The first cut is the deepest

Raising a debut opportunity fund is an arduous undertaking, but with capital abundant, real estate hot, and investors eager, has the process gotten any easier? By Paul Fruchbom

In May of 2005, David Marks, a principal with Blackstone Real Estate Advisors in London, and Jason Blank, a Tokyo-based executive with the real estate investment arm of Merrill Lynch, decided to raise their own private equity real estate fund. At first glance, the two friends—they met at MIT while pursuing their master's degree in real estate—seemed like the perfect candidates. They were both young and ambitious. They had the right background and experience. And their strategy was focused and compelling: investing primarily in assetintensive operating companies in the UK.

Yet Marks and Blank faced a unique set of challenges on the fundraising trail. In a perverse twist of fate, the hurdles they had to overcome in order to woo investors were the very same factors that made them attractive in the first place.

“Someone who had difficulty raising their fund three or four years ago might be able to raise money much easier now.”

Yet Marks and Blank faced a unique set of challenges on the fundraising trail. In a perverse twist of fate, the hurdles they had to overcome in order to woo investors were the very same factors that made them attractive in the first place. First, their age—Marks was 35 years old, Blanks 33. As one European placement agent puts it: “Having a broad team with enough gray hair is an important factor” in raising a debut private equity real estate fund.

Second, they had no audited track records. Given their backgrounds in much larger organizations, which legally prohibit departing individuals from claiming responsibility for particular deals, Marks and Blank had to rely on potential investors to make their own background checks and due diligence calls. “If they can't put on a piece of paper what their track record is, then it becomes much more difficult for an institution to underwrite them,” notes one US placement agent.

And third, their strategy. Though the UK is one of the largest property markets in Europe, it is also one of the most competitive and capital-rich in the world. “If [investors] are going to take a risk on a new market or strategy,” notes the US placement agent, “they are more likely to underwrite a first-time manager.”

Such is the arduous and, at times, confounding ritual of raising a debut private equity real estate fund.

Nevertheless, Marks and Blank were ultimately successful in their efforts. Their firm, Brockton Capital, recently held a first close on $275 million after a little more than six months of fundraising. Yet the hurdles they faced—and how they overcame them—raise some interesting questions about the current state of the global fundraising market for private equity real estate funds, particularly for GPs raising their first institutional pools of capital. Specifically, how much of a fund's capital-raising success, or lack thereof, is dependent on the experience of its principals and their investment strategy? And how much is attributable to the current fervor for high-return real estate strategies?

In other words, first-time funds provide the private equity real estate equivalent of an age-old sociological debate: nature (the environment) vs. nurture (the individual). In the world of opportunity funds, as in human development, definitive answers are equally difficult to come by.

By almost any measure, the overall fundraising market for opportunistic vehicles is at historically high levels. The largest private equity real estate firms are raising multi-billion dollar funds to invest around the world; the emerging markets of Eastern and Central Europe, Brazil and Asia are spurring the formation of regionally focused vehicles; and niche strategies are flourishing in the more competitive and capital-rich markets of the US and Western Europe.

Yet even as the buoyant state of the fundraising market encourages industry professionals to launch their own funds, it is not necessarily clear that the largesse shown to the Morgan Stanleys and Goldmans of the world is trickling down to the new kids on the block. According to many industry practitioners, raising a debut private equity real estate vehicle is never an easy enterprise. For the most part, new GPs must be able to present a clear and verifiable track record, have a sufficiently deep and experienced team, articulate a coherent strategy that also fits with an investor's portfolio, as well as demonstrate an infrastructure capable of dealing with the demands of sophisticated limited partners.

In other words, while Blackstone may raise $5 billion with ease, one of Blackstone's former operating partners, on the fundraising trail for the first time, may face an uphill battle rounding up $250 million. In fact, the frothiness of the current market may actually be a double-edged sword for new managers.

“New groups face a hell of a hurdle,” says Michael Hoffman, president of San Francisco-based placement agency Probitas Partners. “The re-up rate in the real estate funds has been pretty aggressive. Investors are getting tapped out, both in terms of dollars and in terms of time for new managers.”

“The issue is not capital,” he adds. “The constraint is—well, think about it—instead of underwriting the latest Apollo fund, you have to roll up your sleeves and underwrite a new team. It's all about time and resources.”

“New groups face a hell of a hurdle. The reup rate in the real estate funds has been pretty aggressive.”

In another respect, however, the prospects for first-time funds remain positive. Investors are now piling more and more money into the asset class. And limited partners today are confronted with an environment where it is increasingly difficult to generate the returns once associated with traditional opportunistic investments. Therefore, as the amount of capital entering the sector has increased, both GPs and LPs, particularly in the US, have been actively pursuing niche strategies in specific regional markets, areas where new funds can flourish. In Europe, the market is also becoming more receptive to newer vehicles, according to Anne Gales, a London-based placement agent with CP Eaton.

“Someone who had difficulty raising their fund three or four years ago might be able to raise money much easier now,” she says.

Doug Weill, a managing director in the real estate private equity fund group at Credit Suisse, agrees, up to a point. He makes a distinction between first-time funds that spin out of larger organizations—which, almost by definition, have no verifiable track record—and those run by real estate operators with a long history of performance. “I think first-time funds are becoming increasingly successful [at raising capital],” he says. “Typically, these are not managers with no attributable track record, but rather managers that are raising capital from the institutional market for the first time.”

