Boutique firms are facing the triple whammy of constrained capital markets, burdensome regulation and larger acquisitive firms. Are the odds stacked against their survival? Shayla Walmsley reports

Small real estate fund managers could be in trouble. For one thing, they are facing disproportionate costs in complying with the European Alternative Investment Fund Managers Directive (AIFMD), which entered the statute books in July.

Few emerging, or boutique, fund managers will be able to avoid compliance if they are aggregating pools of capital into funds or fund-like structures, and that will have an impact both in terms of the cost of compliance and the people they need to hire to manage it. "There is already pressure on management fees. It will lead to mergers and to smaller managers leaving the market altogether," says Oliver s'Jacob, a partner in law firm Reed Smith's funds group.

He believes fund managers should be ready for it - but they are not. "The regulation was unanticipated and has not been well managed," he says. "What has struck me about real estate funds is that they've come slowly to being regulated. The private equity and hedge funds industries are used to it, because many private equity and hedge fund managers started off in a bank. Real estate funds tend to have come out of property companies branching out into investment management from a surveyor or agency background. The fact that they come from a different background sometimes means they're just not as used to this kind of regulation."

Thresholds within the AIFMD may advantage small players that invest in property assets without establishing a fund management entity, since they will fall outside its scope. "But it also means you can only ever paddle in the kids' pool and you won't ever be able to dive in the deep end of the adults' pool," says s'Jacob.

Melville Rodrigues, a partner in the real estate team of CMS Cameron McKenna,
points out that smaller fund managers will find themselves at a competitive disadvantage as they vie for stock with these very deal-by-deal micro-acquirers that fall outside the AIFMD's remit. Rodrigues says that these property fund managers are the ones that will feel the squeeze most because they can neither escape the strictures of AIFMD, nor do they have the scale to meet its obligations. "It will be difficult for them to operate," he says.

But John Styles, head of Knight Frank investors, believes this is an exaggeration and that the likely impact of the AIFMD has probably been overestimated. By the time its provisions are introduced in the UK, he says, it will look similar to the demands of the Financial Services Authority (FSA), the UK financial services regulator. "It will have more impact on smaller fund managers than larger ones, but perhaps it won't be as horrific as people think," he says. "To be honest, we're not too scared of it."

Appetite for core not helping
It is not just regulation that is driving distress among emerging managers. Not only do they have to get to grips with custodians and depositaries, they also find themselves - if they are specialist funds - competing with a more appealing core proposition coming from larger managers.

Legal & General head of property Bill Hughes suggests that more banks will be motivated to sell non-core real estate assets as a condition of receiving state aid, or as a result of shareholder pressure, while others will have to sell because Basel III will have weakened their balance sheets. Not only will banks retreat to core, he says, but so could other investors - a reflection of sovereign debt concerns.

The AIFMD coincides with a period of noticeable caution from those with capital to commit. Even for large managers, the ability to persuade investors in the last fund to invest in a new one has become a real test. The crunch point will come as funds come to the end of their lives and some small managers find themselves unable to raise cash for follow-up funds. For a large fund management house, this would be a problem. For a small one, which might be operating fund by fund, it is an existential threat.

"There will be a particular issue around funds reaching the end of their investment period," says Nabarro partner Jonathan Cantor. "A test will be whether investors commit to follow-on funds. If they don't, I can see attrition being a possibility."

Cantor points out that investors also have their reputations to think about. With an established name and a well-known global brand, there is a weaker perception of investment risk. Conversely, if a pension fund invests in a less well-established manager and the fund does not succeed, the finger will be pointed at the people who made the decision to invest. "That may impact on the ability of funds managed by smaller managers to launch successfully," Cantor says.

Many emerging managers are specialists; their larger counterparts are more likely to have global core funds. With pension fund investors still hovering at the core end of the risk spectrum, emerging managers have been the losers.

But that has not been a universal phenomenon. Munich-based boutique real estate fund manager Catella Real Estate has created small, focused funds since 2007. It has no global funds. Portfolio manager Benedikt Gabor points out that, in Germany, open-ended funds are under pressure and Spezialfonds, in contrast, are more attractive to certain investors because of their specific real estate strategies.

"Open-ended funds are global and they're in difficulty," he says, pointing to Axa closing its €2.5bn German Immoselect fund in October, because it could muster only 10% liquidity against a requirement of 30%.

"There's a trend for more specialised products and we've been like that since the beginning," says Gabor. He also suggests that specialist funds - Catella's themes range from medical centres to Baltic States - make for a more responsive model because the fund manager comes up with the idea for a fund based on demand from a specific investor, then scouts other investors who might be interested in it.

