Co-investment is not a new concept in private real estate, but the practice whereby investors supplement fund commitments with external capital has never been as pervasive or as influential as it is today.
It had once been regarded as a useful tool for managers trying to acquire expensive assets without overextending their funds. Now, these vehicles have become top picks for investors with ambitions to add more direct exposure to their property portfolios, maintain greater discretion over these exposures and seek better returns – all on more favorable economic terms and with familiar sponsors.
“The understanding is investors can enhance yield and create additional alpha, while also tilting their allocations to asset types they feel are attractive,” says Jeff Giller, head of real estate at the New York-based asset manager StepStone Group. “It gives them an opportunity to get direct exposure to attractive assets while paying reduced fees.”
Savvy investors have positioned themselves to participate in these deals – also known as sidecars – more readily with a view to capturing the most attractive positions in investments possible. Some are making their co-investment interests known before committing to funds. Others are inquiring about co-investment possibilities without contributing to funds at all. Keen to serve this capital, managers are responding with more co-investment offerings than before. Private real estate’s multi-managers are joining in too, particularly secondaries firms which have placed co-investments high on the agenda for their current strategies.
What co-investments are used for is changing, too. Sidecars have traditionally been used to acquire valuable, income-producing core assets, such as Class A office buildings in global gateway cities, or multifamily properties in prime housing-constrained markets. As these vehicles become more popular, though, managers have used them to purchase non-traditional assets, such as hotels and student housing.
And they carry relationship value. Investors and managers alike are increasingly regarding the use of co-investments as a means to strengthen their connections with one another, laying the groundwork for future collaborations.
“It’s a win-win situation for both us and the LP, in that they achieve what they prefer as a model for what they’re investing, and we actually will be able to manage more money,” Christina Gaw, managing principal and head of capital markets at Gaw Capital Partners, tells PERE. “We’re able to get more capital into certain deals that are appealing to LPs, that satisfy their needs, while we get more assets to manage without actually deploying more resources on the deal side.”
However, as sidecars become more fashionable and new users of these vehicles enter the private real estate market, the boundary lines of what constitutes co-investment have blurred. The term is being applied, often loosely, to several vehicle structures. It is this underlying murkiness – and the transactional nature of traditional co-investing – that makes it difficult to quantify exactly how much the practice has grown in recent years beyond the escalating anecdotes and noise surrounding it. Trade groups and research analysts do not track this part of the market.
One indicator, however, can be found in PERE’s own data, which clearly demonstrates an uptick in sidecar use in recent times. According to PERE data, almost 13 percent of the total five-year equity raised for private real estate funds by the sectors’ top 20 firms in 2017 and 2018 was for co-investing, up from about 10 percent in 2016.
While that increase seems modest from a proportion of total capital raising perspective, it is stark when evaluating the numbers on absolute terms: the data show $29 billion was raised by the top 20 managers in 2018, a 52 percent increase on the $19 billion they raised for co-investment vehicles in 2016.
Nevertheless, in spite of this surge in use, when compared with corporate private equity, in which co-investment is a common and long-running practice, the concept of co-investment tends to vary more between real estate investors, Jennifer Wenzel, head of the Texas Teachers Retirement System’s Real Estate/Real Assets Principal Investment program, tells PERE. That can lead to confusion.
“People kind of lump co-investing in with a lot of [other investment structures] and there tends to be more misinformation,” Wenzel says.
“In the PE world, a co-invest is a traditional co-invest alongside a fund and it’s more black and white. There just tends to be a lot of misinformation on the real estate side about what people are really talking about when you’re saying ‘co-invest.’”
As co-investment becomes more intertwined with real estate strategies, Wenzel adds, a lack of uniformity could become an issue as managers set expectations and investors compare their sidecar outlays. “It just muddies the water,” she says.
Further problematic is the potential for conflicts of interest as co-investments become breeding grounds for future deals and managers go beyond their stable of investors to source capital.
One long-time industry participant tells PERE some consultants have already raised eyebrows by placing outside capital into co-investments while also advising investors in the underlying funds, raising the question of whose best interest they truly had in mind.
“The inherent conflict comes in when consultants are advising investors on strategies while managing money for outside co-investors,” the participant says. “It raises the question, ‘Could the advice I’m getting be biased?’”
Such dilemmas did not exist when co-investments were limited to pre-existing investors.
There is, however, a relatively straightforward treatment for this and other ailments related to co-investing, Jeff Jacobson, global chief executive for Chicago-based manager LaSalle Investment Management, says: transparency. As a discretionary investor for large institutions and a fund sponsor with $3 billion of co-invest assets under management, the Chicago-headquartered firm is accustomed to balancing obligations in this space.
