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The Dodo of Private Equity Real Estate

The dodo (raphus cucullatus) was a flightless bird native to the island of Mauritius. It stood about a metre tall, weighed about 20kg, lived on fruit and nested on the ground. The dodo has been extinct since the mid-to-late 17th century. It is commonly used as the archetype of an extinct species because its extinction occurred during recorded human history and was directly attributable to human activity. The phrase “to go the way of the dodo” means to become extinct or obsolete, to fall out of common usage or practice, or to become a thing of the past.

One of the first things that stuck out at the recent REIW Asia conference in Singapore was the sponsorship. Gone were the days when the large global banks occupied the top rungs of the sponsorship banner, hosted multiple tables at the awards dinner and anchored the key speaking slots. Sure, there were other noticeable changes such as the reduced number of participants and the absence of Indian developers. But as to the missing banks, was this temporary or had the world of private equity real estate shifted?

Discussions with institutional investors, pension funds, fund of funds managers and consultants across the globe suggest that a new model is emerging. This new model is arising in response to the weaknesses in the old model that were laid bare by the global financial crisis.

I suggest that bank-sponsored real estate funds are, to borrow a phrase, going the way of the dodo. At the same time, as the void is filled, a new and stronger model will develop. The reasons are obvious and the evidence is out there. There is a need to husband scarce capital, to channel capital to flow businesses and to exit noncore, unscalable business lines. These are the drivers behind banks’ withdrawal from the real estate private equity business. It can be argued that investor concerns would have hastened this extinction just as well. These concerns encompass many of the issues that will find relevance in the new models.

Fear of GP Failure or Irrelevance

Take a brief look at the landscape and you will realise that any discussion about GP failure being a “low-risk event” is moot. Investor concerns are not centred solely on failure in the traditional sense of a GP that goes bankrupt. Failure comes in all sorts of guises.

A certain major US bank was marketing an Asian real estate fund in 2008. The bank was acquired in the fall of 2008 and the fund pulled. This is a GP failure. For an investor who had devoted valuable and scarce human resources to underwrite this fund and perhaps take it to their investment committee or board, this is a huge waste. This experience will influence future selection decisions. In fact, this was repeated in early-2009. Two additional bank-sponsored funds, one of which had achieved a significant first close were also pulled as the institutions – or their new parent companies, which may include the US government – formally announced their exits from the business.

Investors who closed into a Lehman Brothers fund just prior to bankruptcy are legally committed through the limited partnership agreement. AIG had closed on more than US$700 million of investor commitments to its Asia fund prior to suspension of activity in the wake of the government bailout of the company. The fund remains a legal vehicle and investors have limited or no repudiation rights.

When Japanese REIT New City Residence Investment Corporation failed, investors only then discovered the extent of problems with the investments made by the manager and had to take steps to replace the GP. The process of exercising LP rights to replace a GP is extremely time-consuming and expensive. Best to avoid any situation where this is a remote possibility.

These are the headline-grabbing situations. GP failure could mean the inability of the sponsor to fund its commitments. Change in ownership or control of a sponsor may lead to an acute investigation of how to back out of the sponsor’s subscription to a fund. This is perceived as a high risk and investors are shying away from any fund where this is a remote possibility.

The fear of GP failure will keep investors on the sidelines until there is clarity in the market. In the first quarter of 2009, investors were hoping this might return by the third quarter. Now, they are talking about 2010.

Size Matters

Investors who made commitments to funds that closed in 2008 have found themselves in a dilemma. Some part of the fund  between 40-70%  will be invested in late cycle 2007/2008 vintage real estate. Investors in some of these funds have formed the view that new investments at best will get them their money back. An unfunded commitment to a manager who has lost the carried interest is a growing concern. Why would an investor want to continue funding new investments when one of a number of adverse consequences could develop – the fund manager’s key people leave as there is no carry; the fund manager “swings for the fences”, taking extraordinary risk with the investors’ capital; the fund manager adjusts the business plan and staffing to maximise fee income. None of these are attractive outcomes.

Size does matter, but it may be that in the new investment world, smaller is better. Investors’ concerns regarding funds in excess of US$1 billion of commitments have to do with the following:

  • The fund manager will be driven by fee income instead of investment performance.
  • The fund manager may make very large bets that are outside the manager’s core competence.
  • There is a potential for excessive concentration of risk.
  • There will be a bifurcation of interests between large and small LPs.