That makes sense when, as with Catella's most recent fund, it is a joint venture with a partner providing investors for the vehicle (in this case Swiss pension scheme clients of private bank Sarasin). But as Cantor points out, investors are looking to consolidate their relationships with managers - a trend that does not lend itself to the emerging manager model.

Cantor does not rule out market opportunities for "smaller, leaner, more focused fund managers" with specialist knowledge to catch mandates and launch funds. "But the winners will be the very big players offering diversity and speciality because they have strong resources and can buy in expertise," he says.

More consolidation and tie-ups?
In the current fund manager environment, large might not be large enough. Volker Wiederrich, CIO at investment adviser Swisslake, claims the mega-fund is re-emerging. In the first three quarters of 2011, 194 fund managers were in the market raising $92bn (€66.7bn) for an average fund size of $475m, compared with $374m the previous year.
These mega-funds are effectively competing with each other. Against their successful first and second closings, small and medium-sized fund managers are having a tough time raising capital from pension fund investors and insurers that for the past two years have not been investing at all.

Other investors, such as fund of funds managers, could invest in niche strategies and may be looking at comparative advantages in specific markets - so they might look to small and medium-sized fund managers providing strategies that are not comparable with mega-fund strategies. "Consolidation and counterparty risk are concerns," says Wiederrich, but it's a limited pool. "They will survive - but not all of them. Some emerging managers won't be there in three years' time."

To be sure, it is a crowded market, with an apparently infinite supply ready to meet far more cautious demand. According to data firm Preqin, there are three times as many funds this year as there were last year. "Realistically, managers won't all raise funds," says real estate manager Andrew Moylan. Even in the best case, it will take longer for smaller managers to raise funds as investors, wary of taking on additional risk, consolidate their own relationships with a smaller pool of managers.

In other ways, too, it is more difficult for smaller managers to meet the ever-increasing demands of investors. As tighter regulation necessitates costly investment in processes and risk controls, investors will increase their scrutiny of fund managers' internal resources, says Simon Redman, European head of product management at Invesco Real Estate.

It was different when some managers were delivering double-digit returns: they did not need to do so much by way of reporting. Now they have to. "They're still asking about all the right things from an investor's perspective - the product, the fund manager's experience and the platform," says Redman. "But fund managers who can't tick all the boxes will find investors much more stringent than before, and they'll really struggle.

"The only way to support the additional requirements will be to invest in infrastructure, and small fund managers won't have the resources to do it," he adds.

So where does this leave smaller managers and their larger nemeses? First, it is difficult to raise capital across the fund universe and it is harder still for first-time managers.  Even some fund managers that have raised funds in the past will struggle, says Moylan.
Second, as a result, smaller fund managers are struggling and predators are circling. Redman admits Invesco is eyeing small fund managers struggling unsuccessfully against the tide of attrition. "There are a few funds coming to the end of their life with or without extensions, and small managers with one or two funds will struggle," he says. From the fund manager's perspective, it is a fund manager recruitment strategy that pays for itself, because it comes with short-term income from the closing fund.

Redman's only surprise is that there has not been more of it already. "Consolidation is continuing and it may even pick up pace," he says. "So far it hasn't happened as much as I thought it would."

Survival of the fittest
The trouble is, says Hughes, emerging managers struggling to survive will not be obvious acquisition targets - especially if they are in trouble as a result of borrowing. "It will probably end up in a survival of the fittest, with those fund managers with a salvageable, well-run business and a discernible reputation continuing to have appeal once they're back on their feet," he says. "Others will disappear."

In the US, emerging managers have been thrown something of a lifeline by public pension schemes such as CalPERS and Mass PRIM, both of which have active emerging managers programmes aimed at diversification. As European investors retrench to larger managers (and core and core-plus investments), such a move on this continent is unlikely.

One alternative to extinction is partnership. Cantor believes we could see consolidation among smaller fund managers as they tie together to share the cost of regulation. Likewise, Emily Bohill, managing partner at real estate and infrastructure recruitment firm Bohill Partners, believes there will be more niche players focused on one geography or asset sub-class seeking partnerships, because it makes sense for them to diversify their investor base.
"There will be consolidation through mergers but not in the volumes I would have expected," she says. "I'm anticipating more partnerships, with niche fund managers and large managers dating each other rather than marrying each other immediately. The attraction for the smaller players is that they get the resources of the larger ones. In return, the large company gets an existing team with a track record. It's mutually beneficial."