The terms, they are a changin'

Between 1990 and 2004, the private equity real estate industry raised roughly $180 billion in value-add and opportunistic real estate vehicles, according to secondaries firm Landmark Partners. It took the industry just three more years to raise the next $200 billion.

As private equity real estate outperformed all other asset classes, investors – and with them fund managers – flooded into the industry.

In 2005, when PERE magazine was first published in 2005, the number of funds in market could fit easily onto one page and included venerable names such as AEW, Apollo Real Estate, Colony Capital, DLJ and Morgan Stanley. Today that same list, Capital Watch, stands at five pages and includes all the well-known – and some less wellknown – players.

As investors start to reassess the relationships they already have, and new relationships being offered to them, many have come to the conclusion that the ball is, definitely, now in their court when it comes to negotiating fund terms.

However as institutional investors feel the pinch of the denominator effect, GPs in fundraising mode are feeling it too.

For pension funds, endowments and foundations the declining value of their listed portfolios has left them over-weighted to alternatives and with significantly fewer dollars to deploy. Coupled with a heightened perception of risk, and a lack of the exuberance seen over the past few years, today's fundraising environment is looking extremely tough.

Almost all industry professionals accept that the following fundamentals will take place in some form or another in the years ahead: that real-term allocations to private equity real estate will be lower in 2009 than in 2008; re-ups to well-established names will continue but for reduced dollar amounts; new GP names and under-performing funds will find life very difficult, with some funds simply not making it at all and fundraising timetables will be extended.

Already one large US institutional fund manager is considering lowering the target – or even delaying – its global opportunity fund because of the difficulties in fundraising, people familiar with the matter told PERE.

Limited partners, though, would also add another point to the check-list of changes taking place: fund terms.

During the annual Pension Real Estate Association conference in Chicago last month, investors lined up to tell GPs their strategy for investing in the current climate was one of, “waiting is better”. Many were already over their target allocations to the asset class, and with distributions not necessarily set to meet expectations, LPs said they would not rush to invest money, and could even try to liquid some of their positions.

This patience is not just LP-specific. It's industry-wide and as investors start to proactively reassess the relationships they have, and new relationships – big and small – being offered to them, many have come to the conclusion that the ball is, definitely, now in their court when it comes to negotiating fund terms. Investors argue it's about further aligning the interests of GP and LP, with preferred returns and catch-up two of the issues they have focused on.

In both cases, LPs says increasing the point at which a GP can start deducting carried interest, and removing the clause that allows a GP to take a greater share of the carry for a limited time, would even-up the balance of power in a relationship. But it's not just financial terms that need to be considered, investors add. The past few months have demonstrated all too clearly, LPs need to consider what happens when a GP goes bankrupt as well. “These are issues we need to reflect,” one investor told PERE. “It's going to take a lot longer and be a lot harder to make money. We are back to being a long-term wealth creation asset and terms have to reflect that,” he added.

That's not to say GPs are adapting to the changing environment overnight. As one investor said, terms were changing “slowly and reluctantly”, but they were changing.