Weill's comment highlights an important point. There are many different types of firsttime funds—from spin outs to operators tapping the institutional markets to so-called “emerging” managers—each facing a different set of challenges and opportunities specific to the individual firm. It therefore becomes difficult to make broad generalizations about the overall fundraising market for new firms. Each example must be studied on a case-by-case basis.

JEN Partners is a case in point. The New York-based private equity real estate firm was recently founded by Reuben Leibowitz, a 22-year veteran of Warburg Pincus. Unlike most new funds, which typically have narrowly focused strategies, Leibowitz wanted to purse a broad range of investments—the firm is primarily targeting private equity investments in real estate operating companies, but it will also invest in real estate assets and the public markets. Given his long history in the business— and the fact that he wanted to raise a relatively small vehicle—Leibowitz eschewed the use of a placement agent and instead made most of his fundraising calls over the phone to friends, former colleagues and industry contacts. The result: JEN hit its $60 million target in two months and eventually topped out at approximately $93 million.

As the example of JEN Partners makes clear, one of the most important factors in raising a debut opportunity fund is relationships. For some, like Leibowitz, those relationships are sometimes enough to raise an entire fund. For others, who are either targeting larger funds or have less robust Rolodexes, personal and professional relationships still play an important role in validating a new manager. Once a firm has raised an initial layer of investor capital, it can position itself to raise even more money from larger LPs.

“The biggest hurdle is finding that first source of capital,” says Gales. “That makes [the fund] real, not just a concept.”

Marks agrees. Brockton Capital utilized a placement agent, Jones Lang LaSalle, which advised Marks and his team to initially target investors that it knew well. Following significant commitments of approximately $50 million each from three large investors, including an Israeli real estate company and a hedge fund, Brockton was able to target a larger universe of well-known institutional investors.

“It was literally like building bricks and starting at the bottom with people we knew well,” says Marks.“We started with private investors or real estate guys that we've known for 10 or 15 years. For them, an audited IRR is going to be box-checking. It is not as important as knowing a team for a long time and sharing consistent views on both the local property markets and the wider macro picture.”

In addition to pre-existing relationships, industry sources note that one of the most active backers of first-time funds are foundations and endowments. As Probitas' Hoffmann points out, these institutions don't necessarily have more time or resources, but they more often get compensated based on performance. They are therefore more willing to take the extra time and effort required to underwrite a new manager if they believe they can generate that performance.

As several industry sources make clear, however, there are downsides to these sources of capital. While a name like Harvard or Yale is a great endorsement for a first-time manager, GPs often have to give on certain terms—such as a favorable GP catch-up— in order to secure a commitment.

“Harvard and Yale are big names that allow you to raise a lot of capital,” notes one placement agent. “But you have to pay the piper. It's an uphill battle to move terms on Fund II.”

Foundations and endowments, of course, have a strong reputation as some of the smartest investors in alternative assets, including private equity real estate. And their track record for finding and backing talented first-time managers seems to bear that out.

“The theory is [first-time managers] generate greater returns,” says Weill.“We actually completed a proprietary internal analysis. We looked at funds by roman numerals and by fund size and we were able to demonstrate, quite considerably, that first-time funds have generated significantly higher returns.”

By most accounts, the amount of capital chasing real estate—and those higher returns—has made the environment for first-time funds more favorable than in the past. Nevertheless, while the probability of success may be slightly higher, the amount of work involved remains the same. Both Marks and Leibowitz note that raising their fund was easier than they initially anticipated in terms of the length of the fundraising process. But it was also more difficult with regards to the intensity and effort involved. Weill, who estimates that 50 to 75 percent of Credit Suisse's business comes from first-time funds, underlines the long-term commitment required to raise a debut vehicle.

“First and foremost, don't underestimate the time and cost of raising a fund,” he advises his clients. “And not just the economic cost, but also the opportunity cost of going out on the road. The second piece of advice is to really think of this as a long-term business. If you're only going to raise one fund, the time and cost doesn't make a lot of sense. You need to believe that where you're taking your business, you're going to have funds four, five and six.”

Despite the amount of time and effort involved, the potential rewards will no doubt continue to lure real estate professionals of all different stripes. This is particularly true given the rapidly changing nature of the asset class in markets around the world—as new opportunities and geographies emerge, it provides a natural avenue for experienced and nimble managers to exploit.

“There are markets now in Europe that are growing, so it gives people more of an opportunity to become independent,” says Gales. “It's a combination of market conditions and talent.”

The same could be said of Asia, as well as some of the emerging, niche product areas of the US. As one placement agent noted above, limited partners are generally willing to take a greater risk on a first-time fund if they are also taking a risk on a new strategy or market. And if limited partners take those risks, higher returns may not be the only benefit. As the private equity real estate industry matures, it may be first-time funds, even more so than the largest opportunistic vehicles, which will create an asset class that is more liquid and more diverse in terms of investment opportunities, strategies and product offerings.

“It's the development of the asset class,” says Gales. “Smart experienced investors will differentiate themselves by investing a small proportion of their allocation in interesting first-time funds.”