The instability and volatility caused by the pandemic and rising interest rates are creating numerous opportunities for real estate investors and managers to generate liquidity through the secondaries market.
No longer perceived as just a tool for investors to exit distressed assets, as was the case during the 2008 financial crisis, investors now use the secondaries market to raise capital, exit future unfunded commitments and strategically manage portfolios. What has motivated this change in sentiment?
Nowadays, most investors’ selling activity is driven by portfolio management needs, says Sarah Schwarzschild, managing director and co-head of BGO Strategic Capital Partners. “For example, there could be a change in strategy – an investor might have invested heavily in international real estate and now they want to do domestic – or they had a sizable allocation to opportunistic real estate and would like to move to more core assets,” she says.
A change in leadership, such as a new CIO or new head of real assets, can also drive investors to sell – or investors may be looking to streamline the number of managers in their portfolio for operational reasons, adds Schwarzschild.
Return to the market
Transactions of investor interests in value-add and opportunistic funds fell to a low of $1 billion in 2020, but rebounded to almost $1.9 billion last year as investors returned to the secondaries market, according to a 2021 report published by Landmark Partners.
During the pandemic, there was a wide bid/ask spread between buyers and sellers, all but halting transaction activity on the investor side, explains Schwarzschild. “That has created a backlog of sellers that decided to wait and are now coming back to the market.”
Secondaries activity was likely driven by the need to hold assets for longer than expected and raise additional capital in growing sectors such as logistics, rental housing and data centers. Conversely, secondaries transactions also offer exits in negatively impacted sectors such as hospitality and retail.
Jeff Giller, partner and head of real estate at StepStone, says: “Volatility and uncertainty can cause some investors to seek liquidity as the expected distributions from their funds are extended, the denominator effect drives them to rebalance their asset allocations, and they make tactical decisions to underweight certain asset classes and overweight others.”
He adds that investor-led secondaries are prevalent where investors see an opportunity to realize extraordinary profits by selling positions in sector-specific funds that have had the wind at their backs, such as industrial and multifamily.
“We’re also seeing secondaries sales activity for interests in funds that have had big mark-ups because investors can sell them at a discount and still realize extraordinary returns,” adds Giller.
In 2021, insurance companies and non-US pension funds were the biggest sellers of investor interests, according to Landmark Partners’ report. In terms of region, investor stakes are predominantly sold in US funds followed by Europe and then Asia.
“In the last 10 transactions we have done, sellers have been sovereign funds, family offices and pension funds, and most activity has occurred in the US,” says Partners Group’s co-head of the private real estate integrated investments business unit, Stefan Lempen.
“Volatility and uncertainty can cause some investors to seek liquidity as the expected distributions from their funds are extended”
StepStone Real Estate
Institutional investors such as pension funds and family offices have become more aware of the opportunities in the secondaries market, increasingly seeing it as an alternative way to boost their real estate exposure.
James Jacobs, Lazard’s managing director and global head of real estate, private capital advisory, says that secondaries provide investors with an additional way to access the real estate market, while enabling diversification and return-enhancement by also opening up avenues into other sectors.
Some would argue that secondaries can also provide exposure to assets on a more favorable cost basis compared with the direct market, while avoiding frictional fees, costs and taxes. “We’re seeing more institutional investors looking to participate in manager-led secondaries targeting lower expected returns, whereas previously, the dedicated secondaries funds only targeted opportunistic returns,” says Jacobs.
The growth in GP-led transactions has been supported by a realization among sponsors that the market can provide a tool for portfolio management. “Rather than thinking they need to exit using the direct market, they can provide some form of excess liquidity, full or partial, to their investors in the secondaries market,” adds Jacobs.
Lempen notes that managers are increasingly using secondaries to solve investor misalignment. “This is a growing part of the market and, in most cases, good-quality assets are being offered up for investment. And that’s where the most activity is at the moment, while traditional investor-led secondaries are not the predominant use of our time these days,” he says.
StepStone has focused almost exclusively on investing in manager-led secondaries. “Our secondaries have always been about investing in sound assets held by good managers, to help them restructure their balance sheets, grow their platforms and provide liquidity to their investors,” says Giller.
Specific segments of the real estate universe are presenting good opportunities in manager-led secondaries. “We’ve seen the opportunity to recapitalize portfolios of assets as part of a portfolio aggregation strategy, especially in sectors like industrial where sizable portfolios command a premium. Some managers require additional capital to build to that scale,” says Schwarzschild.
Another area is tail-end recapitalizations, which are targeted at the last assets remaining in a fund vehicle. “The manager is seeking to wind-down the fund for the investors but believes those assets would benefit from more time,” she says.
Where there is most activity is in the growth-orientated or demographically driven sectors in which investors are buying into a portfolio that has strong prospects for the future, says Jacobs. Lazard has been active in recapitalizing residential, industrial and data center portfolios in the last couple of years.
For Lempen, an asset that provides a predictable stable cashflow is probably more suitable for the secondaries market. This includes industrial assets, residential assets and, to some degree, office assets. “That’s less true for retail assets, which increasingly are switching toward turnover-linked rent,” he says.
However, Lempen believes it has been more difficult to confidently take on office investments because the sector is more challenging to forecast. “Office tenants have more power to negotiate favorable leases and lease contributions in terms of capex contributions or rent-free periods,” he says.
Opportunities to create liquidity through the real estate secondaries market are now many, and the volatility caused by the pandemic and other macro factors is expected to continue fueling an increase in both investor- and manager-driven transactions in the months ahead.