Have I got a deal for you!”
Boiled down, that is essentially the starting point of every conversation for an operating partner that approaches a potential capital source.
Then the merry dance begins. The opportunity, the stage of the purchase agreement, the timeframe for exit are all unfolded in the opening discussion. For his part, the pitched capital source will then ask about realized track record, team stability, challenge various assumptions, and provide a verdict on whether it fits the stated strategy of the fund or separate account.
Hundreds if not thousands of such discussions take place on a daily basis around the world, and unsurprisingly, only a few actually make it through to the next stage – drawing up the agreement. Which is where the real fun starts.
The model of private equity real estate firms using operating partners to help populate their funds with deals is as old as the hills, of course. It has never really fallen out of favor for very long either, and for good reason. No matter how large and sophisticated a real estate investment manager might be, can its team really know how to gain a zoning variance from the relevant local authority, where the next local tenant is coming from and what contractors to use, and for how much? The answer to that is invariably, ‘no’. And so, the legions of specialist real estate operators that possess that ‘unique’ know-how to find a deal, create some value and manage that asset find themselves in demand. At the same time, many of these operators are desirous of capital, which is where the private equity real estate firm or institutional investor comes in.
As James Broderick, chairman of Goodwin Procter’s real estate investment management practice in Boston explains, the real estate joint venture market can be roughly separated into two groups, both defined by numbers. Firstly, there is the prevalent 90:10 joint venture model between the “money partner” and the operating partner. If the private equity firm likes the deal, it will put up around 90 percent of the equity. Secondly, there is the 50:50 joint venture between roughly equal partners, a structure far less common and trickier to agree terms over. The split may not be exactly 50:50 but the point is that the two parties are more equal in terms of capital and clout.
Foreign capital is a perfect example of the latter. Numerous joint ventures have been struck up in the past few months and years between sovereign wealth funds or pension funds and a US real estate operator. An example would be Norges Bank Investment Management on behalf of the Norwegian Government Pension Fund Global that last October agreed to a joint venture with Boston Properties to acquire a 45 percent stake in three prime offices for $1.5 billion, the assets in question being 601 Lexington Avenue in New York and the Atlantic Wharf Office Building and 100 Federal Street in Boston.
Goodwin Procter’s Broderick explains that under The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), for many foreign investors it is beneficial to invest in US real estate through a joint venture in which the foreign investor owns less than a 50 percent interest and the remaining interests are owned by US entities that are domestically controlled. The result has been a surge in the number of new joint venture relationships between major investors and operators in the marketplace.
Unlike a 90:10 joint venture, the conventional rules of the road for establishing the rights and obligations of the parties in a 50:50 split are not so obvious. After all, this is essentially a marriage of equals. If both sides must agree upon everything, how does anything actually get done? And what about the inevitable major decision deadlock between the two parties? Common suggestions for resolving issues are arbitration or the trigger of exit rights, but those are not perfect either as deadlock can arise again.
The list of major decisions that require joint approval can be as long as one’s arm, but the most significant always include exit rights, financing (including maximum loan to value, term and the extent of guarantee obligations that are acceptable and who puts them up), capital call obligations, approval of annual operating budgets and approval of major leases. The foreign investor/domestic operator model also raises a number of unique challenges for the parties to resolve, such as how to deal with ongoing transfer rights of the parties given the foreign investor needs the joint venture to remain domestically controlled. Also, the foreign investor often needs the joint venture to hold each asset in a separate “baby REIT”, and sell shares in the REIT rather than the asset itself at the time of exit. That leads to a negotiation between the parties over whether one party or the other takes the risk that the sale price for the REIT shares is less than a possible sale price for the asset itself.
The scenario that private equity real estate fund managers are more used to, however, is the 90:10 equity split. In a 90:10 equity split or a close variation between a private equity firm and an operating partner, the private equity real estate firm expects a commensurate large degree of control. Not much can be done by the operator without prior approval of the money partner. In a sense, this uneven match of capital power makes for a more straight-forward relationship. “The money talks,” says Broderick.
This is not to say that in a typical 90:10 private equity real estate operating agreement there are never any problems. Far from it.
Unfortunately, these arrangements were sorely tested in the most recent financial crisis of 2008. Many private equity firms found it difficult to get control of ventures when the wheels came off. For example, when attempting to restructure a loan with a lender, or perhaps to even hand back the keys, private equity firms found that the operating partner with just 10 percent of the equity or even less had approval rights over any deal to be cut with the lender. The operating partner might have been primarily concerned about his exposure on a completion guaranty or a “bad boy” guaranty, whereas the private equity real estate firm not on the hook for these guarantees had other priorities. Interests were not aligned, and deadlock often ensued.
