Does the rise of JVs and club deals mark a structural shift in the real estate funds sector, or is it merely a blip? Richard Lowe investigates

More than three years after the collapse of Lehman Brothers, real estate funds are still finding it very difficult to raise capital in Europe. It is interesting to reflect that appetite for real estate among institutional investors is at a real high.

INREV estimates that capital raised by European real estate funds in 2011 was down 9% on 2011 levels at €9.3bn, the poorest year on record after 2009. Yet European - and global - property transaction volumes have continued to climb; DTZ estimates European investment volume increased from €104bn in 2010 to €110bn, for example. Investor surveys also suggest allocations to property are on the increase; IP Real Estate’s annual investor survey showed that 69% of European pension funds expect to maintain stable allocations over the next 18 months, while 19% expect to increase their exposure.

To an outsider, this might seem like a glaring contradiction. The problem, of course, is that investors want exposure to the asset class, but they are asking some fundamental questions about how they should go about achieving that exposure.

One explanation is that capital that in the past would have flowed into real estate funds is being diverted into joint ventures and club deals. These more direct forms of investment have become more visible in the market and INREV’s Investment Intentions Survey has recorded an increase in desire to invest this way from its investor members.

A survey conducted by KMPG with help from IP Real Estate showed that 80% of investors believed club deals and joint ventures would become established as the principal means of gaining real estate exposure over the next five years. Respondents were typically large investors and the survey was produced for RE-Invest, a summit for institutional investors at this year’s MIPIM convention in Cannes.

It all paints a rather dire picture for the traditional real estate funds industry. Or does it?
One problem with this explanation is that it only pays consideration to the large end of the investor spectrum. For a great number of smaller and medium-sized investors, joint ventures and club deals are beyond their resource capabilities or economies of scale. It is logical that there will always be a role for funds.

It could be that the industry is experiencing a more permanent bifurcation of the market, where large investors focus exclusively on joint ventures and club deals, while real estate funds become the preserve of smaller investors. This scenario poses a problem for new real estate funds: who will act as the cornerstone investors?

Anthony Biddulph, who recently founded capital markets advisory firm Riverbridge Capital Partners, says those investors who can cornerstone funds with €50m tickets simply are not there today. “It is almost impossible to achieve first closes by bringing together a number of smaller investors each with €10m tickets,” he says. “They are happy to sit on the sidelines.”

Michael Clarke, head of European real estate at Mesirow Financial, says there could be a structural shift taking place among Europe’s larger institutions. “There will be some who are big enough to go out and do separate accounts in different regions and different countries rather than be the cornerstone investor in a fund,” he says.

“What that results in is that the GPs [general partners] of funds have a more challenging environment in raising the capital because they don’t have the cornerstone investors. Rather than one investor representing €100m for your first close, you may have to have five €20m investors for your first close, so it becomes more of a logistical challenge to get the fund off the ground.”

Clarke says this is especially an issue for funds targeting markets and sectors with large lot sizes, where there is a need for greater economies of scale to build diversification. This is exacerbated, he adds, by a renewed predilection among European investors for low or zero leverage.

Off-the-record conversations with fund managers confirm these points. The lack of cornerstone investors is stopping funds from getting off the ground despite there being investors ready to commit in principle to the manager and strategy. Some investors are just not comfortable taking a place in a first close and will only commit in the second round of capital raising.

It is important therefore not to simply equate the lack of capital raised for new funds in recent years with a lack of appetite among investors generally. It is likely that this volume would have been higher had the cornerstone issue not been such an impediment.

Fund managers have sought to remedy the problem by offering attractive terms - that are not commercially sustainable for the manager - to lure investors into first closes. However, this has created its own problems: when the next round of investors carry out due diligence they want disclosure on the terms offered to other investors. Fund managers are under pressure to be transparent but know investors will not accept uneven terms.

But is there an argument to be had for a two-tier fee structure? First close investors are essentially buying into a different product with a higher risk profile than subsequent investors, especially when the former enables the purchase of a seed portfolio of assets.
Another solution is for fund managers to achieve a first close with a large investor by establishing a complementary co-investment strategy on individual deals undertaken by the fund. The nominal capital raised for the first close may be modest, but the co-investment programme will mean the fund manager has the potential for far greater investment capacity.

“You are increasingly seeing focused funds raised but with co-investment strategies alongside them,” Clarke says. “An investor can commit a certain amount to a fund but then have a capacity to do co-investments on individual projects alongside. You are seeing that quite often used for funds that are €100-250m in size, so their buying power is still quite strong.”

An Atlantic divide?
Laurent Luccioni, European CEO at MGPA, believes there are investors in the market with the capital and inclination to cornerstone new real estate funds. The private equity real estate fund manager achieved a first close on its fourth European real estate vehicle towards the end of 2011. The $100m in capital raised pales in comparison to the $1.3bn raised for its predecessor in 2008 (even if MGPA hopes to eventually raise a further $650m for the new fund). But in today’s market environment a first close is an achievement in itself.

