Funds and their managers are moving around in an unprecedented wave of consolidation. Is the industry ready to see the end of it yet? Shayla Walmsley reports

The claim in May that half of real estate funds would "bleed to death" may have been provocative but, as it turns out, its author was not alone in thinking that a hard rain was going to fall - at least on some fund managers.

Claude Angeloz, co-head of the private real estate business at the Partners Group, said he became aware of the trend in Q3 2009. The firm had issued its annual due diligence questionnaire. The year before, in Q3 2008, it had counted around 1,150 teams; a year later there were 1,000 left.

Consolidation is too soft a term, if you ask Ted Leary, president of US advisory firm Crosswater. "Consolidation implies mergers and that's not what's happening here," he says. "I'd call it the elimination of managers and their assets being taken over." In some cases, this will mean assets being transferred to another manager in the same house investors have more faith in. "They're keeping it in the family," he says.

Yet some of this movement is more benign than Leary suggests. According to Hermann Aukamp, CIO of €7.5bn German doctors' pension fund Nordrheinische Aerzteversorgung (NAEV), concentration and regulation are the push and pull drivers of two different trends.

On the one hand, he points out, real estate is no longer a key business for some banks and they are forcing it out as a result. In this category you might include John Gellatly last November taking two of BlackRock's funds and much of his team to Aviva Investors, where he heads the multi-manager business. "BlackRock was exiting that bit of the business and there was an obvious buyer, so there was a willing seller and a very willing buyer," says Gellatly. "The team was already in place to offer continuity but there was also the advantage of a new home with bigger platforms, and more access to flows. Without a willing buyer, he says, there is the risk that you end up with "a small fund with a small team and investors putting in redemptions".

On the other hand, regulators require restructuring (read: sell-offs) as a means of repairing balance sheets as a condition of state aid. ING REIM in quick succession hired banker William Connelly as head after his predecessor, a veteran ING man, lasted less than a year, and within weeks charged Morgan Stanley with finding a buyer.

Aukamp suggests the outcome will give a strong indication of the likely impact of the trend on investors. "Up to now it's been rumours and discussions," he says. "For pension funds, I think there won't be a big change. They will only buy into companies when the key people go, too. That will make a big difference - potentially a difference big enough for investors to go to new entities. The key for buyers is to keep people on board. It must be a smooth process for both buyer and seller."

Team transfer might look like the least painful option, but handled badly it is not necessarily so. "There are teams that are on their way out after the heads of those teams left. It usually starts with the head, and it's usually not a good sign," says Angeloz. "Teams tend to fall apart when the captain jumps ship."

Early defectors include Nick Cooper, former CEO of ING Real Estate Select, who left for the Townsend Group, and David Schaefer, former head of Citi Property Investors, now at DTZ. The departure in both cases preceded the rethinking of the property business.

"In a transition, the first principle is that you have to be communicating with shareholders," says Gellatly. "If you're not speaking to them, whatever you do afterwards will be difficult. In our case there was no resistance at all. It was a major positive for them because they were going with continuity of management and a team that knew and understood their investments."

Last man(ager) standing
To have survived consolidation, you need to have been a veteran, successful fund manager when the crisis struck. Leary believes the managers at greatest risk are the late arrivals - the ones who raised their first or second fund late in the cycle, where those funds have performed poorly because they do not have the institutional relationships that help in a down market, or the internal capital to ride out the storm.

The upside of attrition, he says, is that "it reveals to investors who the good and bad fund managers are. We went for five years where any idiot who fell out of bed in the morning could set up a fund. Every manager has lost money - good and bad. Now the question is how you decide which they were. Is it relative performance? Is it a deep dive into the decision-making process to see if it was a disciplined investor who hit a difficult market or an undisciplined investor?"

The problem is, around half of the 500 managers managing around 800 real estate private equity funds worth $500bn between 2004 and 2008 were first-time fund managers, says Susan Swanezy, a member of the $37bn AUM Credit Suisse real estate investment team that left to form Hodes Weill & Associates, an advisory and principal investment business. Managers are unlikely to break even without substantial capital under management - typically when a manager is on their second or third fund. "When values fall 40% and the capital markets dry up you can understand the problems first time managers are facing," she says.

Cull or a cure?
For some, consolidation is not cull or cure: it is an opportunity. Bill Hughes, managing director of property at Legal & General, draws a distinction between operations with equity that have managed through the crisis and those in financial distress or that have had state aid. "Those with cash will find opportunities in those distressed," he says.

