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April 04, 2005 01:00 AM

Alternatives: The capacity problem

Plan sponsors are itching to get a piece of the pie. Where will they put all that money?

Arleen Jacobius
Christine Williamson
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    Table: The top 50 pension investors in alternatives

    Institutional investors' craving for alternative investments has created a huge capacity crunch that's not expected to ease any time soon.

    This year, institutional investors plan to put at least another $121 billion into private equity and $51.4 billion into real estate, according to various industry researchers. Institutions could invest as much as $50 billion in hedge funds this year and as much as $210 billion over the next three years, according to growth estimates from the Bank of New York and Casey, Quirk & Associates LLC.

    However, where that money will go is an unanswered question. Lines of institutional investors are already stretching outside the door, according to many alternatives managers, particularly for core real estate and venture capital funds.

    "It's going to be a real challenge for institutional investors to invest in these asset classes," said David Hammerstein, principal, Yanni Partners, Pittsburgh. "It's absolutely critical in each of these asset classes to pick the best managers and to get capacity, a space within their funds. It's very possible that institutional investors will not be able to meet their target allocations" because of current and impending capacity constraints.

    U.S. institutional investors allocated nearly $500 billion to alternatives in the year ended June 30, 2004, according to data from Greenwich Associates Inc.'s annual survey. About $210 billion was invested in equity real estate, $185 billion invested or committed to private equity; and $90 billion in hedge funds and hedge funds of funds.

    Some 34% of investors surveyed by Greenwich said their hedge fund allocation would rise by the end of 2007, 31% said their private equity investment would be larger and 23% would boost the equity real estate allocation.

    $230 billion

    Private equity and venture capital managers are expected to attract at least $230 billion in 2005, according to data from Private Equity Intelligence Ltd., the London-based private equity research firm. Funds already being raised this year represent total target values of $121 billion in buyout funds, $36 billion in venture capital funds and $14 billion in private equity funds of funds.

    By comparison, 2004 data from Private Equity Intelligence show that private equity fund managers raised $66 billion in buyout, $30 billion in venture capital and $11 billion in fund of funds.

    The London firm's data showed public pension funds invest $210 billion in 319 private equity firms, corporate pension funds invest $90 billion in 393 funds, foundations and family offices invest $27 billion in 467 funds and endowment plans invest $26 billion in 328 funds.

    As for hedge funds, a September 2004 survey by Casey Quirk & Associates, Darien, Conn., and the Bank of New York, New York, estimated that investment in hedge funds by U.S. institutional investors is expected to increase 12-fold. By the end of 2008, investments should grow to $300 billion, up from about $25 billion as of Dec. 31, 2001.

    Large buyout and late-stage venture capital funds are only expected to be producing returns of 3 or 5 percentage points more than returns of the Standard & Poor's 500 index over the next year said Thomas R. Dorr, chief investment officer of the private markets team for Morgan Stanley Alternative Investment Partners. Still, those strategies are still attracting much of the institutional private equity dollars.

    Large buyout funds currently in the market, including the $6 billion Carlyle Partners IV, the $6 billion Thomas H. Lee VI and the $3.5 billion Clayton Dubilier & Rice VII, have no trouble attracting investors. Even the whopping $10 billion fund being raised by The Blackstone Group, New York, is expected to be oversubscribed.

    "Whether they are TPG (Texas Pacific Group), KKR (Kohlberg Kravis Roberts & Co) or Tommy Lee, the expected variables and the results are pretty narrow," said Mr. Dorr. "It's the same people looking at the same deals. But they are reasonably reliable and a good product for large investors."

    Oversubscribed funds

    Venture capital funds are also oversubscribed as they raise funds that are 25% to 40% smaller than previous ones, noted Parag Saxena, managing partner of INVESCO Private Capital, New York. "Now, there are non-top-tier funds raising larger funds. … These managers are taking the money and raising the size of their pool," Mr. Saxena said.

    For example, Golden Gate Capital, San Francisco, a 5-year-old private equity fund manager led by David Dominik, who was a managing director at Bain Capital, turned away billions when the firm raised its last fund, said Jeff C. Hammes, senior partner at Kirkland & Ellis, a Chicago-based law firm who represents Golden Gate.

    Institutional investors are seeking to invest more and more money in private equity funds, Mr. Hammes said. "I see $1 billion funds who are getting $5 billion in commitments."

    But most private equity fund managers are not risking their returns by collecting all the investment dollars that are offered, said Mr. Hammes.

    "They're in an IRR (internal rate of return) driven business. They are looking to produce the largest IRRs," he said.

    Some institutional investors who cannot invest as much as they would like with top-tier private equity and venture capital firms are investing in hedge funds and real estate funds, Mr. Saxena said.

    "A lot of people are finding and going into hedge funds," Mr. Saxena said. "Overall the beneficiaries of the search for IRR are the hedge funds and to some extent real estate."

    One reason getting into hedge funds will be somewhat easier is the likelihood of changes in global capital markets, which create opportunity for hedge fund managers, said Yanni Partners' Mr. Hammerstein.

    "If market dislocations occur, like some of the major credit events of 2002, that creates great opportunities for hedge fund managers, especially those offering distressed debt or credit strategies," Mr. Hammerstein said. The more volatility in the market, the more capacity hedge fund managers tend to have, he added.

