Morgan Stanley, LPs Map Fund Compromise

Morgan Stanley’s decision to pull its roughly one-third share of the capital from a $3 billion open-end fund that it sponsors is likely to result in the spinoff of the vehicle’s management and the division of its assets.

The bank last year told limited partners in Morgan Stanley Special Situations Fund 3 that it planned to gradually withdraw its capital because of the Volcker Rule, a provision within the Dodd-Frank Act that limits a bank’s fund investments. Morgan Stanley wanted to retain the fund’s lucrative management rights, but some major limited partners balked, prompting negotiations.

Under a proposed compromise likely to be adopted, the fund’s operation would be spun off into a new shop run by the existing management team, led by chief investment officer Tim Morris and global portfolio manager Willem de Geus. The 2% annual management fee would be reduced by an unspecified amount.

Also, Morgan Stanley would unwind its investment primarily by assuming ownership of the fund’s stakes in Australian real estate giant Investa Property and Crown Golden, the developer of a massive resort in southern China. Those stakes, the fund’s two biggest investments, are roughly equal in value to Morgan Stanley’s investment. Morgan Stanley might also assume some smaller investments from the fund to make the math work out.

The compromise was made after four leading limited partners — Abu Dhabi Investment Authority, Abu Dhabi Investment Council, California State Teachers and Washington State Investment Board — objected to having Morgan Stanley continue to manage the fund without having any capital invested. The four investors and Morgan Stanley last fall hired Evercore Partners of New York to advise them on their options.

Those investors and Morgan Stanley have agreed to the compromise, which now has to be approved by the fund’s other investors. Agreement is expected to be finalized in time for the fund’s annual investor meeting this month. “This is the best alternative scenario,” said one investor.

The Special Situations fund, which buys noncontrolling stakes in real estate operating companies around the world, closed on $2.2 billion of initial equity in August 2006. Its net asset value grew to roughly $6 billion in two years, with more than 60 investments, including many in Europe and Asia. The market crash halved the fund’s value, but it has since stabilized, in large part because it used limited debt to finance its acquisitions.

Until now, Morgan Stanley has reinvested its distributions from the fund back into the vehicle. Under its original plan, it intended to gradually withdraw its capital by retaining distributions, gradually “monetizing” its investment.

However, under the compromise, its stake in the fund would be unwound at once. It would then have the option of liquidating the investments in the Australian and Chinese companies. The arrangement also provides flexibility to Morgan Stanley because it controls all of the remaining equity in the Australian company and most of the remaining equity in the Chinese company via its $8 billion Morgan Stanley Real Estate Fund 6 International.

Under the proposed management spinoff, Morris and de Geus, who are Morgan Stanley managing directors, would leave the bank and set up their own management shop. Other members of their team would presumably join them. Morgan Stanley might continue to hold a minority piece of the general partner position.

The management team would continue to be entitled to a 25% profit split once prescribed performance hurdles are achieved, but one investor said that is moot because the vehicle is unlikely to meet that threshold. “It’s not doing well enough to hit the ‘carry,’ “ the investor said. “It’s doing okay. I think they’ll get a full return of capital on that fund.”

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