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After pruning manager lists, real estate investors now want results

Pension funds look for returns from the firms that survived roster cuts

Ted Leary
Ted Leary

Real estate investors' decisions to invest more capital with fewer managers is putting pressure on managers to show clients something special or face a long, slow demise.

While investors began pruning their rosters of real estate managers following the financial crisis, many are renewing that effort. California Public Employees' Retirement System, for example, changed its real estate portfolio and began reducing managers in 2010. But last June, CalPERS officials said they would reduce the number of managers in their total fund by half, to 100 by 2020. Real estate managers will be reduced to 15 by 2020, from about 76 now, confirmed Joe DeAnda, spokesman.

As part of this process, CalPERS in November sold $3 billion worth of limited partnership interests in 43 real estate funds to New York-based Blackstone Group LP.

Right now, the biggest real estate money managers and the smaller, specialized boutique managers are getting the bulk of the available real estate capital, leaving hundreds of other managers in the dust. The result is expected to be a reduction in existing real estate managers as the “have-nots” run out of fresh capital and run down their portfolios.

“There are far too many managers out there,” said Ted Leary, founder and president of consultant Crosswater Realty Advisors, Los Angeles. “There are the megamanagers like the Blackstones and the Blackstone wannabes, about eight to 10 of them that snarf up half the money. Then there are the smaller but highly focused players. That leaves 25% to 30% of the available capital for 600 firms that I call the mushy middle.”

The “mushy middle” comprises real estate managers that aren't large and don't have “a truly compelling” investment strategy, he said. There isn't enough capital to support them all.

While the total amount of capital raised in real estate funds dipped 4% to $107 billion in 2015, down from $111 billion raised the year before, the number of funds closed last year dropped 33% to 177 in 2015, from 265 in 2014, according to London-based alternative investment research firm Preqin.

Blackstone Group raised the largest fund last year. Its gigantic $15.8 billion Blackstone Real Estate Partners VII fund greatly overshadowed the next-biggest fund raised in 2015, the $5.8 billion Lone Star Real Estate Fund IV.

Examples of specialized real estate funds that closed last year include the $1.4 billion Beacon Capital Strategic Partners VII, which invests in value-added offices in U.S. urban markets; the $511 million Waterton Residential Property XII, LP, which invests in a value-add multifamily properties in the top 12 to 15 markets in the U.S.; and the $60 million Rock Creek Property Group Fund II, which invests in retail, office, multifamily and industrial properties in Washington, D.C., Maryland and Virginia.

Even the winners in this brewing have/have-nots scenario could be in trouble later if they fail to deliver on current promises, Mr. Leary said.

“It's beginning to look like a bubble in the making. Historically, real estate got in trouble where there was overbuilding, overleverage or both,” Mr. Leary said.

While leverage is creeping up, there's not much overbuilding. This time it's a different kind of bubble, he said.

Bubble in expectations

“I don't think it's a bubble that will immediately explode, but there is a bubble in manager promises and client expectations,” Mr. Leary said. “There's little room for error.”

Fundraising hasn't been easy for the majority of managers out there. Currently, there are 492 funds in the market seeking a combined $174 billion. In 2015, 36% of funds exceeded their fundraising target, down eight percentage points from 2014, with the percentage of funds failing to meet their target remaining at 42%, according to Preqin.

Indeed, at CalPERS the top 20 real estate firms invest 93.7% of the Sacramento-based pension fund's entire $27.5 billion real estate portfolio, according to the latest CIO Performance Report for the period ended June 30.

“There's also a process of natural selection that takes place among clients with a large roster of managers,” said Jack Koch, principal of The Townsend Group, a Cleveland-based real asset consultant and money manager.

Investors are less open to newer relationships than they were just after the financial crisis, said John H. Sweeney, vice president at New York-based placement agency Park Madison Partners LLC.

“Now most investors are happy with managers they have and so the bar for a new manager is a lot higher,” he said.

The Oregon Investment Council, Tigard, which runs the $69.7 billion Oregon Public Employees Retirement Fund, plans to invest more real estate capital in larger, strategic partnerships, according to its Dec. 9 real estate review. What's more, officials plan to invest with new relationships “for complementary investment styles only” and to be selective with investing in current managers' new funds.

“When investors start contemplating new relationships ... they want to know the new relationship will be there for the long-term,” Mr. Sweeney said.

“They ask the question, `Is this strategy repeatable or is this a moment in time?' If the latter, investors have to ask what is the next strategy?” he explained.

New managers are especially having a tough time raising first funds, said Gentry Ashmore Hoit, partner at Park Madison Partners. “We have to make more calls and knock on more doors.”

The peak in the fundraising cycle for emerging managers was 2011 to 2013, she said.

“There was this period after the financial crisis in which investors were cleaning out portfolios and replacing those managers that had underperformed,” said Park Madison's Mr. Sweeney. “They (investors) were more open-minded to new relationships at that time.”

There is likely to be a reduction in the number of firms, “maybe a substantial reduction,” Mr Leary predicted.

However, Mr. Koch said the number of managers probably won't change, just the names of the managers.

“I don't think the overall numbers will greatly shrink. Guys will split off from their old firms and form their own. People will always think they have a better mousetrap,” Mr. Koch said.

Even so, it is harder for smaller and newer managers to raise money than it was five or 10 years ago, he said. Firms in the middle will have the most difficulty being successful. They will have to demonstrate absolutely to investors that they have the expertise and the ability to perform, Mr. Koch added.

"Getting squeezed'

“The middle market is getting squeezed,” said Michael Underhill, chief investment officer at Pewaukee, Wis.-based real asset manager Capital Innovations LLC, which has about $1 billion in assets under management.

“Managers have to have not only a niche, but they need to have the experienced people running the money,” said Mr. Underhill.

They also have to be willing to be a resource for investors, he said.

Capital Innovations strives to differentiate itself by offering knowledge and information to clients, he said. It offers clients access to white papers published by the firm's Capital Innovations Institute.

“When clients ask us what is going on with financial structures or the geopolitical risk ... they get the answers very quickly in a prepackaged manner,” Mr. Underhill said.

It's possible that the trend to consolidate managers will moderate.

Private equity investors also have been writing larger commitment checks to fewer managers but that trend is beginning to slow, said Eric Zoller, co-founder and partner at Sixpoint Partners LLC, a New York investment bank working with middle-market private equity firms.

The trend was big in 2010, 2011 and 2012 but investors reached their typical 10% limitation, restricting the percentage of a fund the investors can make up, Mr. Zoller explained.

This article originally appeared in the January 11, 2016 print issue as, "After pruning manager lists, investors now want results".