L&G could well be at the centre of a few of them. Hughes makes no secret of the fact that he is scouting distressed fund managers in continental Europe. "It's just by accident that we've ended up with the UK-only business," he says. "Our underlying client base will potentially benefit from activity outside the UK."

He identifies three options for expanding outside the UK: buy a fund manager with a revenue platform; invest in a joint venture with a partner that has property skills in specific markets; or go for organic growth, hire a team and grow steadily (and slowly). A fourth option might be to invest via other organisations, such as multi-managers, or to invest in those skills itself.

"We only want to be in markets and geographies where we can be a significant player. Add it together and what it means is that we're most interested in fund management platforms we can add to what we already have," says Hughes.

Expansion will drive one group of predators; entry will drive another, believes Aukamp. "Big asset managers that aren't linked to banks want more business in real estate. Look at Fidelity, which has gone into listed real estate having been in unlisted for a long time. It could add to its business," he says.

Caveat investor
In the meantime, investors have sensed a chance to get a much better deal out of fund managers. Sam Meakin, managing analyst at private equity data firm Prequin, says: "We're hearing some stories of investors with large amounts of capital invested in separate accounts bringing down annual fees significantly. CalPERs is one of them. But it depends on the size of the LP." Where there has been pressure, he says, it has been with new fund investments, although there is still some traction even in existing relationships.

The negotiating balance between capital and managers has changed, agrees Gellatly, with investors demanding more time, quality, and input from managers. "During the boom, managers were thinking far too little about what might happen, especially about exits," he says. "Now capital is much more cautious."

Andrea Carpenter, director of professional standards and communications at INREV, claims discussions between fund managers and investors centre on how to rate funds in terms of governance, alignment and fees. "The balance is always in favour of one or the other and now investors are in a stronger position," she says. "I wouldn't say investors are using their power unduly. But both sides want to be sure the fund will stand up."

Investors are choosier not only about the fund manager but about their co-investors. "Some have started to look round the table at those investors who couldn't meet capital call requirements," says Carpenter. "There's been a shift from one-size-fits-all funds to funds geared towards specific strategies."

She adds: "That will mean a change in investor classification. Pension funds might be happy to invest in a fund of funds manager, but other institutional investors will have different characteristics. Allowing investors to help means fund managers will be building better kinds of fund."

One of the impacts of attrition has been a shift towards the secondary market. Last year about US$19m (€14.6m) went into secondary deals, triggered by investors no longer being able to serve capital calls, wishing to rebalance their portfolios, or being uncomfortable with the investment, the portfolio, or the fund manager, Angeloz points out.

But it works the other way, too. As the secondary market strengthens, institutional investors, including pension funds, become more comfortable with it. Mikko Räsänen, head of private equity and non-listed investments at Finnish insurer Ilmarinen, has invested in a secondary dedicated fund of funds as part of an investment approach that makes investments in units in existing holdings.

"Stock selection is key," he says. "There's a lot of rubbish out there for sale. The secondary process is more time consuming and schedules are very tight. It's a resource-intensive process. It takes two or three weeks to submit a proposal, compared with two to three months in the primary market, so it's really quite different."

So why do it? "Pricing is still quite attractive, and you can get good units at significant discounts. Competition is not too fierce. There is an imbalance between supply and demand. The offloading of distressed assets is not over yet, so it's a valid strategy," he says.

Not with a bang but a whimper
Despite forecasts of 50% attrition, what makes the consolidation trend so difficult to pin down is that it is all happening relatively quietly - as Angeloz said back in May, "it won't be spectacular."

"Even if those funds don't get terminated, they will go way and die. The feeling is not to have big stories around it," agrees Leary. "All sides are being very polite about it. It's the natural order of things. Capitalism without failure is like Christianity without hell. There is a periodic cleansing process."

When might property funds be judged ‘cleansed'? Gellatly claims investors going global need big businesses. Before, he says, pension funds might have had in-house expertise, which they no longer have or which is insufficient to manage larger, global portfolios. "It isn't just about consolidation of the management base of fund managers; the underlying investors are involved, too," he says.

"Funds of funds will increasingly come out of larger houses. Like investment banks and surveyors, you'll have a few large global players and then niche players in local markets."

As it gathers pace, pension fund investors that have been up to now relatively sanguine still believe it is a problem not for them but for fund managers. Aukamp is "not afraid" of consolidation.

"I haven't seen any trouble in our funds up to now," he says. "The real danger is that long-term rumours will create uncertainty and that's a problem for asset managers trying to raise capital for new funds."