August 18, 2016
The United Kingdom’s vote in June to leave the European Union has further fuelled uncertainty surrounding pre-crisis real estate funds, which are already facing pressure to sell tens of billions of pounds/euros/dollars worth of assets.
Preqin has estimated that $9.32 billion (€8.4 billion) of assets remain within 2008-vintage Europe-focused real estate funds alone, with $10.65 billion (€9.58 billion) of unrealised value among 2007-vintage funds and $9.02 billion (€8.11 billion) in 2006-vintage vehicles. This compares with $3.15 billion (€2.83 billion) of unrealised value held by 2005-vintage funds and lesser amounts for 2004- and 2003-vintage funds. The “Unrealised value for Europe-focused real estate funds” table below gives further details.
The figures raise questions about whether managers should continue to hold their pre-crisis investments — executed in the era of dramatically rising deal values — in the hope of recovering value in the long term.
Keith Breslauer, founder of Patron Capital Partners, says: “The problem with that logic is that a lot of people are in debt. If something is over-levered and the banks have too much debt on it, the banks may be extending the process for purposes of their own balance sheet but the borrower — the manager — is now essentially working for the bank.”
Alex Price, chief executive of Palmer Capital, explains: “There are a lot of European banks that still have outstanding loans to real estate and those loans may be worth less than the value of the asset.”
Henri Vuong, director of research and market information at INREV, the European Association for Investors in Non-Listed Real Estate Vehicles, adds that the returns from pre-crisis investments have also contributed to the backlog. She says: “Leverage has come down so it’s not necessarily a case of them just being highly-levered. There are two more plausible explanations. First, if performance has disappointed, it doesn’t make sense to place assets on the market. Second, since real estate is still an attractive play, it doesn’t make sense to take your money out only to have to reinvest with fewer attractive options available.”
According to Preqin, 2008-vintage European real estate funds have delivered a median net internal rate of return — an annualised measure of performance — of 3.3 percent. This compares with 6.2 percent for 2007 vintages, 1.5 percent for 2006 vintages and –5.0 percent for 2005 vintages. In stark contrast, 2004 vintages returned a median 15.6 percent.
From 2009, as can be seen in the “Private closed-end real estate fund IRR performance” table to the right, the figures rebounded significantly — 14.0 percent, followed by 12.1 percent in 2010 and 14.6 percent in 2011.
Time pressure
The structure of closed-end funds, which typically have 10-year lifespans, makes the challenges in exiting legacy portfolios more complicated. Such funds traditionally have an approximately five-year investment period and a five-year exit horizon. Investors would expect all of their capital to be returned by the end of this cycle, putting pressure on managers to realise their portfolios on time.
Following the financial crisis most closed-end vehicles approaching the end of their cycles secured extensions rather than winding up in a bid to avoid exiting their investments well below par, according to INREV. It said that, as the exit market had improved, managers had faced less pressure to extend vehicles. However, the United Kingdom’s majority vote on 23 June to leave the European Union has caused further uncertainty around the future of highly-levered and underperforming assets.
Mark Wilkins, head of the European property multi-manager investment business at Aberdeen Asset Management, says that the Brexit vote will make it more difficult to sell real estate assets — particularly in the United Kingdom — in the short term. He says: “Investors dislike uncertainty and the resultant negative sentiment feeds into short-term pricing of assets. This is less visible in UK property markets but the steep falls in the value of UK-listed real estate companies do reflect, among other things, an expectation that the values of the underlying UK property assets are falling. We would expect this uncertainty to spill over into continental Europe as well.”
Paul Parker, managing director for real estate in Europe and Asia at secondaries firm Landmark Partners, says: “Where asset marks are still held above valuation and those assets have some hair on them, Brexit will not assist at all. Overseas capital will likely become more selective in identifying opportunities, in light of market dislocations and currency devaluations.”
Jos van Gisbergen, a senior portfolio manager at Syntrus Achmea, says: “The United Kingdom may suffer if business is re-allocating toward the continent and takes jobs with it. If this is going to happen, it will be positive for the continent but bad for the United Kingdom. Time will tell and it is too early to make any predictions yet.”
Real estate portfolios that have entered wind-down include Doughty Hanson’s real estate business. In 2014, the UK private equity firm agreed with Invesco Real Estate that eight executives from Doughty’s real estate team would join Invesco Real Estate, where they would manage five of the remaining assets in the Fund II portfolio. Doughty opted to retain its investment in Fund II and manage three of the remaining assets.
The move followed the death of Nigel Doughty, co-founder of the firm, in February 2012, after which the firm said that it would focus on its core private equity business and raise no further real estate funds.
Doughty Hanson currently lists one remaining real estate investment on its website — Golf Park, a light-industrial and office building in Toulouse.
In 2012, Palmer Capital took Invista Real Estate Investment Management private for £41 million (€48 million) after the business, which had net assets of £58 million (€68 million), had suffered from a lack of investor interest. The company had come under Lloyds Banking Group’s ownership after Lloyds’s acquisition of HBOS, Halifax Bank of Scotland, in 2008. However, Lloyds’s focus on Scottish Widows Investment Partnership meant that little attention was paid to Invista, according to Palmer Capital’s Price.
