SPECIAL REPORT: The resort before last

Bank of America Merrill Lynch’s agreement to a $650 million settlement with the LPs of its Asia real estate fund has caused the entire sector to sit up and take notice. PERE Magazine November 2010 issue.

At the tail end of December 2001, Merrill Lynch Investment Managers settled a £130 million negligence claim out of court with Unilever Superannuation Fund, the investment vehicle of London- and Rotterdam-based consumer corporation Unilever.

The claim was based on allegations of negligent capital management actions against Mercury Asset Management – subsequently bought by the investment bank – that saw it underperform a pre-determined benchmark. It was ultimately settled following a gruelling court hearing, with the investment bank paying a settlement reported to have been approximately £70 million.

That was the last time an institutional investor took an asset manager to court. During a mention of the case by The Financial News earlier this year, one commentator said: “Going to court is a painful business. It should always be the last step to take from both sides’ point of view.”

Whether cognisant of the case or not, Merrill Lynch’s new incarnation, post-merger with Bank of America, evidently was keen to avoid court altogether when the limited partners of its Merrill Lynch Asian Real Estate Opportunities Fund, which closed on $2.65 billion in November 2008, came baying for compensation. The move came in the wake of actions taken by Bank of America Merrill Lynch (BoA ML) that were considered non-fiduciary by the LPs.

News of the settlement, broken by PERE last month, has shaken the private equity real estate industry. Indeed, talk of the subject between senior executives on the sidelines of last month’s Pension Real Estate Association conference in San Francisco underlined just how widely significant the news was regarded. The story also dominated PERENews.com’s most-read list all week.

I think there are special circumstances here beyond investments not working out the way people hoped. I see investors elsewhere being grumpy but not litigious.”

Unnamed source

Despite such fervour, the fact that there was a settlement just over two years since the fund’s inception came as little surprise to some – a glance at PERE’s news coverage of the vehicle and its platform (see timeline below) demonstrates its turbulent existence to date. But at approximately $650 million, a figure considered by some to have been a deliberate “no-brainer” for the LPs to accept, the settlement has raised more than a few eyebrows. One source with knowledge of the matter said: “The outcome didn’t surprise me, but that number surprised me.”

The settlement, alongside a transfer of the general partner responsibilities from BoA ML’s Global Real Estate Principal Investments (GREI) division to private equity and real estate giant The Blackstone Group, was the climax of a New York mediation process between senior figures at the bank and the fund’s Limited Partner Advisory Committee (LPAC,) which reached an accord at the end of August. Comprising investors such as the Abu Dhabi Investment Council, the General Electric Pension Trust and French insurance group AXA, the committee spent last month on the road attempting to convince the remainder of the approximately 25 member-strong investor pool to accept the settlement and was described by another source as “probably the single most active advisory committee in private equity”.

The settlement also ushers a curtain call for the GREI platform just three years after former Merrill Lynch head of Asia Pacific banking Damian Chunilal declared the bank’s intentions to build a real estate platform as part of a wider third-party investment management assault at China's Boao Forum For Asia. Its smaller European arm spun out via a management buyout, led by European head Roger Barris, in September, although the bank remains an LP in both Europe and Asia. BoA ML's original equity commitment to the Asian Real Estate Opportunities Fund was approximately $800 million – nearly a third of the total originally raised.

Copycats unlikely

Central to the limited partners’ complaints were actions taken by BoA ML during the first years of its Asian Real Estate Opportunities Fund’s management, which included an ill-timed foreign exchange trade and some poorly executed valuations adopted when transferring real estate assets previously owned by Merrill Lynch’s Asia balance sheet into the fund prior to its final closing. The fund was largely pre-seeded and had little blind equity.

One rival manager said it would be premature to expect LPs of similar vintage funds to stage comparable mutinies, as the issues raised were shrouded in “special circumstances” and were against the backdrop of the merger between Bank of America and Merrill Lynch, which was completed just as the fund held its final closing.

 “LPs are certainly realising they should be more organised,” the manager said, “but I think there are special circumstances here beyond investments not working out the way people hoped. I see investors elsewhere being grumpy but not litigious.”

Parties with knowledge of the matter insist poor investments had nothing to do with the potential litigation, with one person pointing out: “All 2007 deals were terrible all over the world”. The Asian Real Estate Opportunities Fund’s capital was invested across Asia in various asset classes in both emerging markets like China and India and in mature markets like Japan and Korea. Blackstone is inheriting a business that, should it regain some semblance of performance, “might end up recovering 60 cents to 70 cents on the dollar,” one source suggested.

Despite the fund’s performance or lack thereof, the real issue is bad fund management. “The vintage was not good, and they made poor investment choices,” the source said. “However, the LPAC was clear it wasn’t seeking a settlement for bad investing but for poor fiduciary fund management, where decisions were not made in a thoughtful way, they were made involving related parties and where they could offer no explanation.”

To BoA ML’s credit, they did not have to do what they did. This was very costly for them.

