Emerging fund managers are scrambling for a piece of the pie in a private equity real estate fundraising market that only seems to be getting more and more competitive.
Data from London-based research firm Preqin shows that there continues to be steady flows of capital into private equity real estate funds, with a total volume of capital raised globally topping $60 billion in the first half of this year. And investors have plenty of options when it comes to choosing where to place that capital. At the start of July, there were 624 real estate funds in the market targeting an aggregate capital raise of $206 billion—51 more funds than at the start of the year, according to Preqin.
Raising capital for private equity real estate funds has always been a bit of a battle. Yet competition has intensified in recent years, and it is especially challenging for emerging fund managers that are going up against the bigger established players, such as Blackstone, Starwood, Broad Street and KKR among others.
“Valuations are at peak levels and investors are nervous, and frankly most investors are not set up to take on the level of risk that comes with an investment in an emerging manager,” says Jen Aleman Hutter, CEO of the KAP Group, a strategic advisory business that works with private equity fund managers.
Investment risk includes organizational risk, platform risk and deal risk. “If you’re an investor, and for the last 10 years you’ve invested with Blackstone and those returns have been fantastic, you’re really not motivated to move down the spectrum and take on additional risk when it’s not clear whether the returns may or may not be there,” says Hutter. So even though there are large volumes of capital being raised, the lion’s share of that capital is going to the Blackstones of the world, she adds.
“It seems that it has gotten even more difficult for emerging managers post-crisis, because so many of the funds have been reducing the number of relationships and number of managers,” adds Susan J. Barlow, co-founder and managing partner at Blue Moon Capital Partners LP in Boston, a private equity investor that specializes in the seniors housing sector. Emerging managers face the added hurdles of selection criteria and mandates that have been designed to weed out new entrants, she says.
Some of the common mandates in play include a minimum threshold of assets under management, such as $500 million or above. Some institutional mandates don’t allow investment in a first or second fund, while others require the company to be a registered investment advisor. One way that institutions can get around those mandates is by investing with fund-to-fund managers, who then invest that capital with emerging managers on their behalf.
Getting a foot in the door
Emerging fund managers are also working harder to carve out a niche in a crowded field of both established managers and other newcomers. Some tips to attract investors is to have a track record; be able to articulate specific strategy or the “secret sauce” for the fund; and have a solid operating platform, says Hutter. Investors do look beyond the fund to the organizational structure of the company. They want to see a firm that has a solid operating budget and an ability to retain talent.
“The emerging managers who tend to get the capital are folks who have been at the Rockpoint, Westbrook, Blackstones who have left to start their own platform, but they already understand the game. They know the institutional nature of the marketplace, and they understand what they need to have in place to get these mandates done,” adds Hutter.
One way to get a foot in the door is to have a specific niche along with specialty expertise. “There has to be a compelling reason to select the emerging managers and for the investment team to go into their board and make a recommendation on a new entrant,” says Barlow. In the case of Blue Moon, it was the company’s expertise and proven experience in seniors housing.
Blue Moon launched its first fund in 2014, with a $175 million capital commitment from Scout Fund II through Hawkeye Partners, and subsequently increased the fund to $250 million. Blue Moon also introduced a second seniors housing fund this spring with a target capital raise of $400 million.
Investors weigh risk vs. alpha
Another factor that draws investors to emerging managers is the potential to generate alpha returns. Although returns vary widely from fund to fund, emerging managers do have a reputation for out-performing some of their bigger peers.
“I think the investors that choose us are looking for a direct relationship with the general partner,” says Stephen Yang, co-founder and manager partner at Yang Capital Group in San Francisco. Investors also want someone who has expertise, with a track record that shows a high return and a good batting average on deals in terms of execution and performance, he adds.
Since 2010, Yang’s personal track record for performance has included delivering average returns in the high 20s and a 2.8x multiple. Although Yang admits that same high-level of performance will be difficult to achieve going forward in what is now a more mature phase of the market cycle, his firm is continuing to pursue deals that have the potential to deliver strong yields.
Yang Capital focuses primarily on hotel investments, where the firm can use its expertise to renovate and reposition existing hotels for long-term holds. Its first fund closed in 2014 with a $12 million general partner co-investment fund. The second fund is currently at $18 million, with a closing expected in October. The company sources most of its capital from high-net-worth individuals and family offices.
The typical target at Yang Capital is to achieve an 8-10 percent unlevered yield on cost, which doesn’t include appreciation or the effect of debt, which is generally additive to returns, notes Yang. “Current yield is really important to how we look at these businesses, and we do look at them as businesses more than real estate because they are so operationally intensive,” he says.
