The Moment, the Question, and the Vision
RealConnex’s Chief Capital Markets Strategy Officer and former investment officer with Morgan Stanley, Candlewood Investors, General Motors and Goldman Sachs, Joseph Stecher has an interesting point of view regarding the poor odds facing almost any firm wanting to raise a private equity real estate fund to finance its business. He proposes three reasons why so many investment managers are willing to risk those odds, and suggests a radically different approach.
Everything has gone right. You’ve just delivered your fundraising pitch: at this point in the cycle the wind is at your back, your team is cohesive, aligned, and perfectly constructed to execute your fund’s focused value-add strategy, your track record (including the Great Recession) confirms that what you’ve done in the past practically predicts that you can do it again in the future, and that a buy-fix-sell strategy makes more sense for investors right now than paying-up for yield. The prospect has been engaged, asking really informed questions, they’ve clearly read the OM – and best of all, the decision makers are in the room, indicating to you that this investor is interested in committing to your fund. A dream first meeting. And then, after an hour, “the moment” comes. The head of alternatives says: “This has been really informative and very useful market insight, but this would be our first investment in real estate, and our board would be more comfortable with something more core-like and diversified right out of the box. But let’s stay in touch, as we build out our program we may have a place in our portfolio for a strategy like yours. Give us a year or two to get our core program in place.”
Some familiar thoughts flash through your mind at that moment: the long flight out here, the confused clerk at check-in, the food, the mattress, your decision to launch a (or another) private equity real estate fund eight months ago, the target raise of $250, $400, or $750 million that seemed so reasonable at the time, and the struggle to get to just $100, $150, $200 million after all this time, effort, distraction, and expense. And that’s before you start wondering how this meeting got scheduled in the first place, with you and this investor mismatched at this moment.
You glance at your colleagues and ask yourself: Is this the best way to finance our business?
I’m sure this has never happened to you, but you may have heard about it happening to one or more of your competitors.
In fact, meetings like that happen frequently today. From 2006 to 2008 our industry raised $100 to $140 billion each year, and saw more than 300 funds closings each year. From 2009 to 2012, we averaged only about $56 billion per year, and fund closings fell below 200 per year. Where it used to take nine months to close a fund in 2007, it now takes nineteen. And, the first half of this year looks like the last four, with $37 billion raised across 82 funds through mid-August.
This means that we are currently raising about 45% of the money in twice the time.
Yet, Prequin tells us that over 400 funds are in the market trying to raise about $150 billion – meaning something like 2/3rds of them will fail if this year is like the last four.
And don’t forget that the “winners” of this contest will have to start the whole process over again in three or four years when their investment period expires. It is almost a dictionary definition of “inefficiency”. The Greek poet Hesiod told us 2,500 years ago that “before the gates of excellence the high gods placed sweat (effort)”, but these stats sound more like Sisyphus to me.
The wrong question is: “Is this the best way to finance our industry?” I think the right question is: “Why would any firm commit to incur the time, expense, and distraction of raising a private equity real estate fund when the odds are very much against it?”
I propose that there are three answers to the question:
- Investment Discretion
- Covering Overhead
- No Other Alternative
Investment Discretion: The Thor’s Hammer of real estate investment management is investment discretion – it lets you find the investment, secure it, perform due diligence, and buy it. There is a good argument that it makes sense to front-load 12-18 months of fundraising to get capital over which you have discretion for three to four years: this way you don’t have to go back to investors for consent each time you want to buy a building, which a private equity real estate team might do every two months or so (10-30 investments over 36-48 months). The argument is somewhat diluted, though, because so few teams are rewarded with a fund after their 12-18 months of effort – recall that 2/3rds of those who try, fail. Another detriment is that the investment environment might change dramatically over the four to six years covered by your combined fundraising and investment periods, converting your strategy from focused to passé.
Covering Overhead: Investors in private equity real estate funds typically pay commitment fees of 1-1.5% or more, which can be worth $2 million to $10 million per year ($200 million to $750 million fund size). A talented team matters so much in our business, both to attract capital and to execute a strategy, and the commitment fees allow you to attract, retain, incent, and grow that team.
No Other Alternative: A team with investment discretion and a reliable stream of commitment fees has enormous advantages over competitors who don’t. So in spite of the enormous inefficiency, we stick with the private equity model, because there has been no better alternative, yet.
What if you could have nearly all the benefits of discretion and a steady stream of revenue to cover overhead and build your team, without the upfront fundraising slog, without the scramble of phone calls; without the meetings to raise “one-off” capital; without having to persuade a separate account investor of the merits of a transaction that has a short fuse? If you could raise capital efficiently and reliably on a deal-by-deal basis, wouldn’t you do it?