He says: “It went from having a great parent to being an independent company. At the same time, a couple of people left the business and it ended up effectively in run-off mode run by an interim staff… with a bunch of assets that those guys didn’t necessarily know.”
As a result, the team managing the portfolio was not aligned with the underlying investors, he says, and Palmer Capital arrived to wind it down — a process that Price says took about three years, effectively ending in September last year.
Interest in secondaries picks up
Exiting a European real estate fund appears more difficult than selling a position in a buyout fund — figures published by Landmark Partners show that last year real estate secondary market deals reached $8.2 billion (€7.4 billion) globally; a 71 percent increase on the $4.8 billion (€4.3 billion) of deals completed in 2014.
US-focused funds accounted for 49 percent of the assets sold last year while European and Asian funds represented 16 percent and 13 percent of deals, respectively. Meanwhile, 83 percent of sellers were in the United States while 11 percent came from Europe and 6 percent from Asia.
Breslauer says that the relative lack of secondary market activity in Europe is largely due to the nature of the underlying assets in the bulk of the market — core and core-plus, quality real estate that sellers are more likely to hold for longer in the hope of achieving more attractive valuations. As a result, the small size of the secondhand market has meant fewer buyers.
Parker says that the real estate secondaries market is catching up with private equity but that awareness and acceptance of the market for secondhand property fund positions was always likely to take a long time to develop post-crisis, when discounts deepened significantly, reflecting over-levered assets.
However, he says: “In recent years, the discounts have become more palatable to LPs considering liquidity and this, coupled with the desire for investors to take more progressive and active management roles in their unlisted portfolios, has combined to deliver the growth that we have witnessed. The proliferation of investors who want to take a more active role in the management of their portfolios will continue to roll into new markets that have yet to embrace secondaries, and this will drive further growth.”
Potentially tricky negotiations
Instead, investors are likely to grant an extension — usually one to two years — if the manager recommends further time to exit deals and if the banks are happy with the plan.
Van Gisbergen says that forced selling at any price would be a bad move for real estate funds and that smart investors should extend the fund’s life to pursue an ordinary sales process and avoid deep discounts. He says: “The funds that come to the end of their time and need to sell are in bad shape. Due to uncertainty, risk premiums will increase and so valuations have to come down in the short term.”
Once investors have voted for an extension, alignment of interests is typically the biggest issue during a wind-down process, according to Price, with the existing fee structure often failing to incentivise the manager to exit the portfolio as quickly as investors might expect.
Price says: “At that point, the manager wants investors to look at the cost of the fund and the fees they are earning to negotiate a better deal for investors. The first thing to look at is the cost base. You need to demonstrate that the business plan you have come up with means that you’re going to make more money in the future than if you were to sell it now.”
Closed-end real estate funds — like private equity funds — traditionally charge investors a 1 percent to 2 percent management fee and a 20 percent performance fee on gains exceeding an agreed hurdle. During its five-year investment period, the management fee is typically based on the amount of capital committed to the fund, and later, the post-investment period, on the cost of the investments made. During a wind-down it is essential to renegotiate the fees so the manager is not incentivised to hold on to assets for an unreasonable period in an attempt to maximise its steady management income.
In some cases, the manager will waive the management fee. Price says: “At Invista, we charged a fee for the first three years and it’s taken us six months longer than we expected on the last assets. We won’t charge you a fee. There is no right or wrong [answer] but a good manager will stick to its side of the bargain.”
Meanwhile, the manager will likely want to rebase the value against which it is entitled to a performance fee, or carried interest.
Jeremy Bell, a partner at law firm Ashurst, says that, in the event that the assets have fallen significantly in value and are highly unlikely to fully recover, the manager may consider a rebased carry in a bid to achieve as much value as possible in the coming years. For instance, if the assets were worth 10 pence on the pound, a new basis could be 10 percent carried interest, should the manager achieve 30 pence in the pound.
He says: “Investors agree to carry terms at the outset, so rebasing is exceptional. I have certainly seen rebasing of carried interest where, through market forces beyond the control of the manager, the assets are under water and will never recover, and where the investors agree to re-incentivise the manager to try to achieve some increase in value.”
In more drastic cases investors may use a no-fault removal clause to remove the existing manager from the fund. Bell describes this process as “potentially painful” and “not to be undertaken lightly” — the manager is typically contractually entitled to a payment from the fund in lieu of lost management fees, which can be as high as two years’ worth.
Bell says: “The removal of a manager and its replacement is a substantial and probably quite confrontational exercise.”
However, Price says that his experience with the Invista portfolio demonstrated that installing a new manager could lead to a better outcome. He says: “You have a bit more energy to deliver, you probably have fresh ideas and you have no legacy for the issues that have been created. You can have a much more open dialogue with your investors.”
Author: Jennifer Bollen, Institutional Real Estate