Capital Consolidation in Real Estate Investment Management

Transcription

1 Capital Consolidation in Real Estate Investment Management NAREIM/FPL Pulse Series Third Quarter, 2013

2 Introduction Over the past thirty years, the real estate investment management (REIM) industry has grown dramatically as the sector has matured and real estate has become a more institutionally accepted asset class. Notwithstanding the real estate crisis of the early 1990s, the industry continued to grow and by the mid-2000s business was booming. Transaction volumes were at all-time highs, fees were lucrative, and capital was plentiful even despite the proliferation of managers that occurred over this period. In a rising tide environment, real estate investment managers of all sizes, strategies and geographies were thriving. Then the 2008 financial crisis hit, and the rules of the game were fundamentally altered. For the first time in years, capital was scarce and firms were forced to aggressively compete for a limited pool of capital that increasingly flowed to only a select handful of high-performing firms. Today, as market forces continue to re-shape the landscape of the industry, capital remains highly concentrated and scale has become more critical to survival than ever before. Increasing market share is no longer a luxury, but rather a requirement for platform viability, and must be a core focus of any manager. This quarter s Pulse report examines the market forces driving this consolidation, why scale and market share have become so important, and how managers are responding to the new world order. Post-Crisis Reality: The New Normal In the aftermath of the 2008 downturn, a meaningful bifurcation emerged between the haves and the have nots. The haves are the fortunate few who have been able to access capital, whether due to top quartile performance, a specialized niche strategy, superior distribution capabilities, or other factors. This access is becoming self-reinforcing, as those with capital were able to transact when asset values were depressed, and now that pricing has rebounded they can demonstrate a positive post-recession track 1) The Preqin Quarterly Update: Real Estate, Q record which is a significant advantage when raising money today. The have nots, on the other hand, could not raise new capital in the period and were not lucky to have dry powder from legacy funds to acquire assets at the bottom of the market. Revenues remained stable for a period of time due to fees from legacy AUM, which became somewhat sticky as a result of fund extensions and investors desire not to sell at distressed levels. However, this was only a temporary reprieve, and now pre-crisis vintage funds are winding down (with no performance fees) and investors in need of liquidity are strongly encouraging their managers to sell assets. There is not enough replacement capital coming in, and as a result fee-paying AUM is in decline. Today, the challenges remain despite the fact that general market conditions are improving. Transaction volume is up, new funds are being raised, and institutional investors are increasing their commitments to real estate. That said, capital flows to REIMs are still well below pre-crisis levels, and the competition for this limited pool of capital is as steep as ever. To provide some context over the last four quarters 181 new funds have closed with $76 billion of equity commitments 1. Those figures can be interpreted as a sign of a healthy market, in particular when compared to the anemic fundraising figures from However, when compared to the fact that there are currently 452 funds in market pursuing $162 billion of capital 1, basic math tells you that a majority of firms are being shut out of the market entirely. In fact, analysis by FPL Consulting predicts that within five years, 50-60% of REIMs active in today s market will either cease to exist or will operate at significantly lower levels as non-discretionary joint venture investors. Further compounding this issue is the fact that the capital that is being raised is becoming increasingly concentrated among a select few managers (see Exhibit 1). There are many explanations given for this trend (see insert on page 3), including the dynamics described above, flight to quality (real or perceived), a concerted effort 1

3 Exhibit 1: Capital concentration by firm 1 All others 42% Firms % Top 5 28% All others 29% Firms % Top 5 45% YTD effort by investors to reduce their stable of managers, and other factors. Regardless of the underlying motivations, the result is clear: capital is becoming more concentrated among a smaller group of firms, leaving everybody else to scramble for the remains. Scarcity of capital is not the only challenge facing REIMs today. Regulatory requirements are more stringent as a result of Dodd-Frank and AIFMD. Investors are more demanding when it comes to reporting standards. Compensation for human capital, and in particular top tier or specialized talent, is up. All of these factors represent a drain on financial resources and add to the cost pressure on managers. Fee structures have also been under pressure in recent years. Concessions can come in different forms e.g., management fee breaks to large and/or early investors, elimination of transactional fees, lower fees on uninvested commitments, reduction or elimination of catchup mechanisms in promote waterfalls, etc. but regardless of form, fee structures are not what they used to be. Multiple distribution channels require dedicated product specialists and IR. It s a major investment in an increasingly regulated and complicated world. - Pulse respondent In combination, all of these forces have had a real impact in driving down profit margins across the REIM industry. Market studies performed by FPL Consulting have shown that EBITDA margins have fallen fallen by as much as 1/3, from an average of 30% in the mid-2000s to approximately 20% today. Since the current figures include some selection bias (i.e., they do not include firms going out of business), the real impact is even greater. above Scale has become fundamental to the management of real estate capital The implication of the aforementioned market forces is that a greater level of scale is necessary for a REIM business to be sustainable today. The reasons for this are numerous. Obviously, in a world where investors are choosing to work with fewer managers, it helps if one is large enough to be on the radar screen and/or diversified enough to meet multiple needs. Since there are meaningful economies of scale in this business (see Exhibit 2), size also creates the financial flexibility for REIMs to absorb the cost pressures described previously and to do things that were once a luxury but are now requirements of doing business. For example, scaled firms can support broader distribution networks to enable access to multiple types of investors. They can dedicate resources to large strategic relationships. They can support the infrastructure required to meet elevated regulatory and reporting standards. Perhaps most importantly, they can offer wealth creation opportunities to employees and therefore recruit and retain top tier talent. This creates a positive feedback loop, as strong human capital leads to strong investment performance, which in turn facilitates future fundraising efforts. Simply put, AUM growth is a must for managers to remain competitive and profitable in today s market. 13 <$2.5B gross AUM 1) Preqin data, FPL analysis, includes U.S.-focused closed-end funds aggregated by sponsor firm by vintage year 2) 2013 NAREIM/FPL Global Management Survey Exhibit 2: Average EBITDA margin by firm size 2 % 24 $2.5-10B gross AUM 30 >$10B gross AUM 2