“There is the risk of conflict, so managers have to be very transparent and open with their partners as to what they’re doing and how that relates to their commitments to the fund and its LPs,” Jacobson says. “It all starts with transparency and I don’t think it’s universal because this is not a transparent market.”
Let’s make a deal
Co-investments have become a common bargaining chip for mid-size managers hard-pressed to compete with mega-sponsors for large investors’ capital. Investors of all sizes, though, are more apt to seek co-investment rights before committing to funds, PERE understands.
Negotiations often focus on dollar-for-dollar ratios and discounted management and carried interest fees. Many investors want these shored up to at least have the chance to say no to co-investment opportunities that do not suit their needs.
Traditionally, co-investments are offered to a fund’s investors on a pro rata basis depending on their initial commitment. Bigger investors usually get priority and unused rights are divvied up among the other investors. This structure is still used today, but some managers have found faster, more reliable capital from well-heeled outside investors or co-investment funds.
Joshua Sternoff, a lawyer with New York law firm Paul Hastings, who advises managers on structuring funds, tells PERE his clients are “sympathetic” to investor requests to lock-in co-investment rights, but they also have their own bottom lines to consider. While it might make sense to grant favorable terms to large investors, he advocates against making blanket concessions during fundraising.
“Some GPs feel like, if we’re co-investing, we don’t want to pre-judge any particular opportunity’s attractiveness to outside capital at the time of fundraising and cut off our ability to raise capital from third-parties on more attractive terms,” Sternoff says. “So, even though co-investing is becoming more prevalent and the LPs are asking for reduced economics up front, it’s a little bit of a varied experience and depends on the circumstances whether those GPs will agree to the economics [requested].”
Ultimately, co-investment capacity is a matter of agility, and many smaller investors governed by investment boards that meet infrequently are not built to operate at such speeds. The investors best suited for these arrangements are ones that can set aside co-investment capital from the outset should an opportunity arise, Chris Merrill, founder and CEO of Harrison Street Real Estate Capital, another Chicago-based manager, tells PERE.
“The more you can identify capital up front, the better, because time can be your enemy,” Merrill says. “In a lot of cases, the firms that have discretionary capital and can move quicker are going to do better than firms that have separate account capital and where things take longer from an approval standpoint.”
Therefore, these opportunities tend to favor sovereign wealth funds, insurance companies and pensions, which can evaluate deals and provide large sums of cash expediently.
Predictably, managers will dangle favorable co-investment rights to these top-tier investors, PERE understands, to secure pivotal fundraising commitments and build relationships. In these negotiations, the biggest investors can secure fee discounts beyond the normal 50 percent as well as governance rights and advisory board seats.
“The bigger you are, the more muscles you have,” Jacobson says.
Co-investing’s rise in popularity has been driven by investors in search of direct exposure to assets they believe will complement their portfolios and drive their returns.
Sidecar performance can be judged by comparing the internal rate of return to that of the underlying fund, PERE understands. Wenzel says Texas TRS, for instance, aims for its direct investments to perform 200 basis points better than equivalent commingled holdings. In other instances, it is benchmarked by stability and income. “It’s a two-way thing, but in our experience, co-investments have typically outperformed the investments of the underlying fund,” Cherine Aboulzelof, a managing director at Metropolitan Real Estate, a New York multi-manager that handles co-investment funds, tells PERE. “That ability to cherry pick and to construct a desired portfolio makes co-investment attractive.”
Nevertheless, co-investments do result in greater concentrations of capital and require large amounts of cash on hand, sometimes even doubling an investor’s initial fund contribution. Alive to that inevitability, investors have grown more sophisticated, their mandates shifting toward establishing greater portfolio controls. A long bull run in the market has given them the funds to do so too.
And so ascendant public pensions, such as Texas TRS and the California State Teachers’ Retirement System, have targeted greater asset exposure through various investment vehicles, including co-investment and separate accounts.
Along with giving it more control over the makeup of its holdings, Texas TRS’s Principal Investment program also helps it align interests with its managers, Wenzel tells PERE.
“We’ve found that by doing a co-invest directly with one of our managers, we really get to know them well, a lot better than just going to an advisory meeting and that’s probably one of the biggest by-products that we’ve seen,” she says. “You really get to know your managers better, how they think and how they view risk and how they underwrite specific deals. So that’s been really helpful.”
While much of the new-found enthusiasm for co-investing comes from institutional investors that, historically, have had little access to direct assets, more of private real estate’s largest investors have become fervent believers in the practice.