As a result, terms in operating agreements today often look a bit different. Many private equity firms are negotiating for unilateral governance rights in certain circumstances. The traditional 90:10 model passed unilateral governance rights to the investor partner only upon an “event of default” under the joint venture agreement. More frequently today, private equity firms are pushing for either unilateral control over all decisions from day one, with a revocable delegation of administrative duties to the operating partner, or unilateral control over at least some decisions in the event of deadlock – financing is a common example. These are obviously protection mechanisms and a response to the financial crisis. Related, and from the perspective of the operating partner, recently there has also been much more negotiation about who puts up guarantees to the lender, the terms of the same, and indemnification obligations between the parties if the guarantees are called.
These are the ways in which the structuring of operating partner agreements has evolved.
Indeed, Andrew Levy at law firm DLA Piper in New York explains that times have dramatically changed since the global financial crisis leading to other differences, particularly in the US major markets (most notably, New York). For one thing, there is less distress, resulting, not surprisingly, in a lot more capital sources.
What this means is capital sources in theory do not possess such an advantage making deals and getting terms and having de facto controls they want. For example, an operator often has his pick of many potential capital sources, and if things go badly enough, then the operator can trigger a buy-sell arrangement and replace capital source ‘A’ with capital source ‘B’.
Says Levy: “It is comparable in a way to the debt market – in times of high interest rates and not much liquidity, an investor often has to scurry around and find a lender providing an acceptable loan. But when times are flush, lenders are chopping their margins and the competition for money becomes much more favorable to the borrowers and not to the lenders, and the operators and not the equity capital providers”. For Levy, “The key thing for equity capital sources is to find an operating partner that is reliable and will do business with you, hopefully on a repeat basis, and ideally in many cases with a platform”.
That may be easier said than done. One only has to conduct a search of ‘real estate operating partners’ in the US on Google to realize how many firms describe themselves as operating partners. They range from the large and sophisticated to the very small localized brothers in business together. Indeed, virtually anyone bringing a deal to a capital source can be an operating partner. What operating partners seem to have in common, however, is that they claim to be experts in something, perhaps a very particular geography or an asset type or strategy.
It is possible to argue that the current market dynamics play a little bit into the hands of operating partners because so much capital including international money wants real estate.
This could potentially exaggerate the inequilibrium of the operating partner model. Specifically, it is well understood that operating partners put up a small percentage of capital for deals, but in today’s market they might put up even less. Say one capital source is willing to put up 95 percent of the equity. Another source could easily come along willing to stump up 98 percent. In addition to the unequal capital injection, there is also the disproportionate level of promote the operating partner can earn. The promote is of course where the operating partner makes it big money and it can represent tremendous yield given the tiny capital it may have put in originally in comparison to the capital partner.
All that said, finding capital partners today may not be the walk in the park some might have you believe. Deborah Harmon, co-founder and chief executive officer at Artemis Real Estate Partners, the Washington, D.C.-based firm, agrees operating partners might be in a stronger position than in the immediate aftermath of the financial crisis, but she points out the number of first time funds raised declined 30 percent from 130 in 2013 to 100 in 2014. “There is a consolidation occurring and the largest funds are teaming up with the largest operating partners. There remains a deep pool of smaller operating partners where capital is not as aggressively flowing.”
A post in December 2013 on the website Wallstreetoasis.com is quite revealing here. Written by someone called “Pinkpoloshorts”, the writer says he works for an operating partner specializing in joint venture land developments with private equity firms. After a year of working on the job, Pinkpoloshorts said: “You spend a lot of your time attempting to convince capital partners to do deals with you. We spend a considerable amount of time walking our potential partners through the model and explaining and defending our assumptions. You deal with a lot of rejection. Once we he have our heads around the deal we take it to capital providers. We try to take each deal to partners whose risk profiles and areas of expertise match the deal. However it’s very difficult to get a partner for the deal, especially if the deal is a little hairy. We often hear ‘it’s interesting but…’ or that it doesn’t quite fit the firm’s mandate. If the deal isn’t in a prime market and has some issues with it (for example the sale of an entity versus an asset sale), it can be hard to capitalize. Even for more straightforward deals I’ve found that it takes several no’s to get a yes.”
