The year of the LP-led comeback

After years of manager-led transactions dominating the secondaries market for private real estate fund shares, many in and around the space expect a significant shift in 2023. While manager-led deals will likely maintain a strong presence, changes to financial and economic conditions are causing many institutions to rethink their exposures to certain funds, managers, strategies and even entire asset classes. 

In turn, as droves of investors rework their portfolios – either by choice or by mandate – managers, capital advisers and placement agents active in the secondaries market expect to see a landmark buying opportunity for quality real estate fund positions at attractive discounts.

“The [investor]-stake market has increased in activity, and the discounts are quite wide,” says Sarah Schwarzschild, co-head and managing director of BGO Strategic Capital Partners, the secondaries arm of BentallGreenOak. 

Under normal conditions, secondaries interests in private real estate funds trade at roughly a 10 percent discount, Schwarzschild notes. After the onset of covid-19, that haircut jumped to around 20 percent. Today, she says, discounts can be had at between 30 percent and 50 percent for interests in well-performing vehicles.

“Those levels are approaching what we saw during the global financial crisis,” Schwarzschild says. “And there are lots of LP stakes in the market right now.”

The starting line

Historically, the real estate secondaries market consisted solely of LPs selling their interests to other investors. Manager-led secondaries, also known as GP-leds, first came onto the scene after the global financial crisis of 2008. These are essentially recapitalizations, in which managers orchestrate the sale of fund stakes. 

In recent years, manager-led deals – especially those looking to extend the life cycles of successful vehicles – have accounted for the bulk of the ever-growing secondaries space. In 2022, they were $9.5 billion of the overall $12.4 billion real estate secondaries market, according to data compiled by Ares Secondaries Group, an arm of Los Angeles-based asset manager Ares Management. In 2015, GP-leds had totaled just $400 million of $8.2 billion in real estate secondaries activity.

“Post-covid, when the market normalized, through the balance of 2021 and the early part of 2022, GP-leds were, by far, the overwhelming majority of the real estate secondary market,” Jarrett Vitulli, senior managing director at advisory firm Evercore Group, says. “Now, a lot of the buyers have shifted to doing LP acquisitions under the premise that, individually, there may be better value there as different LPs may be experiencing liquidity or capital preservation needs.”

This change in secondaries transaction origination has coincided with a paradigm shift in capital markets during the past year. Since 2008, monetary policy had been extremely accommodative, with most major central banks holding interest rates at record lows and, in some cases, engaging in asset buying to ease financial conditions further. That all reversed quickly from spring 2022, as those same central banks began hiking rates at the fastest pace in decades and in a unified fashion that may never have been seen before.

Those leaps impacted the real estate fund sector in several key ways. First, they made financing more expensive, dragging down the profits of individual assets, hampering sales markets and putting stress on highly indebted investments, especially those backed by floating-rate loans.

Higher rates also deflated asset prices broadly, making it difficult for investors to commit to new vehicles. They also mean that investors can once again generate returns by investing in government-guaranteed sovereign debt, ending the search for yield that had been a catalyst for private market growth in recent years.

Jeff Giller, head of real estate for the asset manager StepStone Group, believes these shifts have led to a “tremendous amount of increased volume” for investor-led secondaries sales. He breaks down the driving forces behind this trend into three categories: the denominator effect, dealing with liquidity constraints and strategic shifts in portfolio management.

Giller notes that most private real estate investors are facing the denominator effect, a term used to describe forced changes to a specific asset class – the numerator – to stay in line with changes to the overall portfolio – the denominator – because real estate values have not been marked down as much as public equities or other assets. The urgency of addressing this issue varies from investor to investor.

“Some aren’t selling because they are just ignoring what their models say, some are increasing their allocations to real estate, and some are selling because they absolutely have to become in balance,” he says. “Or they are not committing to new funds to fall in balance over time.”

The denominator effect can apply to any asset class with a trajectory that deviates from the broader investable universe. But private market assets, especially private real estate, face an additional challenge on this front, Schwarzschild notes.

“It is a combination of numerator and denominator effect,” she says. “It is actually a double whammy because while the value of the public markets has come down, the value of the real estate went up so high that now you have a numerator effect and, as always happens, the public side resets much faster than the private side.”

Going a different route

Reducing these exposures can prove difficult, particularly when so many institutions are going through the same adjustment period. While offering steep discounts is one way to break through the gridlock, it is not the only strategy gaining traction.

Kristina Kulikova, vice-president at secondaries-focused advisory Setter Capital, notes that another solution investors are turning to is offering extended payment deferrals, which allow the seller to exit a fund quickly and free up future funds for deployment elsewhere.

“The buyer becomes the LP of record, the price is locked in, but there is a financial agreement in place that says they can pay 50 percent of the purchase price now, 50 percent in a year, or 25 percent now, 25 percent next year and 50 in two years. There is variability to how those deferrals are structured,” she says. 

