Recaps are no substitute for a soaring secondary market, according to the leading players. Shayla Walmsley reports

You can see why not only opportunity funds but also pension schemes want to take part in the real estate funds secondary market: private equity-like returns, immediate cash flows, and an opportunity for global diversification.

In fact, in a recently published white paper, Clairvue Capital CIO Jeff Giller suggested that secondaries might be one of the few medium-term, high-yield real estate investment opportunities because economic uncertainty makes it difficult to see any improvement in fundamentals or a rise in property values.

The secondary market has matured relatively quickly, spurred on by the financial crisis. At first, two factors held it back. The first was pricing. "There was a lot of buzz but not a lot being transacted," says Ron Dickerman, president of Madison International Realty, pointing to mismatched expectations between buyers and sellers.

Stanford University, for example, announced back in the autumn of 2009 that it planned to sell a $1bn (€750m) private equity portfolio on the secondary market. The university's management arm reviewed the offers in October; by the end of the year it had backed out of the market.

The second was a lack of general partner (GP) engagement: fund managers often took it rather personally when their limited partners (LPs) sought to divest their fund interests.

"Over the past few years there's been broader acceptance of real estate secondary trading as a normal activity," says Bob Dombi, partner in Landmark's real estate group. "Before, a few managers couldn't see why anyone would want to get out of their fund. Now they're better informed about why it makes sense, and why they shouldn't be afraid of it."

Almost all secondary market participants interviewed by IP Real Estate said they had been approached by GPs who saw a chance to provide a service to their LPs by helping them to exit their fund.

An indication of the market's maturity is its rapidly acquired diversity, even among a relatively small group of players. Madison International invests in property-level ventures rather than funds, such as large single assets and joint ventures. "They are harder to underwrite because there is less of a homogeneous theme but more diversity," says Dickerman.

Morgan Stanley Alternative Investment Partners, by contrast, buys interests only in small and medium-sized funds with 10-15 assets. "We don't bank on a portfolio effect and it's difficult to do a true underwriting on hundreds of assets," says executive director David Boyle. He adds that the firm tends to buy from funds that see it as adding value because of Morgan Stanley AIP's investments in ‘primaries' (new funds), secondaries and co-investments.

Many pension funds, meanwhile, have their own competitive advantage: the right of first refusal. Giller says his firm is competing head-to-head with pension plans with secondary mandates and an in-built spoiler for months of due-diligence effort.

Institutional investors have every reason to continue to explore the secondary market but, says Giller, they are not necessarily geared up for the up-front work involved. "In the secondary market you spend time sourcing, doing due diligence, assessing the right price and time to buy. As a secondary buyer, if you don't invest correctly up front, you won't make up for it later," he says.

"In the US, institutional investors have looked at the secondaries market because they believe they understand funds, and the pricing of funds. I would argue that the amount of due diligence you need to do to participate in the secondaries market you don't learn from a manager's quarterly report. When you buy a secondary interest, you're effectively buying pooled assets."

What is at issue is not appetite for the secondary market but the future pipeline. It helps that pension funds are as aggressive sellers as they are buyers, prompted partly by a desire to rationalise their fund manager relationships, but also as a result of structural allocation shifts. According to private equity research firm Preqin, pension funds form the largest group (21%) of non-traditional investors in the secondary market, followed by private-sector pension funds (13%).

Divestments last year by CalPERS, the California Public Employees' Retirement System, included an $800m portfolio of LP interests. The same source claims 287 investors are looking to sell private equity or real estate portfolios in the secondary market in the next two years, 9% of them immediately.

According to Marc Weiss, who leads Partners Group's global real estate secondary investment business, there is a trend for larger pension funds to move towards safer, more secure investments in their respective home countries.

The shift is making them rethink their long-term holdings in non-core open-ended real estate funds with a 10-year life. But there is traction in Asian markets, where he says Partners Group has been able to find arbitrage opportunities created by market opacity.
Certainly the market drivers have changed. Basle III and Solvency II are forcing banks and insurers to reduce the risk profile of their balance sheets. At the same time, banks that made commitments to funds to build relationship are now likely to dispose of them.

Add to that a couple of trillion in Europe and the US in maturing debt. Loan-to-value ratios are lower, and lenders are more conservative. "The only thing that would solve the problem is a hockey-stick trend in values. None of us really believes that is going to happen," says Giller.

Hence the demand for recapitalisation, even if the increased interest on the supply side is not necessarily the result of secondary scarcity. But it might make sense to see recapitalisation and secondaries as opportunities along the same continuum. GPs unable to recapitalise their funds will find LPs looking to the secondary market to shed their interests. Aviva Investors pursues both secondaries and ‘recaps', as do seasoned secondary investors Liquid Realty and Madison International.

The markets for secondaries and recapitalisations are "similar but different", says Giller. When a fund needs more equity, it might look at recapitalisation on a debt or private equity basis. Investors looking for more capital might scout the secondaries market for an investor to buy its interest in the same fund.

"It is the same vehicle you provide capital around, but to different recipients," he says. "The drivers are different. I look at them as being counter-cyclical. Recapitalisation is important in a downward trending market where liquidity is constrained and fund managers are unable to draw more money from LPs.

"You're seeing it in Europe now as we were in the US a couple of years ago," adds Giller.
"Real estate is a capital pig - it always needs more money."

Yet other investors in secondaries rule out investing in recaps altogether. "There's one compelling reason why we're not active in fund recaps: alignment," says Boyle.

"We don't want to be in a different part of the capital structure from our partners, and to be the only capital in the fund would create misalignment."