FEATURE: The smart guy in the room

Visit the headquarters of Harvard Management Company (HMC) in Boston and one quickly gets the impression it is protected by top security. Sharing 600 Atlantic Avenue as it does with The Federal Reserve Bank of Boston, which is part of the nation’s central bank, it is little wonder that visitors are faced with airport-style X-ray security. Guests must run their possessions through imaging machines and step through a full body scanner before progressing to the elevators to get up to the 14th floor.

The physical aspects add particular intrigue to HMC but even more so at present because of what it happening behind closed doors. For as PERE's sister publication, Secondaries Investor, reported last month, HMC is currently shopping the largest ever portfolio of fund interests on the real estate secondary market. 

The secret process is shrouded in client confidentiality and non-disclosure agreements making the sale opaque and details hard to come by. However, even though the process only began in February, already it is anticipated to have a dramatically different outcome from the endowment’s previous real estate secondaries sale five years ago, according to people PERE has spoken with.

It is understood that HMC is intending to sell up to $1.3 billion-worth of partnership interests in approximately 35 real estate funds. The offering would be equal to more than 40 percent of its real estate fund investments, and nearly 27 percent of its total property holdings, which stood at $4.8 billion as of last June. According to Secondaries Investor, Dallas-headquartered advisory firm Cogent Partners is handling the sale, about which the endowment has declined to comment publicly.

HMC’s offering is believed to be the largest ever made in real estate secondary market, and likewise would be the largest transaction in the space if it were to close. “This will be one of the most widely-distributed real estate secondaries transactions ever,” said one secondaries investor.

Indeed, the potential pool of buyers for the HMC portfolio is anticipated to be wider and deeper than any previous real estate secondaries offering. For one thing, Cogent is said to have approached at least 20 different groups with the HMC portfolio. Obvious candidates would be traditional real estate secondaries buyers such as Partners Group and Landmark Partners, which have both raised significant amounts of capital through dedicated secondaries funds in the past year.

Also expected to be in the running are new, nontraditional buyers, most notably NorthStar Realty Finance. The publicly-traded commercial real estate company has become one of dominant investors in the real estate secondary market since striking a pair of large portfolio deals two years ago: the purchase of a 51 percent ownership stake in a portfolio of 45 real estate fund interests from TIAA-CREF in February 2013 for $390 million, followed by the acquisition of 25 fund interests with a net asset value of $925 million from the New Jersey Division of Investment at roughly par four months later. 

But at $1.3 billion, the HMC portfolio also could attract interest from private equity secondary firms that previously haven’t invested in real estate but are drawn to the vast size of the transaction, such as Pantheon, Lexington Partners and Coller Capital. Meanwhile, sovereign wealth funds – several of which have recently built teams dedicated to secondary investments – also are being seen as likely bidders, given the huge amounts of capital that those institutions have to deploy in real estate.

Going back to 2010

Current market conditions stand in stark contrast to the environment that the endowment faced when it last was selling a pool of property fund stakes. In late 2009, HMC put up to $500 million in existing and planned real estate fund investments on the market, in a transaction said to be known as Project Bluefish. The portfolio reportedly comprised more than 30 real estate fund interests that ranged from $50 million to $500 million in size and included commitments to private equity real estate firms such as Beacon Capital Partners and Lubert Adler. Funds by those two managers also are believed to be in HMC’s current real estate secondaries portfolio.

HMC ultimately sold hundreds of millions of dollars’ worth of interests in a number of its funds to buyers that were said to include traditional real estate secondaries firms, as well as institutional investors that were acquiring stakes in specific funds. However, the endowment received some criticism for not divesting as many property stakes as some prospective buyers had anticipated, in part because of the pricing that was being offered for partnership interests back then.

“Generally during the financial crisis and into 2010, there was a lot of downside risk within real estate funds and therefore large discounts were quite common,” noted Peter McGrath, managing director at Setter Capital, a Toronto-based advisory firm that currently is working on 10 real estate secondaries deals. At the time, a real estate secondaries portfolio typically sold at a 20 percent to 40 percent discount on the aggregate net asset value (NAV) of the fund interests, he said.