“Sellers might not get all the cash up front, but they are freed up to commit to new managers by shifting their allocations through a sale and getting some cash in the door.”

For investors selling out of funds, Kulikova says, freedom takes more than one form. Along with the near-term benefit of getting exposure off their books, they are also liberated from their future capital call obligations. In an uncertain environment, “cash is king,” so this is very attractive for some institutions.

Because of this, Setter has seen an uptick in sales of stakes in younger funds with more unfunded obligations. The firm’s annual secondaries volume report – which tracks activities across all asset classes – found that the average age of funds purchased in a 2022 secondaries transaction was 5.25 years, down from 5.78 in 2021. Roughly 70 percent of sales were for funds aged six years or younger.

Kulikova notes that pension funds have emerged as prominent buyers of real estate secondaries stakes in 2023. The long-dated liabilities of retirement funds make them agnostic to the type of duration risk that other types of institutional investors fret over.

“A secondary fund that has a 10-year fund plus two single-year extensions can’t take on a 25-year life fund, even though it is a closed-end fund,” she says. 

“That is where a lot of pension funds have been great, because they are able to take on that exposure. They may not be an active player in the market, but if it is a GP they back and a strategy they like, they have the ability to hold the fund for a much longer timeframe and generate a stable return that matches their liability profile.”

Freeing up liquidity

For institutions that do not enjoy the same stability in their funding inflows and liability outflows as public sector pensions, including insurance companies, endowments and foundations, the need to free up liquidity – both near- and long-term – has become urgent in the current environment, Giller says.

“When values drop, managers stop selling assets, so expected distributions curtail. LPs depend on those distributions to meet funding obligations in other aspects of their portfolio, so they suddenly have liquidity problems and need to sell certain fund positions in order to fund obligations in other positions in their portfolio. So, that is driving secondaries sales as well, and when they don’t have liquidity, they may sell positions with big unfunded commitments to relieve themselves of those future funding obligations.”

Yet, while some investors are experiencing distress they have not seen in years and responding to that with varying degrees of speed, Vitulli says he has yet to see the type of extreme liquidity crunches that defined past seminal moments for secondaries transactions.

“During the GFC, we worked with clients that had genuine liquidity needs, whether it was regulatory or cashflow. It does not feel like that this time,” he says. “All things being equal, investors would like to monetize their positions, they want to free up some capital, whether it is to create a buffer or to take advantage of what they think will be an interesting investment vintage. But most don’t appear to be forced sellers.”

Regardless of how severe the market shake-up ends up being, Giller believes the shifting capital market will inevitably lead to investors revisiting their strategies and adjusting accordingly. He expects investor-led secondaries to play a significant role in that process.

“During times of dislocations, institutional CIOs often look at their portfolio and decide to rationalize their portfolio of managers. They will cull out their lower performing managers or they will decide to refocus on different geographies or product sectors or capital structure orientations,” he says. “They will rethink how their portfolios should be structured and then execute secondary sales to put them in balance with their new asset allocations.”

Flight to stability

Kulikova notes the big shift her firm observed last year was a flight to more stable strategies. Setter tracked a 65 percent increase in secondaries transactions for core funds, while volumes of value-add and opportunistic transactions declined. She expects more of the same this year.

“The overall market and interest rate environment is going to dictate a lot of portfolio allocation decisions this year,” she says.

If there is one thing standing in the way of a deluge of investor-led real estate secondaries transactions, it is the inability to set prices efficiently. There is a broad consensus that valuations have declined during the past year as interest rates have risen, but as is always the case for private real estate, there is little transparency about exactly how much values have moved.

“There is an acknowledgement that private market values in funds and institutional portfolios have not really caught up to where the markets are at this point in time,” says Doug Weill, co-managing partner of the advisory Hodes Weill & Associates. 

“So the expectation is that we will see some further markdowns in the first and second quarter. And then maybe that will be the bottom, but who knows.”

Weill notes the fact that declines are being driven by external factors, rather than the performance of the assets, has made managers even more reluctant to mark down their portfolios.

Ultimately, a catalyst event could be needed to paint a clear enough picture of where values stand for transactions to kick off in earnest. Some say a wave of maturing debt this year could well be that moment. Others say it is too difficult to predict what that moment might be, let alone when it will occur. 

It is clear that whenever that time does arrive, the opportunity set will have enormous potential.

Based on BGO’s analysis of closed-end real estate funds currently investing, Schwarzschild says there is approximately $800 billion of value in the market that could be opened up to secondaries transactions, both LP- and GP-led. During the financial crisis of 2008, the last major buying opportunity, the market was just $320 billion.

“You have over 2x the amount of value that can be actioned from a secondary perspective,” Schwarzschild says. “The opportunity set is bigger for the secondary buyers because the underlying assets that we can do our work with has gotten much larger.”