4 Investor perspectives: factors driving capital concentration Why is investor capital becoming more concentrated amongst a smaller group of managers? There are many possible explanations, including the following key factors: Flight to quality / risk aversion Given the losses sustained by many in the downturn, institutional investors have become more risk averse. As a result they are funneling investments more selectively to the firms that have demonstrated the best performance records. This stricter performance evaluation means that lower ranked managers are unable to raise new capital in meaningful amounts. Another example of this risk aversion is the fact that far fewer investors will invest in first time funds today than has historically been the case (see Exhibit 3). Exhibit 3: Investing in first time funds 1 Will invest 28% 31% 41% 66% 13% 21% Will consider or spin-offs only Will not consider More rigorous risk management and reporting requirements Consistent with the theme of risk aversion, investors today are more demanding of their managers when it comes to reporting standards, risk management processes, governance systems, succession planning, and other related factors. In other words, they are requiring managers to be other words, they are requiring managers to be more institutional, which gives an advantage to scaled firms with robust infrastructures over smaller, more entrepreneurial shops. While such considerations in isolation are generally not sufficient to secure a capital commitment, they are certainly important enough to eliminate one from contention. Decreased administrative burden through larger commitments across a diverse range of product offerings Many investors do not have sufficient human capital resources to successfully oversee a large stable of managers. As a result, they are seeking to work with fewer managers in order to decrease the administrative burden. The use of fewer managers means that larger commitments must be made, on average, to each one. That makes managers that can offer diverse product offerings (i.e. one stop shopping ) more attractive. This trend represents a dilemma for mono-line managers who want to meet the needs of investors while at the same time are cautious of straying from core competencies. We are affected by the fact that we have only one product; several LPs have said they would be inclined to give us more money if there were more products. Our challenge is to move slightly without compromising our basic investment tenets. We do not wish to diversify for diversification only. - Pulse respondent Bargaining power Investors recognize that larger commitments facilitate the negotiation of more advantageous fee structures, yet another benefit of working with fewer managers. 1) 2013 Preqin Global Real Estate Report 3

5 The pursuit of market share Since AUM growth will not be driven by rising tide market forces, the only way to achieve it is to take market share from the competition. This cutthroat environment, wherein managers must increase share or face obsolescence, is not dissimilar to the evolution that occurred in the equities and fixed income industries some 40 years ago. So how are REIMs responding to the new world order, and what are they doing to gain market share in this ultracompetitive environment? Even the relatively successful firms, the haves that benefit most from the consolidation trend, are reevaluating and making changes to their business models. For example, many are working to broaden their investor relationships to include channels that historically have not been actively pursued. International investors, high net worth and family offices, for example, represent a wealth of underutilized opportunities that are playing an increasingly prominent role in the space. Other firms are diversifying their offerings by expanding into new products and/or geographies. While specific approaches vary, the consistent theme is that diversification is key to scale and managers are actively pursuing strategies to expand and grow their AUM to ensure their continued sustainability. We are reaching out to new U.S. investors and, for the first time, actively targeting non-u.s. investors. - Pulse respondent For small and mid-sized REIMs, the path forward is less clear. Some are simply doing what they ve always done, sticking to the same formula, hitting the pavement, and hoping investors will sign on. This approach is viable for some specifically the niche players with differentiated strategies and firms with top quartile performance track records. For everyone else, it represents an uphill battle. Other firms are making more dramatic changes by pursuing product line extensions, new vehicles, and/ or reforming their investment strategies to address more more specialty markets where there is less competition. While this approach has merit and can be successful, it is also difficult to execute for a variety of reasons. Firstly, it can be expensive because new initiatives often require new human capital with experience and track record to legitimize the effort. This is no small obstacle, as these firms are already struggling financially. Secondly, strategic shifts are generally not viewed favorably by investors who prefer that their managers stick to what they know. In addition to the organic options outlined above, many firms (both large and small) are considering nonorganic approaches that are more transformational in nature and represent a faster path to scale. One such approach is to seek a strategic partnership with a larger enterprise. While these partnerships can take many forms, they generally involve either a new joint venture or a minority investment in the REIM business (i.e., the management company). The rationale for pursuing these transactions is twofold, with the first being access to capital in the form of enterprise growth capital for new hires/initiatives and/or sponsor coinvestment capital for new funds. The second rationale, and the most important one from a strategic perspective, is to access new investor distribution channels that a strategic partner can provide. While the potential benefits of these types of transactions are obvious, they are not easy to realize. For example, the promise of distribution does not always come to fruition. Moreover, if the REIM does not have a strong performance record to begin with, it is unlikely to generate interest from potential partners. An even more transformational approach is to sell or merge the business with another firm that is either already in the REIM business or is seeking market entry. In addition to the potential benefits outlined above, this approach can offer other advantages in the form of operating efficiencies through economies of scale as well as access to new human capital. The latter consideration is particularly important for firms that have significant organizational gaps and/or succession planning concerns. Despite these benefits, there are also a 4