    Since many institutional investors are making their hedge fund allocations through fund-of-funds managers, the issue of capacity becomes the intermediary's problem, sources said.

    For bigger hedge fund-of-funds managers, those with more than $5 billion under management, capacity is usually not a problem, said Jeff Gabrione, research consultant in the U.S. investment manager research group of Mercer Investment Consulting Inc., Chicago.

    While most of the biggest hedge fund-of-funds managers are receiving plenty of institutional dollars — among them GAM AG, UBS Global Asset Management, Blackstone Alternative Asset Management, Permal Asset Management and Ivy Asset Management — industry observers said a number of midsize hedge fund-of-funds managers are coming into their own.

    Institutional investors are beginning to steer business toward up-and-comers with between $1 billion and $5 billion, such as Attalus Capital Management LLC, CAMG Rock Creek Group, Cadogan Management LLC, Silver Creek LLC, ArchStone Partners LP, Aetos Capital Management and Mariner Investment Group.

    Asset Alliance Corp., New York, with about $4.2 billion in hedge fund and fund-of-funds assets, is controlling capacity issues by buying minority stakes in promising hedge fund managers and incubating emerging managers, which guarantees future access, said Bruce Lipnick, president and chief executive officer.

    Asset Alliance owns minority stakes in 14 hedge fund managers and in about two weeks will make an investment in a 15th manager, which Mr. Lipnick did not identify.

    By buying stakes in two or three hedge fund managers per year and providing start-up capital and investment in another two to three fledgling managers, "we get into the best managers that everyone wants. You have to keep investing to keep capacity open," Mr. Lipnick said. Asset Alliance also uses 24 outside hedge fund managers and offers two funds of funds.

    Russell Investment Group, a Tacoma, Wash., manager of managers, offers non-directional, lower beta hedge funds-of-funds strategies which often use capacity constrained underlying managers, said Jeff Geller, director of hedge funds. That necessitates keeping a close eye on the size of assets allocated to each individual manager because "we want every investment we make with every manager to have a meaningful impact on the performance of the portfolio," Mr. Geller said.

    Mr. Geller said Russell carefully monitors the cash flow coming from clients and won't accept more on a monthly basis than its portfolio managers are certain can be put to work with underlying hedge fund managers.

    "From our standpoint, we want to make sure that we don't continue to grow a particular fund to the point that it is so large that we begin diluting the impact of `high confidence' managers who happen to be closed (and will not accept more cash)," said Mr. Geller, who is based in the firm's New York office.

    Russell manages $4 billion in hedge funds of funds.

    While hedge fund managers say that institutional investors will have no problem investing all the money they want in the larger hedge funds, institutional investors are having more trouble investing their real estate allocations.

    Investing in real estate is getting more difficult as investors are angling for space in the best opportunity funds, consultants and investment managers say.

    Real estate funds by managers such as RREEF/Deutsche Bank Real Estate, JPMorgan Fleming Asset Management, Apollo Real Estate Advisors LP and Heitman LLC have been oversubscribed.

    Some big investors are continuing to form joint ventures with both investment management firms and real estate operating companies to invest their real estate allocations.

    For example, last month the $125 billion California State Teachers' Retirement System, Sacramento, entered into joint venture with First Industrial Realty Trust, New York, investing $300 million in U.S. industrial property. CalSTRS was not the only pension fund competing for the opportunity, said Mike Brennan, First Industrial's president.

    First Industrial invests in the development and repositioning of corporate real estate and raises money in part through co-investments, Mr. Brennan said. First Industrial does not raise funds, but co-invests with institutional investors such as Kuwait Finance House, he said.

    A number of pension funds vied for the opportunity of entering into the current joint venture with First Industrial, Mr. Brennan said. He declined to identify them or give the number. But he added: "in making the choice we looked at the financial capacity and in the level of sophistication. They (CalSTRS) are sophisticated and knowledgeable and well-advised by CB Richard Ellis."

    Investors are clamoring to either co-invest with fund managers or real estate operating companies or invest in real estate funds mainly for the returns but other factors are also enticing, consultants say.

    "The performance of the real estate market over the last five years has been spectacular. … Continued appreciation potential, consistent cash flows as well as portfolio diversification are the primary reasons why pension funds are allocating more and more funds to real estate," said Scott Farb, principal with real estate consultant Gumbiner Savett Inc., Los Angeles.

    "So far the capital flows into real estate appear to be unabated. So long as commercial property fundamentals improve enough to offset rising interest rates and escalating operating expenses, you will see a lot of interest in real estate, and real estate should continue to perform comparatively well.

    "If you see a reversal of the economy or fundamentals get worse such as a rise in the unemployment rate, or lease and occupancy rates go down, returns will decrease. It really depends on the overall economy."

    Non-U.S. real estate funds are starting to grow in popularity among institutional investors. A February report by San Francisco-based real estate consultant Kinsley Associates for Institutional Real Estate Inc., a Walnut Creek, Calif., real estate trade publisher. revealed that large tax-exempt plans are more than doubling their allocation to overseas real estate to 8.4% this year from 3% in 2004, Mr. Farb noted.

    "According to Ernst & Young (Ernst & Young LLP), opportunity funds are now going abroad with 60% of all the capital going overseas because of the high prices for commercial real estate in the U.S.," Mr. Farb said.

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