That’s a question that has been driving our founder, Roy Abrams, and my colleagues to envision how that alternative might work. We looked at how other industries use interactivity and networking technology and imagined creating a website that allows capital and ideas to find each other quickly based on very granular criteria.
So imagine that you need $20 million of equity to buy an apartment project in Massachusetts with a value-add strategy, 55% loan to value, a three to seven year hold, and a specified range of yield and IRR components. What if you could enter the criteria on a website, hit submit, and conduct a search for investors who have entered their own granular search criteria that mirrors yours, and then have the site match your project and their capital? Once the site makes a match, you are each alerted and given the opportunity to connect. Roy calls it a “lighthouse search” (imagine a beam of light scanning the darkness in a continuous circle).
The site we have built to execute the vision will Initially be a “dating site”, meaning that once the site introduces you to an investor, the rest of the courtship occurs off-line –
a phone call, maybe coffee. In some ways it’s similar to today, although clearly the investors the site would find for you are more interested than the prospect in the
“dream first meeting” described above.
But what about the next investment? If your next investment is similar to the first in terms of strategy, risk, return, governance, and fees, and investors are reasonably happy with how the first one is going, many of them may choose to skip the dialogue and just hit “click” and send the money as soon as RealConnex alerts them. You might raise
that capital in two weeks, or a day, or an hour. At that point, the “dating site” (really a professional networking site) becomes a transaction site, with far lower fundraising cost to you and to the investor.
And that’s where it starts to get really interesting, and may change how we all do business.
If you were confident that you could make three, four, or five investments per strategy, per year, every year, and raise the capital through such a professional networking site, you could cover your overhead as you built up the portfolio without raising a fund. Suddenly, there is an alternative way to achieve the benefits of a private equity
real estate fund.
Imagine a world where you could go to a single site and see a bar chart where we anonymously aggregate investor supply of capital for certain strategies. If you need $20 million to buy that apartment project, and RealConnex tells you that there is a billion dollars looking for that strategy, you might be more willing to go hard on a project than you would otherwise – or you might decide to be contrarian.
The site will also allow you to permit investors and prospective investors to “follow” you, your company, and your projects – what have you bought or sold, how is the execution going? And the site will allow you to track who is following you, and which strategy they appear to like best by telling you how often they check in (and you can notify them of updates). Then when it comes time to raise money, you know who is really interested because they have told you through their interest in your online presence. And you can see their profiles to get a sense of whether they are qualified or not – possibly including many investors whom you may have never met before.
Or maybe all this could modify the private equity fund model in some way rather than replacing it. Perhaps sponsors will quickly sign up a few large corporate and public pension funds and sovereign wealth funds, who will commit a substantial amount to your program, and in exchange for some benefit, they will allow you to say that they – the smart money — are investing in the same opportunity. That would be a very strong endorsement in the minds of many investors who find your investment opportunity on-line.
What about secrecy and confidentiality? And what about being bothered by people you don’t want to meet? We are designing the site to hide you from all the other lighthouse searches going on, and to introduce you only to the people who fit your search criteria. And even when people find you, they get only an outline of who you are, but no contact information – until they request it, and you give them permission. So you don’t have to give the address of that apartment project in Massachusetts until you have checked out the investor and made sure he or she is not a competitor.
And there is no reason that this format would appeal only to individuals – many institutional investors are set up to invest deal by deal, and have made it clear
they prefer it.
And this approach is on the right side of regulatory trends – the one area where financial regulation is easing is Reg D – getting equity into private investments, including real estate.
That’s the vision – more deals, much faster. Less inefficiency. Lower cost. More connected.
The thinking here is focused on connecting capital and ideas. But this could allow everyone in the industry to connect: architects and clients, and GCs and subs, national law firms with an institutional real estate practice and local counsel. And let’s say you identify a strategy, but need a local operating partner to help you source and execute: this system can show you everyone in that space and you can pick the best one. Compare that to how you find local operating partners today.
Too many of us are having too many meetings like the one described in the first part of this thought piece. If we were starting fresh today, would we use the private equity model with its inefficient fundraising model, exclusively? No. We would look at how our fastest growing tenants – technology companies – conduct their business and seek to apply that model to our business. RealConnex does just that. That’s what we are trying to make happen with the RealConnex system: connecting the technology, networking and information dots for real estate investment managers.
Joseph Stecher, RealConnex’s Chief Capital Markets Strategy Officer, is a recognized industry figure with a more than twenty-year career at Morgan Stanley, Goldman Sachs, General Motors Asset Management, and Candlewood Investors, which he founded in 2012. Prior to Candlewood, Joseph was Chief Investment Officer and founder of Morgan Stanley Alternative Investment Partner’s real estate fund of funds business.← Turning the Graying of America into the Rebirth of Retail Why NAREIM Matters →