6 The pursuit of market share (cont d) a variety of risks inherent in such a transformational event. For example, issues of control are often paramount in these situations. Integration complexities, cultural risks, reputational risks, and other factors must also be carefully considered. Despite the risks, many firms today are pursuing some type of enterprise transaction, whether it be a sale/acquisition, combination event, or strategic partnership. In fact, two-thirds of Pulse respondents indicated that they have at least considered one of the aforementioned approaches over the last 18 months. Moreover, there have been several notable examples publicized recently (e.g., Ares/AREA, BlackRock/MGPA, Henderson/Texas Teachers, Carlyle/Metropolitan, etc.). Given the potential benefits to both buyer and seller and, more importantly, the market trends driving a widespread requirement for scale, we fully expect this trend to continue in the foreseeable future. For firms like ours (small REIM where senior partners fund the co-investment) acquiring or being acquired represents a viable means of accessing GP capital. Additionally, some kind of transaction could mean either new products for our platform or access to broader distribution for another platform. - Pulse respondent Conclusion Today s real estate investment management industry is more fiercely competitive than ever. Capital is consolidating, costs are rising, and scale has become a fundamental requirement for success. In this environment, managers of all sizes must be proactive about planning their growth strategies and increasing market share, whether through organic and/or non-organic methods. With the exception of top tier performers that can rely primarily on track record, REIMs that stand by and simply stick to the old business model risk facing obsolescence. 5

7 Index This quarter s index value was 62, indicating that most executives feel current real estate investment management conditions are improved from the previous quarter. This value reflects a slight decline from Q2. How do current Real Estate Investment Management industry conditions compare to the prior quarter? Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q About the Index: The index is calculated as follows: a point value is assigned to each response, worse (0), about the same (1/2) and better (1) then dividing the total number of points by the number of respondents. Therefore, an index of 50 indicates the overall sentiment is about the same as the prior quarter; similarly, any value over 50 indicates a better environment and under 50 indicates a worse environment. 6

8 Methodology In late Q3, NAREIM and FPL Consulting sent out a survey questionnaire for the purpose of gathering investment managers perspectives on capital consolidation and strategies for addressing this important industry dynamic. The survey consisted of eight multiple choice and open-ended questions, including our recurring market conditions question included with each survey. Participants vary in size, strategy, and location and represent a cross-section of real estate investment managers. FPL gathered, clarified and analyzed responses to the survey and conducted independent research to develop this summary report. Due to company policies and/or unique aspects of their operations, not every participating company was able to provide information for every survey question. In cases where certain participants did not respond to a particular question, they were excluded from the reported statistics related to that question. We extend our sincere appreciation to all participating organizations for providing valuable information. Contact Please direct all inquiries regarding this study to: Gunnar Branson Chief Executive Officer NAREIM 410 N. Michigan Ave. Suite N 30 Chicago, IL Phone: (312) gbranson@nareim.org Timothy Kessler Principal FPL Consulting 191 North Wacker Drive, Suite 2850 Chicago, IL Phone: (312) tkessler@fplassociates.com 2013 FPL Consulting, a division of FPL Associates L.P. All rights reserved. No business or professional relationship is created in connection with any provision of the content of this document (the Content ). The Content is provided exclusively with the understanding that FPL Associates L.P. is not engaged in rendering professional advice or services to you including, without limitation, tax, accounting, or legal advice. Nothing in the Content should be used in or construed as an offer to sell or solicitation of an offer to buy securities or other financial instruments or any advice or recommendation with respect to any securities or financial instruments. Any alteration, modification, reproduction, redistribution, retransmission, redisplay or other use of any portion of the Content constitutes an infringement of our intellectual property and other proprietary rights. The views and opinions expressed by each participants are such individual s own views and are not necessarily the views of FPL Associates L.P. or such participant s employer. 7