Over 40 years ago, Warren Buffett penned a letter to Katherine Graham cautioning investors about group-think and investing as a herd. “I am virtually certain that above-average performance cannot be maintained with large sums of money,” he wrote. “More money means fewer choices – and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites.” This statement could not ring more true than it does in the real estate fund universe.
While the world gets smaller and smaller every day, the universe of real estate investment dollars seems to grow exponentially. Based on PERE data, 2015 is on track to exceed the record amount of capital committing to private real estate funds in 2008.
In addition, based on current industry data, foreign direct investment into real estate is already at almost $45 billion year-to-date, surpassing the $40.7 billion raised during the prior market peak in 2007. While fundamentals may still be attractive and the real estate party may not yet be nearing its end, the fundraising trends raise two meaningful issues.
Year to date in 2015, the five largest North America-focused funds have raised approximately 35 percent of the capital, with the next five largest raising an additional 15 percent and the remaining 69 funds left to account for 50 percent of the capital. Only 17 funds currently have equity goals of more than $1 billion, and of the 350 funds raising less than $1 billion, 86 percent of those funds are actually targeting raises of less than $500 million.
This doesn’t bode well for small and emerging manager funds. Despite record levels of capital targeting the US real estate market, based on current industry data, first- and second-time funds have received a record low 16 percent of the capital year-to-date, down significantly from the peak of 37 percent in 2011.
While the market essentially appears to be creating an index around a few large market players, this has implications for investors’ real estate portfolios as well. The percentage of investor capital, individually and in the aggregate, being raised by a handful of funds makes it difficult to create true alpha in a portfolio. While certainly these funds have track records to warrant investment, investors need to be diversifying meaningful amounts of capital into the smaller end of the market as well. Commitments to a single large player should be matched by similar allocations split among smaller managers. Through these allocations to early stage and small cap managers, investors are helping create the next generation of large cap funds, and if structured appropriately, they may even secure preferred terms for the long term.
The second disturbing fundraising trend is the pace at which capital is being raised. It has somehow become universally acceptable that a fund manager – large or small – must have capital at all points in time. Investors are no longer requiring managers to prove out their investment thesis through realizations. From 2004 to 2008, managers sought to double or triple their fund sizes without returning capital to investors. The result of that back-to-back fundraising activity has been multiple vintages of troubled funds from the same sponsor.
The relative difficulty that smaller managers have had raising capital, however, has had an unexpected benefit for both investors and the firms themselves. The fundraising periods for such managers are typically longer than larger, more established managers, creating more time for their investment theses to be fully demonstrated. These protracted diligence and fundraising periods forced on smaller managers and first- and second-time funds may actually help contribute to their overall performance. Historically, industry benchmark data supports out-performance by smaller and early stage managers; over the past 15 years, the data reveals these emerging managers typically out-performed the benchmark by approximately 250 basis points.
Without a crystal ball, it is difficult to predict how the cycle will evolve. With record amounts of capital targeting larger deals in the US, the often over-looked smaller managers may have a competitive advantage both in deal sourcing and pacing, resulting in additional outperformance over coming years. Perhaps more investors should heed Buffett’s enduring advice to Katherine Graham in 1975: “A manager can be found handling smaller amounts whose record has been good for the right reasons. Then hope no one else finds him.”