Investors will find out in the coming years whether the clubs and JVs they formed to avoid funds can withstand the long haul. Shayla Walmsley reports

Is the sheer effort needed to make club deals and joint ventures work serving as a reality check for investors that have favoured this approach in recent years? Not judging by the most recent INREV Investment Intentions survey, which found that 47.4% of investors expected to increase their allocations to joint ventures and club deals in 2013.

Despite a seemingly unabating appetite for club arrangements, some investors are rethinking a model that can look suspiciously like a cosy fund with an uncertain exit.
One criticism of club deals is they take longer to deploy capital than a fund and offer less diversification. A typical fund gives investors access to 15-20 assets, whereas in a club they would have access to three or four for the same amount of capital, says Paul Vosper, COO at Morgan Stanley Alternative Investment Partners Real Estate.

That is if the instigators can find appropriate partners for the structure in the first place. Club members need to know they are thinking along the same lines in terms of return and risk, how the investment will work within a broader portfolio, and its strategy. “It’s important to set out these terms upfront,” says Vosper. “If you start off with differing objectives, it’s difficult to correct upstream.”

But upstream is precisely where the trouble could start. To date, too few of these club deals have come to maturity to understand how successfully or badly they will turn out.
Another attraction of the club format is greater control and alignment with fellow investors, but, given the typically lengthy holding periods for real estate, there is no guarantee that different organisations will maintain a shared perspective over the life of a transaction. Exit strategies could become highly contentious over time.

Anthony Biddulph, CEO of Riverside Capital Partners, suggests that clubs are potentially dysfunctional structures. “Institutional investors might believe they are like-minded when they agree to invest in German office or US logistics, but the problems may come five years down the road when one or two investors discover that their perspectives have changed,” he says.

Within that time, he points out, the entire strategy of a pension fund might have altered, or regulators may be requiring institutions in specific jurisdictions to allocate to asset classes with a different risk profile. “You could be left with the club that one or two members no longer think is in their interests to be in.”

While some investors have targeted club deals as an alternative to a tarnished fund model, others are now seeking to reduce their counterparty risk by opting for joint ventures, capital and resources permitting. “The more people there are around the table, the more difficult it is to agree,” says Matthew Ryall, head of indirect investments at Allianz Real Estate. “If there is one partner, it’s dead easy. If there are two, it will take more time.”

Two Nordic investors, including a €25bn pension fund, refuse to engage in club deals because they suspect other investors in the club could try to exert unequal influence, for example, although they will invest via joint ventures where this is less likely to happen.

But how much less likely? David Green-Morgan, Singapore-based global capital markets research director at JLL, points out that the same risk – that once likeminded investors will find themselves at odds down the line – applies to joint ventures just as it does to clubs.

“The biggest danger is that you fall out with a joint-venture partner and the relationship turns sour either because your expectations or the partner’s expectations are not met,” he says. “I’m not saying that all joint ventures will turn sour in the end, but there are instances where that has happened.

“You won’t see joint ventures unravelling but the biggest risk is that the partner goes in with the best intentions and alignment. But alignment issues emerge as they go on.”

New members of the club
Conventional wisdom has it that, given the choice, investors of all sizes would prefer to invest with one or a couple of like-minded investors in a bespoke arrangement, rather than to plough capital into a fund. But a couple of trends suggest that this is an oversimplification. The first is that much of the impetus for joint ventures is coming from new capital coming into the asset class, rather than necessarily jaded fund investors.
The trend to match capital and expertise has come from international funds, including sovereign wealth funds, wanting exposure to commercial property because it provides a better return than many other asset classes.

The driver is partly geographical. Some funds that would take on 100% of an acquisition in their home market or region are more wary about doing so in less familiar markets. But a more significant driver, says Green-Morgan, is the fact that many of these overseas funds are new to real estate. The novices are likely to opt for joint ventures even within their own markets.

One possibility is that the sovereign wealth funds will opt for risk-sharing joint ventures with local funds while they build up their own in-house teams, as large European pension schemes began to do with infrastructure a couple of years ago. But it is a time-consuming and expensive process, and even abundantly capitalised sovereign wealth funds are looking to make more efficient use of time and resources.

The second trend is the willingness of significantly sized institutional investors to allocate to both clubs and funds. Allianz Real Estate, the German insurer, sees no contradiction between its club deals, co-investments – such as the one with Prologis to invest in pan-European logistics – and investing in funds with multiple other investors.

Despite Ryall’s concerns over the need for due diligence on prospective partners, Allianz Real Estate signed a club deal with GIC Real Estate, APG and Swedish pension fund AP4 at the end of 2012 to invest in a €264m Swedish vehicle operated by a Blackstone subsidiary. “Investors became more concerned from 2008 with who were they getting into bed with,” he says. “You found investors with financial difficulties over the cycle which, as a result, became difficult to work with. They didn’t have the resources to take positions on advisory boards, for example, which made them difficult to handle.”

