Market Turmoil Taking a Toll on High-Yield Funds

Cracks are starting to show in the real estate fund juggernaut.

For the first time in at least a decade, the number of active or planned high-yield funds has started to decline. Operators are being forced to lower their equity goals for new vehicles as investors pull back. And crumbling property values have led to big writedowns on investments made when the bull market was peaking.

Faced with an increasingly depressed environment, fund sponsors have started to shift gears. Many are increasing their emphasis on investments in distressed assets, especially debt plays. Some are reducing their fees or looking outside of the U.S. in a bid to attract capital. And the largest operators may have to reduce sizes in their next round of funds.

Those are some of the findings of Real Estate Alert's annual review of high-yield real estate funds. Operators acknowledged that more pain lies ahead, because property values likely still have further to fall. But they also said the sharp economic downturn is setting the stage for lucrative investment opportunities down the road.

The review identified 466 active or planned closed-end vehicles, down from a peak of 520 in September, according to a running tally maintained by the newsletter. That reflects the sea change that occurred last fall when Lehman Brothers failed, accelerating the already sharp downturn in the financial markets. More than 50 planned funds were canceled or put on hold since September - accounting for the bulk of the 65 vehicles in that category since the credit crisis began in the fall of 2007. Those 65 funds had hoped to raise $19.4 billion of combined equity (see list on page 38).

With the decline, the number of active or planned funds has now fallen back exactly to where it was a year ago. And fund pros think there's more consolidation to come. "Many funds will cease to exist," said one veteran operator, adding that sponsors with multiple vehicles may "close their weak lines and concentrate in the areas where they have the most expertise."

Initially, it was small and debut fund operators that shelved planned funds. But more recently, big-name players like CB Richard Ellis Investors, Hines and Walton Street Capital have gone the same route.

At the same time, dozens of operators scaled down their equity targets after finding it hard to drum up investors. Some 32 funds completed marketing campaigns shy of their equity goals in the past year, raising a total of $13.7 billion rather than the planned $24.4 billion of equity. Seventeen other funds still being marketed have reduced their combined target to $13 billion, from $21.5 billion. CBRE, Cerberus, Credit Suisse, Goldman Sachs, Morgan Stanley and Stockbridge Capital Partners were among the players to either miss an equity goal or reduce their target.

What's more, a host of operators have asked investors for permission to extend marketing campaigns for planned funds by one year. There's every reason to think many of those players will also fall shy of their equity goals.

Over the past few weeks, a number of marketing pros have either left or been laid off by fund shops and placement agents. That trend is likely to continue because of the expectation that it will be tough to raise equity for the foreseeable future, even for operators with lengthy track records.

"I looked at the horizon for the next 12 to 24 months, and I didn't see a lot of good news," said one marketing specialist who recently left the sector.

Commitments from U.S. institutional investors have been few and far between since October. In fact, withdrawn commitments may have outpaced new commitments. For example, Pennsylvania Public School Employees recently pulled pledges to five fund operators, while New Jersey State Investment nixed two planned commitments. Those withdrawals exceeded $1 billion in total.

The sudden pullback has led fund operators to increasingly look overseas for capital. While global and international funds have always been backed heavily by such investors, now many operators of U.S. funds have stepped up their approaches to foreign players, including sovereign funds in the Middle East and Asia.

Some fund operators have tried to stand out from the crowd by reducing their management or incentive fees. For example, while sponsors typically can achieve a 20% share of profits, Colony Capital capped the profit split at 10% for a debt fund that recently completed raising $900 million. And Alcion Ventures and Sorin Capital Management have set 15% profit limits on funds they are now marketing.

Meanwhile, several other sponsors, including Integrated Capital and John Buck Co., have set higher hurdle rates before they are entitled to a 20% profit split. And one operator, the recently formed Wilshire Finance Partners, isn't charging any incentive fee at all for two planned debt funds. Instead, the company will rely only on management and loan-origination fees. Other operators have either reduced or stopped charging annual management fees on committed but uninvested capital.

Some fund pros think the trend toward reduced fees will grow the longer it takes for the economy - and investors' ability to commit equity - to bounce back. Others say the changes are little more than marketing gimmicks. "I believe most investors would be happy to pay the [traditional fees] if the fund performed," said one veteran fund executive.

But lately, most funds have struggled mightily, taking big writedowns because of plunging property valuations. The list of operators that posted double-digit quarterly declines last year includes some of the biggest names in the fund business, such as Beacon Capital Partners, Blackstone Group, Colony Capital, Goldman, Morgan Stanley, Starwood Capital and Walton Street. Quarterly losses were as high as 63%.

