits that hit target returns before its final equity closing.
“Before the reorganization, I’d have said negative, stop, don’t even bother looking,” he said. “My conclusion is they are doing the right thing. I like what I see. But why would I risk my reputation to back MSREF in front of a Blackstone fund? Blackstone has a 20-year unblemished record, even if today they are too big. They never lost money. Morgan Stanley cannot say that.”
Even so, MSREI has come a long way since it was suffering from investor attrition and frequent market derision – “I’m sure it was very painful,” the ex-MSREI executive said, knowingly. And yet with heavyweight seed investors in tow, a few years of positive results to point to as it markets G8, and a senior executive team that has stayed faithful to the firm and to its script, this former private equity real estate giant is slowly standing up again to be counted.
It wants as much as $3 billion for the fund. If it gets that, the voices of its detractors will be further challenged by mounting evidence of support.