He also adds: “Sometimes the operating partner doesn’t get to operate the deal. Once we’ve got the deal capitalized and we’ve closed on the property, you’d think that the hard work is over and now we get to do what we do best which is develop and sell the land. This is not always the case. Despite having the expertise, the capital provider brings the money and they often have their own ideas about how to execute the deal. They may want to bulk sale land raw while we want to develop it out. The best deals come out of constant communication between the capital provider and the operator so that everyone is on the same page. If you don’t have the same vision for the property as your capital provider, that can lead to deals not performing.”
Finally, he does confirm what everyone knew: “You don’t get paid until the end, but your return on equity can be huge. Land deals normally work like a J-curve. You have the initial outflow of capital, then in a few years you (hopefully) achieve break even and then it’s all profit after that. As an operator we get paid a promote out of the profits that increases after certain hurdle rates. We may not see significant profits (outside of management fees) for several years. However our profits may be huge multiples of our relatively small co-investment if the deal ends up performing.”
For the record, his firm would agree the first hurdle generally in the low-mid teens. “You get 15-20 percent after that, then it’s maybe an 18 percent and a 1.7 or 1.75 and you take 20-25 percent after that, then maybe 30 percent after a 25 IRR.”
Clearly, an operator would claim there is plenty of ‘sweat equity’ the capital source does not possess. This justifies the beneficial profit-split.
A high promote notwithstanding, from the perspective of the private equity firm or investor, the operator arrangement must be worthwhile otherwise they would not enter into them. Yet finding an operating company is not at all easy. You are looking for a firm that knows the nuts and bolts of running a real estate business, dealing with tenants, contractors, knowing which direction the market is going in, how to deal with local planning authorities, real estate taxes, repairing a building and so on. The capital provider is unlikely to be able to deal with all of that, hence the model of operating partners is alive and kicking.
‘The market is telling us it is worth it, otherwise the capital allocators would not do it,” says DLA Pipers’ Levy. “Sure the operating partner needs to get permission from the capital source for a big decision, but the capital partner is relying on the operator’s knowledge of the market.”
Experts said that the hurdle rate to earn promotes has lowered in recent times because of the changing market. This phenomenon is to do with lower interest rates and a general belief that profits from deals will not yield as much as in the past few years.
Whereas the carry may have started at a 10 percent hurdle in the past, it could be closer to 8 or even 6 percent today. There is nothing inherently wrong with this, so long as the private equity real estate fund – and ultimately limited partners – are comfortably with the promote being earned at a lower gate. That said, it could be the same for the private equity real estate fund manager and the fund it is deploying.
Artemis Real Estate Partners employs an operating partner model. It began investing its first fund in June 2011 and has completed close to $2 billion of deals, nearly all of them being with operating partners. Indeed, it has 44 operating partners, a majority of which have done multiple deals with Artemis.
According to co-founder Harmon, one of the key trends for operating partners is the ability to access capital across the risk spectrum, in other words, “a one-stop shop capital provider from core and core-plus to value add and opportunistic.” More than half of Atermis’ operating partners have executed transactions with Artemis across the spectrum. She also observes that in this market, with declining yields, operating partners are particularly interested in core-plus capital. From a product perspective, Artemis Fund II, a 2014 vintage fund, has been more active in industrial and retail, whereas Artemis Fund I was overweight in the multifamily space. Further, Artemis has been more active with operating partners in the self-storage, healthcare, and student housing markets.
Artemis invests with both established and emerging operators. Harmon says emerging operating partners are interested not only in dollars but for other transaction and infrastructure contribution including the provision of a credit facility so that they can close on deals all-cash. Interestingly, she observed that in her experience it is possible “to do a bad deal with a good partner and still end up with a good result”. That is, if the operating partner has a lot of expertise to work out a problem and the commitment to a long-term successful relationship.
But one area Harmon is very cautious about is where an operating partner advocates for strategy shift, for example, a long-time Florida multi-family operator attempting to enter the New York City hotel market.
The longer term trend in the industry that has already been witnessed is some operating partners becoming fund managers. Tishman Speyer would be a classic example from years and years ago, and Related Companies would be a more contemporary one. (see page 41). They have to weigh up the advantages to having capital always on hand with the extra uncertainty raising a fund brings and with the increased regulatory and fiduciary responsibilities that go with being a fund manager.
The downside is also that the return in a fund format is blended, so a bad deal can ruin a whole fund and therefore the promote. In contrast, joint ventures with various capital sources are ring fenced, so that’s different.
But so long as it remains so difficult for a first-time manager to raise a fund and while they can get capital sources sometimes even willing to put up 99 percent of the equity and agreeing a very beneficial promote, operating partners will continue to exist in their droves.