“My sense is that there are a large amount of LPs [limited partners] able to provide investment of between $75-150m, which you would consider a cornerstone,” Luccioni says. He cites an unnamed US pension fund that MGPA has “direct experience” with as an example: the institution is able to write $100-150m tickets but would not consider investing directly in real estate.

But does this highlight another shift that has taken place in the market: a bifurcation between US and European investors? Capital raised by US-based fund managers from US-based investors in recent months is clearly outstripping that of their European counterparts.

“In the US the traditional fund model hasn’t really changed,” Luccioni says: “Not that many people question it. I think in Europe there has been more discussion about it, but that I would think is a very short-term issue.”

Bidulph says there is definitely bifurcation taking place where it is now almost impossible to pool US and European investors alongside each other. One factor, for example, is leverage: Europeans today want lower levels of leverage - and by extension more moderate levels of risk and return - but US investors will only come into a European fund if it seeking to achieve mid-teen returns and above.

A similar issue was brought up at the INREV seminar in Cannes, during MIPIM in March. Gabi Stein, managing director for equity capital markets at Tishman Speyer, told the audience how European investors, in contrast to their US counterparts, were demanding the ability to vote on individual deals.

“It is quite telling that the fund industry is still quite alive in the US,” Clarke says. In the main, US institutions have a longer history of investing indirectly in funds than large European investors, while the latter have a longer history of investing directly in their domestic market and have the internal resources to do so.

“Very few pension plans in the US have direct real estate staff within them and therefore they look to external partners to manage it either through a fund structure or through a separate account,” Clarke says. “The big players in the funds industry in Europe have mainly been insurance companies and pension plans, and a lot of them are very dominant in their own domestic markets, with quite often sizeable investment teams running direct portfolios in-house. They have then been charged with undertaking an international strategy. So you’ve got real estate experts taking decisions in Europe.”

In other words, large European investors have more options to consider. “That is why the whole funds industry isn’t coming under so much scrutiny in the US,” Clarke adds. “Some of the European pension funds and insurance companies may well think they do have an alternative, because they can do it directly, because they are managed by real estate experts. Unfortunately, a lot of European pension funds and insurance companies went international for the first time in the mid-2000s and therefore their first experience has been a bad one. That immediately puts pressure on boards to stay domestic.”

Structural or temporary shift?
Simon Redman, senior director and head of product management at Invesco Real Estate, agrees that the funds industry in the US is not being affected in the same as it is in Europe. But he does not believe this represents a structural shift. “If you go to the US, the business model is exactly the same as it ever was,” he says. “It seems to me to be more of a European phenomenon than anything else. Do I think it’s a structural shift in the market? No, probably not.”

Again, Redman points to the speed with which the European real estate funds sector grew, especially between 2003 and 2005. “If you look at all the funds created over that time it was very rapid - lots of funds being launched, lots of money going into the market, lots of debt being used,” he says.

“Ultimately, it’s a model which I don’t think is broken at all, but we’re in a period of time when investors are cautious. What that is suggesting is - for the moment - when they are committing capital they want more visibility and transparency and that helps [drive] things like club deals.”

Mark Evans, head of equity placement at CBRE, says there is a structural shift in two ways: one, new players - the large pension funds and sovereign wealth funds - have entered the market and because of their size are doing it on a joint venture basis; two, existing indirect investors are asking, “do these structure really give me what I want as an investor?”

Evans predicts three main features of the indirect real estate market that will become established in Europe. First there will be the more direct joint ventures and club deals preferred by the largest investors. Second, there will be “perpetual” core funds, and finally the private equity-style closed-ended funds.

He cites the €380m Dutch retail fund that was launched by insurance company ASR with help from CBRE. Evans said the three investors wanted it to be a club-deal-type investment, but it eventually took the form of a fund.

“Managers need to create the products that investors are happy with in order for the indirect market to move forward,” Evans says. “The key thing for any manager when they are launching new products at the moment is that they have it absolutely targeted to the investor base they are looking for. I can’t stress enough how important control and alignment of interest is around these vehicles. Many managers we see are still trying to force old market terms on the investor base and they simply won’t succeed; they need to be moving with the times, they need to be innovative and they need to be looking at innovative structures and new ways of doing things.”

But Redman questions how realistic investors are being when drawing up their wish lists. “You have to be very aware of whether what investors are asking for is actually deliverable. And what we hear quite often is that investors would like the ability to invest in a club deal with like-minded investors, have the luxury of looking at an asset and deciding whether they do a deal or not - and still make sure that deal is available to fit in with their own timescales. And that is just not possible.”

“Club deals are possible to do and we’ve done quite a number of them, but you have to be very skilled at being able to source opportunities which are around and have good relationships in managing the investors, because if people think it is easy to put a club deal around a transaction, it is not. It is very difficult indeed.

“There will continue to be club deals - as there always were - and there will be funds as well,” Redman adds. “I don’t think it is a structural shift, but what I think we are seeing is a natural evolution of the industry, which will settle down so that you have a mixture of funds, club deals, joint ventures, single acquisitions and separate accounts.”