There are few hard and fast rules in the private equity real estate industry. Prices go up. Prices go down. And what was yesterday an overlooked market can quickly become crowded and overpriced.
But over the past few years, as the asset class has enjoyed unprecedented growth and liquidity, one constant has been readily apparent: the fundraising market has been red-hot. In 2006, opportunity and value-added funds raised approximately $60 billion (€46 billion) worldwide, according to figures compiled by Private Equity Real Estate, an increase of more than 60 percent compared to the previous year, which itself was a significant jump over 2004.
However the rest of 2007 unfolds, rest assured, the fundraising market will be busy. The themes that have shaped the past few years—increased allocations to real estate, movement up the risk-return spectrum, migration to new markets in search of yield—appear poised to continue for the foreseeable future. Yet amid the fundraising frenzy, other themes are quietly beginning to gather steam.
How will 2007 stack up? That remains to be seen. Private Equity Real Estate is tracking more than $100 billion of funds currently in the market, but not all of those vehicles will get raised and certainly not all of them will close by year-end.
Industry practitioners appear to be split in their opinions. One consultant suggested that 2007 will rival or surpass 2006 in terms of fundraising dollars, an opinion seconded by a real estate placement agent. Nevertheless, another placement agent, citing a recent report from Kingsley Associates, predicted that only $40 billion will be raised in 2007. And yet another industry observer noted that despite certain reports which suggested fundraising totals would fall, his own experience was convincing him otherwise.
However the rest of 2007 unfolds, rest assured, the fundraising market will be busy. The themes that have shaped the past few years—increased allocations to real estate, movement up the risk-return spectrum, migration to new markets in search of yield—appear poised to continue for the foreseeable future.
Yet amid the fundraising frenzy, other themes are quietly beginning to gather steam. These developments may not have the impact of the ones mentioned above—in fact, many of them are merely at the embryonic stage. But if fully realized, they do have the power to alter the dynamic of the global fundraising market, both today and in the years to come.
The return of the contrarians
The past few years have not been particularly robust times for investors focused on distressed real estate. The run-up in the global property markets has created an environment in which very few assets, even those with a considerable risk profile, meet the conventional standards of a contrarian investor. Though there have been small pockets of distress, be it certain residential markets in Spain or a one-off condo converter in the US, there has been nothing to whet the appetites of vulture investors on a large scale—and certainly very little capital raised to take advantage of any market dislocations.
Yet the tides may be changing. A number of investment firms are gearing up for what they see as potential disruptions in the CMBS market, where massive debt financing packages have fueled much of the current boom in the private equity real estate industry. John Brady, the new head of Oaktree's real estate group, notes that his firm has already seen a number of one-off deals in the debt markets. He expects many more to follow. And he is not alone.
“You got to believe that the next stage in the cycle will be distressed,” says Michael Crawford, a placement agent with Rowayton, Connecticut-based CP Eaton. “And you got to believe that [it starts in the debt markets.] Something is going to go bust.”
Of course, similar warnings have been heard before. The overriding theme of the past few years has not just been the boom in the worldwide property markets, it has been industry observers predicting that the boom would end—and end badly. And every year thus far, they have been wrong.
“I've heard it for five years now,” says Dennis Yeskey, the head of real estate capital markets at Deloitte. “Two years ago, it was the homebuilders. And it didn't happen. The last year, it's been condo converters. It didn't happen. Every time a little bit of distress pops up, there's so much money circling it and then nothing. It never amounts to a huge trend. It's just talked about all the time.”
Secondaries take shape
Another theme that has been talked about constantly is the substantial movement of LP capital into real estate. As institutional investors have increased their allocation to the asset class in recent years, they have created a huge supply of capital for private equity real estate firms. But they have also created huge headaches for themselves, both in terms of the growing size of their portfolios and the unwieldy number of relationships they are forced to manage.
To address these issues, some industry observers predict that LPs, particularly in the US, will soon look to prune their portfolios in the secondary market. Such transactions would allow LPs to reduce the number of managers in their portfolio— something that many institutional investors have stated they want to do—and also take advantage of the current boom in real estate prices.
Terry Ahern, the chief executive officer of pension fund consultant The Townsend Group, notes that LPs are quietly asking themselves if it's time to unload a portion of their portfolio. But he adds: “We haven't seen much in terms of execution.”
Partly, that has been a result of liquidity. Despite the massive capital flows into the market, secondary-focused funds are relatively few and far between. However, new firms such as Madison International are forming and veteran investors such as Liquid Realty and Landmark Partners are poised to raise larger amounts of capital and invest in a wider range of deals.
At the same time, LPs themselves may become more willing buyers of secondary portfolios. This may be particularly true for new entrants to the market, who are finding it difficult to build up a substantial portfolio on their own. Buying a portfolio of secondary interests would enable them to access a large diversified set of funds relatively quickly—particularly if they partner with a secondary fund with the experience to analyze the underlying portfolio.