“Today, the market is completely different,” said McGrath. “Many funds have worked through their issues and buyers are much more optimistic about their prospects. Downside risk appears to be in check.” Portfolios now commonly trade for 85 percent to 100 percent of NAV, with individual funds sometimes going above NAV, he said. 

Real estate secondary transaction volume has been on an upswing in recent years, increasing from $5.1 billion to $6.8 billion in 2014, and is anticipated to rise further to $7.7 billion this year, according to a recent report from Setter Capital. Most of the volume today is in earlier vintages, largely 2004 to 2007 – that have been known to be among the worst-performing for real estate funds in recent years.

Market timing

Given current pricing for real estate fund stakes, many market participants believe that the endowment will be much more successful at selling its fund stakes than it did in 2010. “Harvard is actually timing the market really well,” said one secondaries investor. “The secondaries market is frothy. There’s a buyer base that has increased significantly, at a time when discounts are at their thinnest.”

Despite some of the criticism it faced for its 2010 sale, “Harvard was one of the smart guys in the room” in terms of how it handled the transaction, the investor said. “It makes sense that they were testing pricing, because no one knew what the pricing was at that time,” he said. And while it was not willing to sell many of its fund interests at a significant discount, HMC was able to redeploy the proceeds of what it did sell into investments that now are generating higher returns than what its original fund interests likely would be yielding today. 

Meanwhile, it is widely believed that HMC will be able to sell most, if not all, of the new portfolio that it has put up for sale. However, the general consensus is that no single buyer would be able to take over the entire portfolio, and therefore the sale would involve multiple buyers and multiple types of buyers. According to one estimate, about 60 percent of the fund interests likely would be sold in bulk to a club of three to five buyers that could include a firm like Northstar as well as a few traditional secondaries buyers. An additional 30 percent could be traded to directly to limited partners that would want to buy interests in specific funds, particularly those of elite managers, and be willing to pay top dollar for those stakes. Meanwhile, approximately 10 percent to 20 percent may be sold in a subportfolio in what is known as a general partner-directed secondary transaction, where the general partner of the fund that HMC is wishing to exit has discretion over which buyer could acquire HMC’s stake in the vehicle. 

“It’s not that Harvard’s position on its portfolio has changed, it’s the market that has changed,” said one source familiar with the deal. “The market undervalued its portfolio in 2010, now the market may be overvaluing it, if pricing today is any indication.”

Different motivations

The endowment is understood to have different motivations for selling its real estate fund interests now than it did five years ago. In 2010, HMC’s real estate secondaries sale was largely driven by liquidity issues in the aftermath of the global financial crisis. At the time, market conditions were unfavorable for selling assets, which left many fund managers unable to return capital to their limited partners. 

Meanwhile, HMC, which had a high allocation to alternatives, had committed to property funds with money that it didn’t actually have – the distributions that it had expected to receive back from its managers but did not. Many of the partnership interests that the endowment was trying to sell in 2010, therefore, were unfunded interests. 

The main purpose of the new sale offering, however, is to rebalance Harvard’s real estate portfolio and redeploy capital in other areas where it believes it can generate better returns.

For this reason, the endowment is expected to be selling 100 percent interests in its real estate fund stakes, since it no longer wants to be investing in these vehicles. By contrast, HMC was selling partial stakes in its 2010 offering because it still wanted to hold onto some of its interests in those funds.

Meanwhile, HMC has given clear indications where it wants to invest the future proceeds from its latest real estate secondaries sale. According to the endowment’s annual report last September, HMC’s direct real estate investments generated a total return of 20.4 percent in fiscal year 2014, compared with a 7.8 percent for its legacy fund investments, and against a benchmark of 12 percent. Direct investments now account for approximately one-third of HMC’s property holdings, even though the endowment only began investing in the strategy in 2010 as it sought to reposition its real estate portfolio. 

In private equity real estate, HMC has been viewed as a leader among endowments and foundations, both because of its size and the sophistication of its real estate team. As it prepares to sell off a sizable portion of its property portfolio, the endowment appears intent to continue to make real estate bets that will keep it at the head of the class.