Mark A. Grinis, global real estate investment funds leader at Ernst & Young LLC, New York, agreed: “The principle is that the co-investment has got to mean something to the general partner.”
If a small, four-person investment group makes a 2% co-investment in a $400 million fund, that is going to mean a lot more than if a big investment bank invests a similar percentage in its real estate investment subsidiary's fund, he explained. “I think the lesson learned is investors are looking for the key principals to have material skin in the game,” Mr. Grinis said.
Across the real estate investment business, many real estate managers are making pre-emptive changes to funds to make the co-investments more attractive. Many new funds are pooling returns so managers no longer are able to extract their returns on a deal-by-deal basis. Instead, profits are pooled and everyone — managers and investors — waits until the fund is liquidated before they can share in the profits and fees, Mr. Grinis explained. What's more, management fees in the new funds are substantially lower and are based on the committed capital, so investment managers can no longer make money in fees whether the properties make money or not.
Large co-investments provide little guarantee of returns. Morgan Stanley Real Estate funds include a 10% capital commitment, which was called for Funds V and VI, sources told Pensions & Investments.
Through March 31, 2010, Morgan Stanley Real Estate Fund V International LP has returned -2.9% since inception in October 2005 and Morgan Stanley Real Estate VI International LP returned -84.2%, since its July 2007 inception, according to CalSTRS' latest semiannual real estate report.
“What helps us sleep at night is the notion that whatever happens to us will happen to the manager,” said Marc Weidner, New York-based managing director of real estate fund-of-funds manager Franklin Templeton Real Estate Advisors. “But it's a mirage.” Some of the real estate managers structured their fee arrangements so any losses from their co-investments were relatively modest when compared to the asset management and other fees those managers received, he said.
Wall Street investment firms with real estate management subsidiaries created the strategy of co-investing to coax wary investors into real estate portfolios the firms had bought through the Resolution Trust Corp., a federal program begun in 1989 to liquidate assets held by insolvent savings and loans.
The idea of shared risk with managers gave investors comfort and worked to draw them into these investments, explained Ted Leary, president of consultant Crosswater Realty Advisors, Los Angeles. Now, co-investment is de rigueur in the industry.
“It makes everybody feel better if the general partner loses money alongside the limited partner,” Mr. Leary said in an interview.
In a letter this month to clients and colleagues, Mr. Leary wrote, “I continue to see no demonstrable evidence that manager co-investment makes a manager a better investor. In fact, some of the most dramatic loss situations I dealt with involved very significant co-investment by the manager. On the other hand, several of the most successful programs I observed had minimal manager co-investment.”
Some managers have defaulted on their co-investment, consultants say, although none would name names.
“Some managers overstretched because they bought the dream that they were selling,” Franklin Templeton's Mr. Weidner said. He would not identify any firms.
Still, not all of the big managers that made large co-investments suffered lousy returns. Many held their own, even during the latest financial crisis. Warburg Pincus LLC, Madison Capital Partners and Square Mile Capital LLC all managed to return investors' capital plus some profits, insiders said.
Alignment of interests is serious business to investors. Last August, CalSTRS bought out its partners' 10% interest in four joint ventures it entered into in 2005 with First Industrial Realty Trust, a real estate investment trust.
“The move was done to achieve full control of the properties because CalSTRS felt there was not a full alignment of interest between partners,” Mr. Duran told P&I at the time.
Most institutional investors are reviewing their real estate investment strategies and how they invest in the asset class, but few are jettisoning their co-investment requirements.
“I must admit I have not won this argument with my clients and certainly not with the consultant community,” Crosswater's Mr. Leary said.