What happens in real estate

If you think terms and conditions is a tough neighbourhood in private equity these days, try strolling over to the real estate asset class, where the traditional private partnership has had to hire bodyguards.
So dramatic has been the collapse of some high profile private equity real estate funds that many fed up limited partners are vowing never to be limited again.

As has been followed closely in our sister publication PERE, a common recent debate at real estate conferences and at negotiating tables has been the need for GP discretion. Many investors, some of whom have been allocating capital to property for decades, have come to believe that they should have veto power over deals.

A desire among investors for some control over how money is invested is, of course, a direct affront to the traditional blind pool limited partnership, which stipulates that the GP has total authority over investment decisions within agreed upon parameters. If LPs don’t like what they’re getting from their GPs they can band together to replace the manager (very difficult), sell their interests on the secondary market (a fraught process) or default on their commitments (painful financially and harmful to the reputation).

What disapproving LPs can’t do is say, “Hold on Mr. GP – I don’t like that deal and so I’d prefer not to back it.” Limited partnerships are set up as very serious legal obligations to prevent exactly this kind of flake-out from happening.

The limited partnership structure also recognises a difference in responsibilities and skills between the two types of partners: LPs provide the capital, GPs invest it. This dates back to ancient seafaring expeditions where the captain of the ship was responsible for, say, taking silver to China and coming back with silk. The local backers of the expedition seldom came on the journey – this was left to the captain and crew (who enjoyed a cut of the profits because it was they who faced pirates and storms, not the landlubbing gentry back home).

But in real estate, it would appear that the LPs want to board the GP vessel and exercise the right to grab the helm.  At this point there is more talk than action, but some property market participants, who see the value of traditional GP and LP roles, are worried that real estate may veer into a multi-year period of semi-discretionary accounts and “deal clubs”, which may make the private real estate opportunity less efficient and less compelling.

Private equity has its terms and conditions tussles, to be sure, but nothing like this. Although LPs and GPs may have different views about the waterfall distribution formula, management fees, LP boards of advisors and no-fault divorces, no one is suggesting that LPs, either individually or collectively, should have the ability to veto deals and thus second-guess the managers they’ve hired to pursue a specific investment mandate.

Indeed, the real estate market is different. It has a long history of separate accounts that predates the era of private equity-style funds. Many investors hire consultants to purchase and manage assets directly on their behalf.  One Class A office building in downtown Houston is similar enough to another, whereas in private equity, two Canadian pet food distributors of equal size may have completely different outcomes that experts in the sector should be hired to sort out.

Despite the blind pool backlash, it is unlikely that the private equity-style partnership in real estate will go away, although a large number of managers will be unable to raise these kinds of funds again. Instead, real estate as an asset class will place more sophisticated terms in these partnerships to hold GPs to higher standards of governance and interest alignment. It is especially telling that the greatest interest in the new terms and conditions guidelines from the Institutional Limited Partners Association comes from real estate industry participants, despite the fact that ILPA is a private equity-only association. At event after event, real estate pros have mused openly about how to retro-fit the ILPA guidelines for real estate funds.

Adoption of ILPA-like guidelines in real estate would be a step in the right direction and far preferable to the abandonment of blind-pool funds. The utility of these guidelines in a related asset class should serve as a memo to private equity GPs that they still have a very good thing in the private equity fund, and should not take it for granted no matter what the waterfall looks like.