Investors are taking a more acute interest in the human resources of their managers, current and future. A number of investors have noted that they expect immediate notification of changes in staffing numbers along with communication about how the manager will address the impact of these changes.

For investors contemplating new commitments, there is a heightened focus on the management team responsible for the fund in which the investor is committing capital. In the past, investors would give equal weight to the institutional nature of the fund manager and the strength of the global business if the manager were part of a global firm, and they would rely on the human resource decisions of the parent company. In discussions with investors today, the parent company or global enterprise is almost irrelevant, except where it can negatively impact the business.

For example, investors are asking direct questions as to the composition of investment committees, the extent to which decisions are made by the fund manager and not by people in other locations, and how decisions impacting size and makeup of staff are made.

There is a correlation between the size of a fund and investor comfort on the issues concerning human resources and fund management. The prevailing view is that a size in the range of US$600 million to US$1 billion affords a fund manager sufficient capital to execute a strategy in a reasonable time period (single-vintage investing), manage a pool of talent and reward that talent, while avoiding the unintended consequences of a mega-fund.

Failure to provide clarity on how investment and asset management decisions are made, on how human resource decisions are made and on how the fund manager compensates staff will most likely mean a pass by institutional investors.

The LP/GP Nexus on Fees, Structure and Documents

Much of what has been discussed in the previous paragraphs will be reduced to some form of transparency. Investors are unwilling to accept assurances; they want to see it in writing.

Fees may not be under as much pressure as one would expect. The general response from investors has been that fees are not the driving issue. We may see combinations of lower fee break thresholds and perhaps marginally lower fees. There is likely to be more discussion about committed versus invested capital as well as NAV as a basis to assess fees. Hurdle rates may drift up or we may see tiered entry points for the carry. Perhaps the thresholds will come down to US$100 million. Fees of 1.5% of committed capital may be under some pressure in the order of 100 basis points to 200 basis points. The expectation by investors is that the hurdle will have to move up by 100 basis points and the catch-up modified or eliminated.

Management team participation will be subjected to crystal-clear analysis, both in terms of direct cash investment as well as the distribution of the carried interest. Feedback from investors is that the management team of the fund in which they are investing should hold 50% or more of the carry, with the sponsor and its entities holding the balance. The line is clearly drawn around the management team, not a global business. Investors acknowledge that they had accepted different distributions in the past during a sellers’ market but are unwilling to do so in the future.

A similar thought process informs investors’ views of key-man clauses. Under the same theory that they are making commitments to management teams, not to global organisations, the key-man clauses will have to reflect this. Investors want to have a tight leash and if the people they are investing with leave, an immediate time-out on any new commitments has to be called. This may be temporary or permanent, subject to discussions with the GP.

While not a matter for the subscription agreements, LPs are struggling with how to get comfortable with compensation. Basically, LPs want to know that the fund manager will be able to compensate and retain talent. For independent managers, this is not a particularly bruising issue but for funds embedded in larger organisations, this is an important issue. Investors want to know that a) headcount envelopes will remain intact and b) compensation will be a function of the fund and not of anything else. Investors recognise the difficulty in translating this wish into something concrete. Some may accept assurances, others will not.

Documents are going to be more precise in what the GP can and cannot do before referring a matter to the advisory board. Wide-open language, which basically allows the GP to do anything and limits the advisory board to after-the-fact approvals of related-party transactions, will not be acceptable in the new environment. These restrictions may apply to leverage limits as well as very granular asset attributes. Other points could be any deviation from a very specific strategy, limits on development or related-party transactions.

Many investors have said they will not participate in traditional funds unless they can be on the advisory board. Other investors have stressed that their concept of an advisory board in the future will be a more active one that is involved in ongoing discussions of strategy.

David Schaefer was previously chairman of the investment committee of the Asia real estate private equity fund CPI Capital Partners Asia Pacific LP, a business he founded with Citi in 2005.

This article first appeared in The Institutional Real Estate Letter Asia Pacific (Pg 13, Vol 1, Number 9, October 2009 issue). For more information, please visit