From private funds to cash
Real estate has become firmly established as a component of diversified investment portfolios, and exposure to it is often obtained through indirect private equity structures. The popularity of this route can be judged from the fact that - according to Ernst & Young - $110bn (e92.5bn) of capital has flowed into such structures in the past 10 years.
Institutionally sponsored, these funds can expose the investor to core, core-plus, value-added, opportunistic, joint-venture, private placement and retail syndication investment strategies.
The initiators of these funds have devoted significant time and attention to the science of aggregating equity capital. A lesser amount of attention, however, has been focused on establishing a credible liquidity mechanism should an investor seek to exit the structure before the planned liquidation of the underlying portfolio.
Investors make commitments to private real estate vehicles that can last for more than 10 years. These interests, amounting to non-controlling, partial ownership stakes in commercial real estate portfolios, are difficult to sell if liquidity is needed.
As sure as eggs are eggs, investors owning illiquid interests will at one time or another require a mechanism enabling them to achieve early liquidity. In fact it is becoming increasingly common as investors’ investment objectives, portfolio allocation strategies, or investment advisory teams change following the initial investment decision.
Common objectives include the desire to redeploy investment capital into other opportunities. Investors might find their portfolios are overweight in exposure to real estate because of a decline in their equity portfolios or they might be fully allocated to real estate and seeking to invest in a new strategy or market.
It is also common that investors wish to realise profits from the appreciation of a private fund’s underlying property portfolio. The real estate sector is perceived by many as being at a cyclical high and many investors are concerned about cap rate expansion as interest rates and returns on alternative investment classes also rise.
Alternatively, some less fortunate investors will be looking to exit ownership of under-performing investments. Not all funds obtain their investment return objectives. It might be prudent for investors to exit ownership of such vehicles as early in the maturity curve as possible rather than speculate on market recoveries or future enhanced performance.
Numerous attempts have been made by firms to address this liquidity need.
Most often they adopt a brokerage model, which is often inefficient and costly to the investor.
Given the number of indirect vehicles, the various regions in which they own property and different legal structures, investor bases and sponsorship profiles, there are few commodity characteristics that lend themselves to a standardised approach.
Pricing tensions exist in all transactions and when you add outsized commissions and frictional costs prices can be artificially depressed, severely handicapping a buyer’s ability to meet the seller’s expectations.
And muddying the waters still further are the realities of understanding indirect property fund structures. Issues of transparency, access to original issuance documents, current financial statements, seller pricing expectations and the temperament of the sponsor are key variables in the successful completion of secondary market trades.
The major focal point on secondary trading has been in large institutionally sponsored and owned real estate fund structures where many of the above challenges are less of an issue. In reality, private placement or club transactions comprising a small group of private investors, property joint ventures and retail syndications constitute a large market segment.
But the emergence of a new category of investor is improving the prospects for indirect property investors seeking liquidity. Such investors, who refer to themselves as liquidity providers, seek to acquire indirect interests as principals in privately negotiated, confidential transactions.
These liquidity providers manage private equity funds specifically targeting the acquisition of partial ownership interests and are well schooled in the challenges of completing such transactions.
Specific expertise is required in the translation of the underlying property value(s) through the indirect fund structure (deducting any profit participation or incentive fees to the sponsor) to derive a value for the interest, as well as in areas of taxation and transfer documentation.
Only then can a credible offer be communicated to a prospective seller. In addition, all of the due diligence costs and potential ‘broken’ deal risk lie with the liquidity providers.
There a number of liquidity providers in the market, offering a range of possible transactions including the direct acquisition of limited partnership, member, joint-venture and fund interests.
Alternatively the liquidity providers will structure new preferred-equity positions to monetise an investor’s equity position; provide capital for partner buyouts or provide capital to retire existing leverage.
Given their familiarity with indirect property structures generally, the liquidity providers can expedite many issues that could otherwise become protracted, such as due diligence and transaction documentation. Consequently, and in the absence of any definitive initiatives on the creation of secondary markets, I would say that for indirect real estate investors seeking an early exit from illiquid vehicles the future is looking quite promising.