The real estate private equity fund market has dominated the real estate landscape and is arguably the most significant driver of real estate transactions today. Through the first half of 2007, capital flows to real estate were still very strong. Our survey respondents have raised more than US$225 billion of capital since 1991 with more than US$38 billion raised in 2006 and US$23 billion raised in the first half of 2007. An additional 35 funds with targeted capital of US$35 billion are in the process of being raised. Considering the returns on alternative investments over the past year, real estate private equity performed comparatively well on a risk-adjusted basis. In light of the strong fund performance, 84% of our survey respondents believe that capital flows to real estate will increase or at least remain at the same high level for the balance of 2007 and for 2008.
Total Fund Equity Raised (by year)
Cumulative Fund Equity Raised (by year)
While some pension funds may be bumping up against their real estate asset allocation percentages, others are still racing to catch up as a result of being underweighted in this asset class during a period of tremendous market appreciation.
As shown in the Investor Base Composition chart below, for larger funds of more than US$500 million, more than half of the capital being raised comes from pension funds, foundations and endowments. In smaller funds of US$500 million or less, a smaller portion of capital raised comes from these sources while more than a quarter of the capital comes from high net worth individuals. The fund sponsor and its affiliates make up an average of 5% of fund capital on a combined basis. Although more common in the traditional hedge fund or private equity fund space, we are also starting to see greater capital sourcing from real estate funds of funds.
Investor Base Composition
The following observations support the view that the capital-raising portion of the real estate fund life cycle has been robust:
Fund sizes are still growing
New funds continue to proliferate
There is a high level of recommitment of capital to successful fund sponsors in their successive funds.
Fund Sizes are Still Growing
Without a doubt, the average fund size in the industry continues to grow. Based upon our survey, the average size of the funds raised from 2005 to 2007 was US$844 million. This is up 79.5% from the average size of funds raised from 2001 to 2004. Where multi-billion dollar funds were once few and far between, they are now more common, with even those first-time fund sponsors we interviewed looking to close their funds at US$1 billion or more. This is a clear indication of the magnitude of capital seeking real estate private equity returns.
Fund Size, 2005 – 2007 (US$)
Fund Sizes, 2001 – 2004 (US$)
Interestingly, conventional wisdom would suggest that fund sizes are linked to the amount of capital a fund sponsor can reasonably invest at or above the fund’s return expectations during the investment period (usually about three or four years). Following this logic, the growth in fund sizes would seem to reflect what must therefore be the fund sponsors’ increasing confidence in their ability to identify and capture real estate market opportunities. Indeed, many recent examples can be cited of fund sponsors fully committing to investment opportunities and reaching the limit of their subscribed capital in a fraction of the time permitted in their investment windows, prompting the launch of even larger funds. However, this experience is not universal.
The significant capital availability that has supported the fund-raising portion of the cycle has fuelled tremendous competition for investment opportunities. Based on some of our interviews, caution appears to have crept into the psyches of some fund sponsors, and these fund sponsors have bucked this increasing fund-size trend. These fund sponsors believe that the increased competition for investment opportunities has and will continue to put pressure on the fund-size decisions of tomorrow.
New Funds Continuing to Proliferate
In our 2005 market research paper, we noted a marked increase in the number of new funds coming to the market. In 2006 and the first half of 2007, this trend has continued and perhaps even accelerated: 36% of the funds raised in the last 18 months by our survey participants were raised by first-time sponsors. These new fund sponsors came from numerous sectors within the real estate investment community. However, one of the more significant trends relates to investment professionals within large funds who have left to start funds of their own. Investment professionals we spoke to indicated that they had helped their former employers successfully invest billions of dollars over the last three to five years and were looking to continue their success under their own banners.
Another interesting trend is the attempted disintermediation of the mega-fund by local real estate developers. In years past, large fund sponsors, often referred to as “capital allocators,” would joint venture with local developers to combine their capital effectively with local development expertise, often to great result. These developers, recognising the returns made by these large funds, are attempting to eliminate what they see as the middleman and go directly to the pension plans to raise capital for funds of their own. They argue that the value being created by the fund intermediary is insufficient to justify the double promote, ie, a carried interest allocation to both the developer and fund sponsor. As a counter to these claims, mega-fund observers point out that these local developers often don’t have the scope and depth of organisation to support a multi-investor/multi-project fund. These larger fund sponsors argue that where the local developers created value by intensively managing two or three development projects each year, their attempt to broaden their focus and increase their volume will dilute the intensive management focus on the development process that made them successful in the first place.
The proliferation of fund players and the continued success of established funds with deep track records are starting to put pressure on the ability of new fund entrants to reach their capital raising targets easily. One new fund sponsor observed that the first question they have to answer is why rational capital should invest in their fund over the many fund options available with deep established teams and a clear and consistent track record.
There is a High Level of Capital Recommitment
In the face of performance returns that seem almost universally positive, one trend of note is the recommitment of capital by investors to a fund sponsor’s successive funds. Many market participants have noted that when it comes to making investment decisions, there is no substitute for performance consistency. Consistent performance returns at or above return expectations were characterised by one interviewee as “nearly addictive.” Of course, fund-offering documents all tend to say “prior investment performance is not necessarily predictive of future investment results,” but this disclosure has not appeared to impact the trend. Recommitment by investors to next-generation funds is widely reported as being very high. If out-sized performance returns continue unabated, it doesn’t seem likely that this trend will change.