Longer-life real estate vehicles are becoming popular, in part for their long-term yield. Samantha Lake Coghlan and Ravi Chopra explore the advantages and challenges they present
With investors seeking yield, real estate managers are looking at alternatives to typical, short-term investments. Longer-life vehicles are attractive, allowing for a focus on yield as well as an ability to ride out adverse market cycles, with managers better equipped to sell illiquid assets at the right time and the right price.
While a typical limited-life private investment fund might have a term of 10 years before liquidation, longer-term capital vehicles (LTCVs) can stretch beyond 15 years, with periodic extensions, with other arrangements in place to deliver liquidity for investors.
Managers can raise capital beyond the initial fundraising. There can, therefore, be an alignment between amounts being raised and the immediate pipeline (in contrast to a typical fund needing to raise sufficient commitments for its entire term at the outset), with investors’ undrawn commitments being deployed more efficiently. Managers can also achieve a stable revenue stream from an asset base that recycles, rather than diminishes, and structure performance fees based on a valuation/yield basis that can pay out earlier than for a typical fund.
Investors may be attracted to a management team focused on a single LTCV – instead of seeking to raise successor funds – and there may be opportunity to negotiate lower fees. The combination of lower fees and longer-term investment reduces the burden of re-allocation and offers efficient capital deployment.
However, areas of LTCV investing require consideration, such as pricing on admission and exit, liquidity and manager remuneration, particularly if based on unrealised gains.
For typical funds, investors admitted after the first close tend to ‘equalise’, so that all investors are as if they had invested on day one, with the same proportion of undrawn commitments, and an additional amount charged (frequently at the hurdle rate) to compensate the earlier investors for the cost of capital of funding investments and expenses.
While equalising has the advantage of aligning the investor base, this may not be appropriate for LTCVs, as earlier investors may balk at being diluted – for example, if the hurdle rate is lower than the net-asset value (NAV) growth rate. Furthermore, early investors can be exposed in the future to cash drag and the need to earmark cash for drawdowns, much as if they had invested in typical shorter-term funds. A common approach, which allows new investors to share in existing investments but leaves earlier investors fully drawn, is to issue units to new investors at a NAV-based price as the LTCV draws down to fund new investments.
Credible liquidity arrangements help give investors the confidence they will not betrapped in an LTCV. Even where the LTCV has been extended, investors may still exit.
Redemption rights, however, need careful consideration; finding the cash to buy out investors will inevitably balance the best interests of exiting investors with those of the continuing investor base.
Where an LTCV has a liquid, homogenous portfolio, it may be possible to realise a portion at a price without sacrificing asset quality. However, real estate holdings tend to be illiquid and it may be difficult to arrange a timely exit without disadvantaging investors – the most liquid assets are often the most valuable. ‘Gating’ restrictions are commonly used to keep redemption requests at manageable volumes.
Recently, confidence in the private secondary market has improved and this is sometimes the principal form of liquidity available. Keen to avoid redemption conflicts, some managers are going to market with formal or semi-formal arrangements with placement agents.
Management fees for a typical fund are structured on investor commitments during the investment period and then on the acquisition cost of unrealised investments until the end of fund. However, the attention required to manage an asset over the long term may not correspond to acquisition costs and investors may not want to keep paying the same level of fees (perhaps indefinitely) where there have been write-downs. LTCV management fees are therefore commonly charged on a NAV or gross-asset value (GAV) basis – sometimes after a commitment-based fee for an initial period.
Equally, while the manager promote (carried interest) for a fund is paid out as a share of distributable cash above a hurdle rate, the assets of an LTCV might not be realised and performance payments might instead take account of unrealised value and/or yield. The exact approach will depend on the target returns. Where a LTCV has a focus on rental yield, this may include a performance fee for exceeding yield. Where there is a focus on capital accretion without realisations, manager incentivisation may need to capture the unrealised capital accretion.
Paying for such performance will depend on cash liquidity and, in the absence of cash, whether the manager can drawdown from investors. In this respect, a robust valuation methodology, with regular independent valuations, becomes important. Some LTCVs apply a rolling average to give investors even more confidence in the valuations.
LTCVs are a good alternative for real estate managers and investors. They provide a focus on yield and can smooth out short-term volatility. However, these vehicles are not as straightforward as a typical fund and they require careful consideration around pricing, liquidity and manager remuneration to create the balance between strategy and investor requirements.
Samantha Lake Coghlan is a partner, and Ravi Chopra is an associate at Goodwin