Unnamed source

BoA ML was further criticised by one source for not observing traditional private equity common practices, such as holding reserves, in its fund. He said the most established private equity firms hold a reserve in case of unforeseen issues, sometimes as much as 20 percent of the fund’s equity. “You needed it in this vintage,” he said. “A lot of people were burned, but the good managers knew each investment needed a reserve provision. [BoA ML] managed its capital poorly and found itself in a tight position. Then things snowballed.”

However, the source noted that BoA ML acted responsibly in reaching a settlement before allowing litigation threats to be realised. “To BoA ML’s credit, they did not have to do what they did,” he said. “This was very costly for them.” Despite that, the settlement, which included certain waived fees and other costs, was not understood to have been material to the bank.

BoA ML, which has more than $2 trillion in assets under management, is nonetheless treating the matter seriously. By agreeing to such a sizeable sum, the bank has placed its priorities on preserving relationships with some of the world’s largest investors. “BoA ML just wants to move on,” the source said. “They don’t want these investors saying bad things about them as they invest in other businesses with them across the [bank].”

Remember tomorrow

Having endured such a tumultuous existence in its early years, it would be easy to forget that the fund still has a life to live. In May last year, PERE reported the fund generated a fee income of approximately $40 million per year, equal to about 1.5x equity. That figure has likely changed since then, however, and some of the personnel collecting that income will also change following the general partner’s handover to Blackstone.

Indeed, Blackstone’s limited Asia staff, working from offices in Tokyo, Hong Kong and Mumbai, is set to increase by between 25 and 30 people from about 15 currently. Martin Seol, BoA ML’s platform head is one of three investment-focused senior managers not crossing over. Moreover, those that will inherit Blackstone name badges will be more asset management focused. Under the leadership of Blackstone managing directors Alan Miyasaki, Christopher Heady and Tuhin Parakh, they will be charged with realising as much value from the fund’s assets as possible.

In the process, Blackstone gains an asset management platform responsible for more than $5 billion of assets in Asia – including additional assets previously held on BoA ML’s balance sheet – from which to earn fees. It also gains exposure to a host of new limited partner relationships to cultivate for future initiatives.
Meanwhile, BoA ML is hoping this expensive exercise will help enable its relationships with the same LPs to survive another day.

From inception to settlement 

Few private equity real estate funds have endured more turbulence in the first years of holding a final closing than the Merrill Lynch Asian Real Estate Opportunities Fund. As its LPs look ahead to a substantial settlement, a change of general partner and generally calmer times, PERE glances back at its coverage of the vehicle from its inception.

April 2008:
Wall Street bank Merrill Lynch reveals plans to raise its first dedicated Asia real estate fund. Damian Chunilal, the bank’s former head of Asia Pacific banking, tells reporters at China's Boao Forum For Asia that the fund is part of a wider strategy to create third-party investment vehicles.

September 2008:
Merrill Lynch is bought by Bank of America for approximately $50 billion.

October 2008:
Merrill Lynch announces a final closing of $2.65 billion for the Merrill Lynch Asian Real Estate Opportunities Fund. Then-platform head Timothy Grady states the fund is a natural progression from the bank’s real estate investment business. The closing comes amid other large capital raisings for Asia real estate funds, including two $3 billion-plus vehicles from LaSalle Investment Management and MGPA.

March 2009:
Just over half a year after final closing, Grady quits newly merged Bank of America Merrill Lynch. PERE reported at the time that his departure was related to disagreements over the future direction of the platform and that he had become “disillusioned” with the number of senior management changes following the merger. He is replaced with the platform’s head of acquisitions, Martin Seol.

April 2009:
BoA ML shelves plans for a follow-up fund as it awaits direction from Bank of America before determining the future of the platform. Fundraising for the vehicle had not begun.

May 2009:
BoA ML instigates a process to sell the management of the fund, sounding out potentially interested parties. Early names reported to be interested include New York-based private equity and real estate firms The Blackstone Group and Apollo Global Management.

July 2009:
BoA ML adds the sale of the management of its entire real estate portfolio in Asia to the sale of the management of the fund. The total value of assets under management at the time is considered to be in excess of $5 billion. One potential purchaser described the opportunity to manage the extra assets as a ‘sweetener’.

September 2009:
LaSalle Investment Management and ING Real Estate Investment Management are the final two firms on a whittled-down final shortlist that previously included Blackstone, Apollo Global and AREA Property Partners. A winner is expected one month following LP consultation.

December 2009:
BoA ML halts the sale process amid further uncertainty concerning the desired strategic direction from the senior echelons of BoA ML and improving market conditions. The process is placed on ice until the middle of 2010.

July 2010:
BoA ML agrees to a sub-advisor role with Blackstone, whereby the asset management capabilities of its global real estate principal investments division are assumed by the New York private equity and real estate giant. The general partner responsibilities remain with BoA ML.  Integration talks begin with the platform’s staff.

September 2010:
After more than a year on the market’s sidelines, Grady joins former Goldman Sachs veteran Mark McGoldrick at his recently launched business, Mount Kellett Capital Management, for a role in Asia.

October 2010:
BoA ML agrees to transfer the general partner function over to Blackstone as part of a settlement with the fund’s limited partners advisory committee to avoid potential litigation. The settlement, to be ratified by the fund’s remaining limited partners at press time, includes a significant payout valued at approximately $650 million.