StepStone Real Estate: Ready to party like it’s 2009

This article is sponsored by StepStone Real Estate.

For Jeff Giller, the head of StepStone Real Estate, it is starting to look like 2009 all over again. That year, Giller, then the managing partner and chief investment officer of his former firm, San Francisco-based Clairvue Capital Partners, saw an opening for a new style of real estate fund investing.

Giller’s prior firm, Liquid Realty, where he was also chief investment officer, was a real estate secondaries firm in the traditional sense. It specialized in buying investor stakes in funds, providing liquidity to LPs while accessing funds at a discount to their net asset value.

But, after leaving Liquid to form Clairvue with partners Josh Cleveland and Brendan MacDonald, amid the global financial crisis, suddenly GPs were the ones in need of liquidity. Giller saw an opportunity to secure exposure to funds more efficiently – with less guess work about underlying assets valuation – and on more advantageous terms.

Why did you enter the GP-led space in the wake of the global financial crisis?

Because we were transacting with the GP and not buying a passive LP position, we could get all the information we needed to really understand the assets and because our counterparty was a GP, not the LP, we could end up in a preferred position or structure for control over our situation. We get due diligence information, we typically get some level of control and we often come in on a preferred basis.

When I set up Clairvue Capital Partners with Brendan MacDonald and Josh Cleveland in 2009, there was no term for our style of investing. We called it special situations secondaries, but today it is known as GP-led secondaries, and it is a big driving force behind the rapidly growing real estate secondaries market.

Recent years have seen GP-led secondaries activity focus mainly on recapitalizing well-performing funds to extend their lives, but the pendulum is once again swinging toward helping managers deal with distressed capital structures, like paying down debt and providing funding when liquidity constrained LPs can’t.

This is back to the future, from our perspective. We launched this strategy in 2009 in the wake of the global financial crisis to help managers and LPs solve liquidity issues, and the same dynamics are happening now.

How has your approach changed?

We focus on a set of attributes for our investments. We want full transparency so we can conduct due diligence and underwrite assets, which is not possible in most LP secondaries transactions. We want to come in at an attractive discount to fair market value or in a structured situation where an adequate amount of equity is subordinate to our investment.

We want moderate leverage, for the assets to be further down their path to stabilization, and we want diversification. Following the crisis, we were able to capture those kinds of deals through recapitalizing real estate vehicles with distressed balance sheets.

As we moved past the period of dislocation following the crisis, we looked for other factors driving liquidity needs for managers. One is that they have had success with their portfolio, but the portfolio may be at the end of its life. There may be assets that could benefit from further business plan execution or more time, or maybe it is a single LP or group of LPs that are just ready for a liquidity event.

“The pendulum is once again swinging toward helping managers deal with distressed capital structures”

We can come in and provide that capital in continuation vehicles to give them more time and more money for their assets. Another catalyst is helping platforms that have become liquidity constrained because of shifts in capital markets.

One-third of all the capital in our industry goes to the top 10 managers. That profound shift to large-cap, big brand name managers has left a lot of strong small- and mid-cap managers challenged in fundraising.

Another approach we have taken is buying out LPs and contributing additional capital or recapitalizing the funds so they can buy more assets. Our recapitalization program, through GP-led secondaries, has become a mitigant to their inability to raise money from LPs in the fund formats they were used to.

There is also idiosyncratic business out there. We continue to find pockets of need to pay down debt to restructure balance sheets, situations where LPs want to reduce their number of managers, re-orient their portfolios, or wanted to exit exposure from certain managers to deal with portfolio and liquidity needs.

We can do a GP-led deal where we fund the GP’s buyout of the LP’s position, maybe on a structured basis. All these catalysts have kept us busy doing GP-led secondaries during the more mature period between the global financial crisis and now.

Are you agnostic in terms of the sort of underlying strategy of the fund or do you focus on specific return profiles?

We are seeking to take on core-plus risk but drive opportunistic returns. Because we are coming into investment vehicles that own assets late in their life cycles, they tend to be stabilized, cashflowing, lower leveraged, so they have the traits of a core-plus vehicle. 

If we are recapping an opportunistic vehicle, by the time we make our investment, those assets have usually already been through their value-add business plans and have been largely de-risked. 

What are you seeing now that makes you feel we are nearing a promising time for the types of secondaries transactions in which you specialize?

There is going to be a tremendous opportunity to recapitalize real estate vehicles to solve their overleverage problems. For an asset worth $100 million financed at 65 percent loan-to-value, when that $65 million loan matures and is resized, because interest rates are so much higher and lenders size off the debt service coverage ratios, the manager may be only able to refinance, say, $45 million. He has to find $20 million to pay off that lender.

If the vehicle can’t fund the $20 million, the manager can get that $20 million through us, through recapitalization, to match the refinancing proceeds of $45 million and avoid losing his assets to the bank or having to sell at a low point in the market cycle. That is why there is a tremendous opportunity, as there was in the post-crisis era, to help managers solve their maturing debt issues by funding this equity gap through recapitalizations. 

There is a half a trillion dollars of commercial real estate debt maturing in 2023 in the US alone, and $2.5 trillion in the next five years, all of which will be settled at a time when refinance proceeds either will be below the payoff amounts, or won’t be there at all. 

We can also help GPs buy out LPs if LPs can’t meet their funding obligations because their distributions have dried up from other sources, or because the denominator effect requires them to sell their positions. GPs can engineer a GP-led secondaries deal with us to buy out those LPs and we can also add additional liquidity to the fund. These are also things we were addressing post-crisis that are absolutely a part of the environment today.

What differences do you see between the global financial crisis and today?

During the crisis, there was operating distress in real estate because we had a global recession, which curtailed tenant demand. That was then coupled with substantial overbuilding because of loose lending and equity investment practices.

So, you had oversupply and eroding fundamentals. Now, the jury’s still out on whether we are going to have a significant recession and how deep it is going to be, and we don’t have oversupply problems because lending was much more disciplined in the post-crisis era. 

But what we do have is value diminution in properties driven by rising interest rates, which translates into higher cap rates and lower financing proceeds and this means there is a funding gap when property owners need to pay off their existing loans upon maturity or meet covenant compliance.

Property values always come back, and they come back in the next cycle at a higher value than they were at their peak in the last cycle. If we can come in, recapitalize these vehicles and help them pay down their debt, they can live to fight another day, and probably exceed performance.

Can you still have those quick turnarounds in this environment, or will these issues push that horizon out?

In the post-crisis period, our durations were even shorter than they were in the recent, more stabilized period. As the markets come back, managers may want to replace our capital with different kinds of capital, so we solve their problems and then we are taken out when the markets stabilize.

In a mature market, you may have to hold assets longer to get the multiples in the value you are looking for. In more dislocated markets, things tend to turn a lot quicker.

How do you feel about StepStone’s ability to compete in a more crowded GP-led secondaries market?

Our competitive advantage is that we are not affiliated with businesses that compete directly with managers and we have a significant advisory business that oversaw investing more than $18 billion in funds last year. We think that our connectivity to the manager universe because of our adviser practice gives us a sourcing and information advantage relative to other GPs. 

Eighty percent of our deals are non-competitive, non-intermediated because we have this direct connectivity. By contrast, the overall market is more than 70 percent intermediated. We have never really gone head-to-head with the other secondaries funds because of the differentiated aspects of our strategy.