But there is still appetite for funds. Ryall cites the $13.3bn (€9.8bn) real estate fund raised by Blackstone last autumn, but he also points to an impressive fundraising from Patron Capital and Hines. “Despite the negativity about funds, you’re seeing large capital raisings. What you’re not seeing is a huge number of capital raisers,” he says.

“We’ve seen funds go through a difficult period, and problems in a number of funds on debt, loan-to-value ratios, swaps, performance and managers leaving. The result is that most investors have wanted more control. There has been a backlash against funds. My point is that it is all very well to [to opt for joint ventures and club deals] but there are resource implications. Investors have to recognise that they have to resource up, which takes time, and to get people capable of making the decisions. I don’t necessarily think that has been fully understood,” says Ryall.

“When you invest in a fund, the documentation comes to you. You may need a side letter, to make a few changes. In a joint venture, you are writing the document. You’ll be taking decisions on a monthly, weekly or even daily basis. It’s a big difference. When you go into a joint venture, there are things the fund manager needs to know and as an investor you need to be aware that you will be getting a lot of calls.”

When is a club not a club?
Add to this the fact that the demarcations between clubs, joint ventures and funds are not always clearly drawn – Allianz’s Swedish deal is a case in point.

In fact, Biddulph questions whether some putative clubs are misnamed funds, albeit with relatively few investors. “When is a club a club? If five investors calling themselves a club cede investment control to a discretionary manager, that is a fund by another name,” he says.

Conversely, some funds are beginning to look remarkably like clubs. Internos Global Investors’ hotel fund, a Spezialfonds launched last summer with four German institutions, now has six investors. But the controlling trend continues, according to partner Jochen Schaefer-Suren. These days a fund typically has fewer than 10 investors, he says. In some cases, the fund manager will introduce new investors; in others, existing investors bring them in. “These things grow organically,” he says.

More strikingly, the investors in this and similar funds tend to look for co-investors with similar profiles, in a fund structure that is familiar to them, hence the spezialfonds.

“Every investor group has its specific issues and requirements. But, overall, investors are unwilling to give a manager discretionary investment power, and that will prevail among big, small, and medium-sized investors. The biggest fund managers, such as Blackstone and Hines, will be the exceptions because they have so much money but, overall, the trend will prevail,” says Schaefer-Suren.

If funds are beginning to look like clubs, the same is true of joint ventures. Co-investments are a case in point. Michael Clarke, senior managing director for institutional real estate at Mesirow Financial, describes the co-investment model as a halfway house between a joint venture and a blind pool fund – one that makes sense for investors with a preference for seed portfolios and where they can see the assets.

The co-investment model is especially attractive to investors in uncertain markets. “You have to have the capital to invest in projects to get co-investments,” says Clarke. “In India and China, there is a degree of nervousness about the market. Investors will put a modest amount into the fund in the same or more in the co-investment.”

For the investor, co-investing means not having to compete with others for opportunities, usually because they request some form of first refusal on deals. One recent fundraising included exclusive rights for one investor to co-invest on deals for between six and nine months; then those rights will be extended to the other investors.

Yet it ties in with the trend towards ‘like-mindedness’, not only among fund investors but perhaps even more so between investors and the fund manager. Five years ago, fund managers would most likely have brought in a third-party investor for a joint venture with the fund. Bringing in fund investors instead gives the manager a friendly partner with a common interest, in contrast, says Clarke, to “an independent partner who is friendly at first but not necessarily as friendly down the line”.

Within funds, at least, common interests are monetised. Fund managers have atoned for what Vosper describes as the “cardinal sins” of the past, such as deal-by-deal carry. But institutional investors want significantly more than that; they want managers to share both the profit and the downside.

For Biddulph, the amount a fund manager is willing to bring to the fund is almost beside the point. What matters is what it represents as a percentage of his or her personal wealth.
For that reason, he says, he would as soon invest in a logistics fund in China owned by three principals who invest half their net worth, equating to 1% of the fund, than with a listed logistics fund manager putting in 20% of the capital alongside other investors.

“In the past, there was rarely much thought devoted to downside alignment,” he says. “But managers need to have skin in the game. It isn’t a matter of how much money they put in.
It’s about understanding who are the key people, whether the documentation locks them into the fund, and how much of their personal wealth they are putting into it.”

The problem with more intimate fund structures, like clubs and joint ventures, is that they take more work than investors may be willing – and fund managers able – to put into them.
Ryall sees the club trend widening to include investors other than the largest ones, but that effectively means more risk as under-resourced institutions take on resource-intensive structures. “The joint ventures and club deals done now are involving more groups of investors – they’re not just the preserve of the largest ones. But those investors, too, need to be aware that you need the resources to service them,” he says.

On the other hand, not even their strongest critics see a wholesale return to (discretionary) funds in the next few years, as investors come up close against what could – and in some cases, of course, will – go wrong.  

“I don’t see a strong trend back towards funds yet from those who have moved away,” says Biddulph. “But some investors are starting to recognise that not all club deals have been well thought through. The telling point will be at the midpoint in clubs’ lives. If clubs develop the dysfunctionalities some suspect they will then the trend could well start to reverse.”

 

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