Given both these factors—growing liquidity on the part of buyers and increasing willingness on the part of sellers— secondary funds and secondary deals could become a much greater force in the years ahead.
“Your pages will be filled with that topic next year,” says Michael Hoffman, the president of San Francisco-based placement agency Probitas Partners.
If secondary fund managers are one beneficiary of overstaffed limited partners, then the victims, at least in today's market, are first-time fund sponsors.
Despite the record amounts of capital in the fundraising market (and the record number of vehicles on the fundraising trail), it remains extraordinarily difficult for new managers to raise capital. And the reason is simply lack of resources.
“LPs say to us 'I have 50 PPMs from new managers on my desk and probably 40 of them are worthy of consideration,'” says Alan Bear, a principal with Probitas Partners. “But they're time constrained and it's more practical for them to simply reup with their existing managers.”
In 2006, for example, Allstate Investments made nine commitments to the asset class, according to Edgar Alvarado, Allstate's head of real estate equity funds, and eight of them were re-ups. He expects more of the same in 2007.
Anecdotal evidence from placement agents, LPs and firsttime fund sponsors suggests that Alvarado is not alone. And though part of the issue may be resources, an equally important factor is the speed with which funds are coming back to the market, as well as the size of the funds they are raising. Blackstone, for example, raised a $5.3 billion fund in 2006, while Morgan Stanley raised $4.2 billion. This year, both firms are expected to close individual vehicles on approximately $10 billion and $8 billion, respectively.
“LPs say to us 'I have 50 PPMs from new managers on my desk and probably 40 of them are worthy of consideration.' But they're time constrained and it's more practical for them to simply re-up with their existing managers.”
“It's a momentum business,” says Crawford. “All the people that were coming back in ‘08 are coming back in ’07. It's even harder to be a first-time fund in real estate. You can't get any shelf space.”
The power of discretion
The difficulty faced by first-time funds is but one of the most visible examples of the inefficiency of the fundraising market. As the investment options available to fund sponsors has increased dramatically over the years—from public equities to opportunity funds to debt strategies, both in their domestic markets and around the globe—the ability to create a unified, top-down strategy has become more and more difficult. And with most institutions looking to boost their allocations to real estate, their workload is even greater.
To compensate, a number of large LPs have begun farming out a greater amount of work to their pension fund consultants, giving them some discretion to choose which managers they should allocate capital to. Many industry observers predict that this trend will accelerate substantially in the years ahead.
“I think the trend is in place now,” says Townsend's Ahern. “It's not without precedent.”
In the traditional private equity sector, for example, gatekeepers such as Hamilton Lane have wide discretion to commit pension fund capital to LBO fund managers. And the same factors that existed in the private equity industry—a growing allocation to the asset class, limited LP resources and sophisticated consultants and third-party advisors—are prevalent in private equity real estate.
Institutional investors have long given separate account managers discretion to invest in direct real estate assets and consultants already do a significant amount of fund due diligence anyways. Discretionary mandates would merely be a logical continuation of those trends.
“You're going to see a switch from consultants to asset managers,” says Hoffmann. “There will be a flurry of separate account managers for strategic investments.”
A slowdown in Asia
One of the biggest fundraising stories of the recent past has been the huge number of funds that have been raised—or are in the process of being raised— to focus on the emerging markets of China and India. Yet as LPs continue to look for ways to penetrate those markets, a number of industry observers predict that the pace of capital flows into those two countries will slow over the next 12 months. That is partly due to the massive dollars that have already flowed into the region, but, more importantly according to one placement agent, it is due to the relatively few realizations that have been generated.
“China has cooled,” says Deloitte's Yeskey. “It's tough to do a deal there. Now China is making a quadrillion dollars, they're going to run the world, they've got a new economic model and we're all going to work for the Chinese. Alright. However, real estate is very hard to do over there. There are a few more deals getting done. But I think the hype got way ahead.”
The hype, today, of course, is on India. Private Equity Real Estate is currently tracking more than 16 funds in the market focused on India with a total target value in excess of $5.5 billion. But there are as many, if not more, questions about India as there are about China (see p. 44). And even if capital is being deployed in these markets, it will probably take a very long time for investors to know how that capital is performing.
In the interim, however, a huge amount of capital has been raised by pan-Asian funds. And if the pace of capital into China and India slows down, Yeskey believes that Japan could generate a lot of interest.
“I still see money going into Japan,” says Yeskey. “I've been saying this for two years. Nobody seems to care. It's a stable country. It's not Asia as an emerging market. They've rebounded. I still see deals being done in Japan and they're big deals. It's like the nose on your face—nobody is paying attention to it.”