At first, many operators thought they could still achieve their return goals, which range from 10% to 20%, because of the long-term nature of their investments. That has since changed as the market has worsened and losses have mounted.

For example, Tom Barrack, Colony's chief executive, told investors that his expectations hadn't changed for the $4 billion Colony Investors 8 fund after it posted a 35% drop in the second quarter of last year. But the fund fell another 26.8% in the third quarter, increasing its decline since inception to 64.6%. That prompted Barrack to lower his outlook, investors said. The vehicle, which has a 10% preferred return and a 20% overall goal, has invested three quarters of its capital. Colony hopes to turn things around in part by investing the remaining capital in distressed debt plays.

Many institutional investors are expressing doubt about the prospects for most investments made in 2006 and 2007, when the bull market was at its peak. "I think it's possible we won't get our preferred return or [even] a complete return of capital," said one investor.

Investors say they aren't necessarily holding poor returns against fund operators, as long as the operators are being transparent in financial reporting and offer game plans for turning around investments.

Some operators think the downturn will separate top-flight managers from sponsors that simply rode the bull market. Operators that have been able to steer through the minefield of writedowns so far are privately gloating about the missteps of some big-name rivals. "In a bear market, the flaws in their strategies, limits of their capabilities and the extent of the risk embedded in their financing has become painfully apparent," said one manager.

Another fund operator suggested that too many top-tier shops focused too heavily on raising multiple billions of dollars and not enough on hiring sufficient acquisition and asset-management specialists to properly deploy capital.

That sentiment, combined with the overall difficulty of attracting capital, could mean that the next round of funds by the biggest operators will be considerably smaller. "Perhaps investors will be less interested or less gullible with regard to the very large asset allocators' subsequent funds," said one sponsor.

Operators that are just beginning to raise equity or have dry powder in existing funds are universally telling investors that the current level of distress in property markets offers an enticing landscape for new investments. A growing number of funds are now targeting distressed plays. Some planned vehicles are designed to provide financing to owners that need to refinance maturing loans or buy transitional properties, but are shut out from traditional lenders because of the credit crunch.

For their part, investors are generally bullish about the outlook for funds that raised money since 2007 but - because of skill or good luck - made few or no investments so far and therefore aren't saddled with any legacy assets. Still, some of those fund operators will ultimately have to ask investors for permission to extend the 3- or 4-year window for making investments, or else be forced to release investors from commitments.

The 466 identified funds are seeking to solicit $312 billion of aggregate equity, virtually matching the figure from a year ago. The vehicles have already raised two-thirds of that amount, up from a proportion closer to 50% in past years. The higher level reflects the fact that the funds in this year sample tend to be older because of the drop-off in new funds, and therefore are further along in their life cycles. The funds have a 16.7% return goal on a weighted average basis, down a fraction from 16.8% a year ago.

The review tracks closed-end real estate funds that have raised or are seeking to raise at least $50 million of equity and are shooting for a return of 10% or more after fees. It encompasses funds that have invested less than 75% of their equity, as well as vehicles that are currently raising equity or plan to start marketing campaigns by midyear. Vehicles that invest overseas were included if they raise capital at least partly from U.S. investors.

Property funds were divided according to their yield targets: opportunity (at least 18%), value-added (14-17%) and core-plus (10-13%). Funds that intend to invest at least half of their capital in high-yield debt were classified under the high-yield-debt category. Vehicles that provide seed capital for new funds or joint ventures, and vehicles that buy fund stakes in the secondary market were grouped under funds of funds.

The growing supply of distressed debt and properties caused a shift in fund strategies. Most notably, the number of high-yield debt funds increased to 73, from 54 a year ago. Those funds account for 16% of the total equity being sought (up from 9%). In addition, many operators of value-added and opportunity funds are telling investors they plan to use the bulk of their equity for distressed debt and properties.

By contrast, there was a decline in the number of opportunity, value-added and core-plus funds. There are now 142 active or planned opportunity funds (down from 153). Those vehicles account for 38% of the equity being sought (down from 41%). The number of value-added funds declined by only one, to 179. They account for 36% of the equity being sought (down from 38%). There are 46 core-plus funds (down from 55). They account for 8% of the total equity being sought (down from 9%). And 26 funds of funds were in the tally, up two. Their share of the equity target remained at 3%.

The review identified 362 active operators, up from a revised 355 a year ago and 277 in 2007. Of the 466 funds, 290 are targeting investments only in the U.S., 127 target only markets outside the U.S., and the remaining 49 are looking both inside and outside of the U.S.

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