Allianz Real Estate, which has €60 billion of assets under management, is one. The Munich-based insurer has added co-investment to its investing styles during the past two years, Annette Kroeger, the firm’s CEO of North and Central Europe, tells PERE.
Unlike Texas TRS and CalSTRS, the Germany insurer uses co-investment to add less-direct ownership structures to its portfolio, Kroeger says, explaining that co-investments give Allianz exposure to properties it otherwise would not have the local expertise to manage independently.
Allianz has used this strategy to explore new markets. By allowing experienced managers to take the lead on managing assets, the firm can get a first-hand education as a bonus.
Kroeger says this method has been particularly effective as Allianz moves into Asia, including its acquisition of the Sky SOHO office tower in Shanghai through a co-investment with Gaw Capital’s Gateway Real Estate Fund V in April 2018. Thanks to its co-investment, Allianz holds 23 percent of the equity in the Zaha Hadid-designed building.
“Having that combination of ways to access the market allows us to grow on a global scale very quickly and also to leverage those relationships,” says Kroeger. “It constructs a network of relationships that we can leverage to further grow the business.”
The seeds of the today’s sidecar trend, like other economic sea changes, were sown in the wake of the global financial crisis, Jacobson says, as investors and managers re-evaluated their respective strategies.
Burned by certain blind pool investments, many investors began searching for ways to enact more control over their portfolios. Starved for capital, managers were willing to be led away from singularly offering traditional funds.
“It fed on itself and became more attractive,” Jacobson adds. “A lot of LPs liked that. GPs found that there was enough liquidity and ability to find LPs for good deals and that offering co-investment was very attractive to get LPs into their funds. You get on the flywheel, where it builds on itself.”
The strategy, bolstered by nearly a decade of growth, panned out, leaving investors flush with returns. US investors have seen net returns of 10.73 percent on non-traded real estate fund investments since 2010, according to the National Council of Real Estate Investment Fiduciaries. Co-investments, meanwhile, have ridden the coattails of those gains and often surpassed them. Now that it is time to redeploy that capital, many investors are inclined to go back to co-investments in what Jacobson describes as a “virtuous cycle.”
And seeing that success, new investors have entered the private real estate market looking to co-invest. Some, PERE understands, are being prodded by investment boards enamored with the industry’s latest proliferating trend – even if they do not know what it means. New managers also have entered the fundraising space from development and operational backgrounds encouraged by having already had histories constructing joint ventures with institutional capital.
This widening array of participants is one reason why definitions of what constitutes a co-investment are blurring. Somewhere between the changing marketplace and the evolution of co-investing, a disconnect about what constitutes a co-investment has taken root.
One senior executive at global private equity firm tells PERE he has had conversations about co-investment in which investors expect rights associated with joint ventures, clubs or separate accounts, a departure from more traditional co-investment practices.
“To me, as a fund manager, a co-investor is another LP that steps into a deal in a passive way. They have no control, they have no say – they’re just another investor,” he says. “There’s a lot of people who might think co-investing means they get a veto on a sale, or a right of first refusal for the part they don’t already own. To me that’s not a co-investment. That starts to be some kind of JV or separate account.”
With so much attention being given to co-investments, the senior executive believes investors of all sizes feel obligated to ask about co-investment opportunities, even if they do not have the capacity to participate in them.
“The investor talk about co-investing is so overbearing, I think there might be some investors who might not really want co-invest, who feel compelled to say to themselves or their bosses or the market that they are active co-investors and want to grow their proportion of co-investment as well,” he says.
The rise in pre-negotiating co-investment rights has cleared up some discrepancies before they arise and weeded out unqualified co-investors. But this confusion highlights the importance of detailing co-investment policies in fund documents, says Paige Mueller, managing director of the San Francisco-based consultant group, Eigen 10 Advisors.
Mueller, who worked as an advisor to several state pensions before starting her own firm, says as co-investing becomes more common, fund documents should better outline a sidecar’s operational structure, investment rights, fees, expenses and allocation discretion. In addition to being sound policy, such a practice could also avoid a run-in with regulators which are ever keeping a keen eye on co-investment disclosures.
“It all has to be disclosed and the SEC is cracking down on disclosure to investors, even from private companies,” Mueller says. “If the SEC wants something disclosed, it’s going to be disclosed.”
Indeed, whether it be private real estate’s regulators, new participants or traditional participants evolving their strategies, those groups having a say in how co-investing materializes are growing in number.
As the proportions of total capital raised for this form of investing keeps growing, they will also have an increasingly important say in how it uniforms too. When that happens, sidecar investing in the asset class will switch from being an art form to being more of a science.