EUROZONE: Beware the B team

Many investors are planning to increase their target allocations to private real estate due to factors such as the volatility of equities and low yields from bonds. This is putting fund managers in a far stronger fundraising position today than in prior years.

In fact, according to data from PERE Research & Analytics, 34 percent of private real estate funds closed at above target so far this year, while just 13 percent of private real estate funds did the same in 2008.

During the more challenging capital raising environment following the global financial crisis, private equity real estate fund managers tapped into strategies such as co-investments, joint ventures and separate account mandates as alternative sources of funding.

Indeed, nearly a third of the capital raised by European real estate investment managers in 2013 and 2014 was via a joint venture or separate account, the PERE data said. 

Part of the rationale for establishing such accounts was so that a fund manager could try and build a long-term relationship with an important investor and to solicit capital for a future fundraise.

Today, however, many fund managers have plenty of capital to deploy, and in many instances they are under pressure to do so quickly. So unless there is a strategic reason for forming a non-fund structure, the idea of adding non-discretionary capital is unappealing.

On the other side of the coin, the investor rationale for separate accounts at a time when property markets are getting ever more competitive is obvious. An investor can get access to deal flow, save on management fees, and hopefully walk away with a heftier chunk of the upside. In addition, a single investor is likely to have a greater degree of control and protection. Investors have typically been able to better specify the investment terms they want and build those into the structures.

These protections are becoming even more of a focal point as PERE is hearing that despite strong interest in committing more to the asset class, some investors are becoming increasingly nervous about creating separate accounts. They fear that these accounts will be overlooked in favor of a main commingled fund.

One placement agent says that there is a concern that the fund manager will put the ‘B team’ on any separate account mandate because the firm is more economically incentivized to focus on the fund through both higher management fees as well as the potential for more carried interest.

To combat any such scenario, investors are seeking tougher protections in legal documents relating to key man clauses in the separate accounts, going so far as to demand certain rainmakers spend a minimum amount of time working on the mandate.

Investors can only push so far, however. If the investor demands certain terms for a managed account, but those terms are not attractive for the manager, then the firm will likely say no.

It is only if the terms of that account are favorable and the size of the investor commitment is big enough that the manager will agree to take on the mandate. For example, a managed account where the fee is calculated on the amount of deployed capital rather than on committed capital will be harder to get greenlit by the manager.

As the graph – which shows how much capital was raised for separate accounts in Europe over the past three years – indicates, at such a frothy point in the real estate cycle, it is not as easy for investors to put large swathes of capital to work in the region if it is not through funds.