Chapter 19 | Real Estate Private Equity Funds

BRUCE KIRSCH: Real estate private equity funds, or PE funds, are a much-talked-about part of the business. But they are a relatively recent entrant onto the scene, having started just in the late 1980s. What’s the difference between what we think of today as a real estate private equity fund and another vehicle that’s been around for a much longer time, real estate equity syndication?

PETER LINNEMAN: When we talk about a syndication, which still exists– I mean, syndication is very much still a common mechanism. Syndication says, here is the property, 712 Manhattan Lane. Very specific property, and I’m going to go out and raise money from a pool of investors for that specific identified property and identified pricing and identified management terms.

Where it could be pooled, I could have three properties in there. But it’s not blind. You know exactly what you’re getting, and that’s what you’re signing in for.

What a private equity vehicle is is different. It says, what I’m going to do is go out and raise money from investors based on my reputation, my strategy, my track record, my credentials, my investment objectives. I’m going to raise the money ahead of time. I’m not going to have any properties I can show you. All I can show you is who’s my team, what’s my philosophy, what’s my track record, here’s my reputation.

Here’s where we all went to school. Here’s what we did in our prior life. And you give me money ahead of time with which I then will go out and invest on your behalf, on behalf of this pool of investors. And it’s very much a trust-me vehicle. It’s a blind vehicle. You don’t know what they’re going to buy.

You know who they are, and up to personnel leaving you know what their strategy is up to them changing. But you’re not buying specific properties. You’re buying into a concept in a private equity vehicle.

And you’re obligated to provide money under contractual terms at contractual fees, contractual profit splits, contractual governance. The governance usually is the manager who’s raising the money gets to decide how to operate the property and how to invest the money and how to dispose of the properties at their sole discretion, as long as they’re a good fiduciary and they’re not doing fraudulent things. So they’re very different.

The private equity is a much harder vehicle to raise money for, because it’s a trust-me vehicle, as opposed to a syndication, or a traditional syndication, where what you’re buying. You still have to trust me to manage it well. You still have to like the pricing. But at least you know what you’re buying.

But the hard part of a syndicate is, well, I don’t have the money with which to tie up the property. And so what happens in the traditional syndication that’s made it difficult is I don’t have the money, but I have to convince the seller to let me tie up their property while I go put the syndicate together and market the property. And that may take three months, six months to get the money corralled and put together documents.

Meanwhile, hold on, I’ve got a sole right to buy your property. The beauty of private equity is it may take me two years to raise the blind pool, because it’s a slow process. It may take me much longer to raise a blind pool than a property-identified syndicate.

But once I’ve raised it, I can go to sellers and say, here’s the money. I’ve got the money. I’ve put the money down. They don’t worry about, gee, I wonder if he’ll be able to raise the money. So they each have their pros and cons as a way to operate.

And the thing I would close that comment on is, increasingly, private equity funds are almost becoming like brand-name money managers. There’s a few– I think there’s a wave of consolidation underway of brand names. Not just reputation of good firms, but brand name. There are a lot of good firms, but there are only a few brand names.

And the business in private equity, since it is very much a trust-me business– it’s a very much, make sure you’re comfortable with who you give the money to and nobody will ever second guess you– it’s reputation plus brand. You’re starting to see firms like Blackstone and Colony, and maybe Apollo and Carlyle and a few, go beyond reputation to brand, whereas a lot of people who have very good reputations– very good reputations– are finding it harder to raise a private equity vehicle and are looking more to syndicate.

BRUCE KIRSCH: Now, in a private equity fund, typically there is a finite life to the fund. Is that typically the same with the syndication, where they say, here is the property, and we’re going to hold it for five years? Or is it more open-ended?

PETER LINNEMAN: Syndicates tend to be more open-ended. They can have a finite life. But more typical in a syndicate is something that says, this is the owner. This is the operator. They get to decide, usually in their sole discretion, when the right time to sell is.

There might be some outside date of 10 or 15 years. Or there may be something that if 70% of the money says you have to sell, you have to sell. But it tends to be a longer-lived, more open-lived phenomenon.

When you look at private equity, remember, it’s a pure trust vehicle. Trust me, I’m going to buy what you want. I’m going to sell what you want. I’m going to do all these things.

The pushback then becomes, OK, I’m only going to give you three or four years to invest the money, and I’m only going to give you maybe seven or eight years total to have my money after which you have to give it back, no matter what, unless I is the investors say otherwise.

So as a trust vehicle, there are more restrictions put on it. The greater you have to have trust. Trust is fine, but. And so syndicates generally have longer lives and more flexible lives.

BRUCE KIRSCH: In what ways have real estate private equity funds changed since the 1980s for the better? And have they changed it all for the worse?

PETER LINNEMAN: For the better, without a doubt, is they’re more transparent. The original private equity funds tended to be you give me your money on this. I’m going to do the right thing with it, but don’t ask me to report a lot. If you want reporting, go get in a REIT or go to a private syndication.

I’m not here to report. I’m here to invest. And so don’t ask for a lot of reporting and don’t ask for a lot of transparency.

I think driven by the increased transparency over the last 20 years that’s come about in the public market, you’ve seen the private equity firms have also had to increase their transparency. They still are not as transparent as a publicly-traded company, but they’ve come just enormous distance on transparency. What do I own? What do I think it’s worth?

Why do I think it’s worth that? What is my plan to do with it? Do I have debt on it? Do I own all of it? Do I own part of it? Is it above water? Is it the low water, all those kind of things.

So the biggest change I’ve seen for the best is much greater transparency. Stan Ross and I wrote a paper 10, 12 years ago. Stan is kind of a legendary guy in the business. And our paper was really admonishing our friends, in many cases, to, if you want people’s money, and you really want it for a long time, and you want the opportunity to flourish with it, get transparent on your own. And I think the industry heard us and has done a great job.

If you said what’s there a thing that’s probably happened to the worse, the thing that’s probably happened to the worse was not intentional, but it occurred. The notion of a private equity fund in the beginning was you, dear investor, pay enough fee that I can break even on my overhead, where I’m paid a minimal salary, and all my employees are paid market wages, and I pay market rent for my space and so forth. But the point is, I’m not making any money from the management fees.

Where I’m really going to make my money is from the carried interest from the promote, my share of the profits from my sweat. And in that situation, while interests weren’t perfectly aligned, they were pretty well aligned. Gee, on a $100 million fund, I was only going to get a million and a half in fees. If you went through my overhead, my overhead was a million 4, because secretaries have to be paid and analysts have to be paid and associates have to be paid and so forth.

I was making no money from the management fee. All the money that I was going to make was being paid from my share of the profits, and I was highly incentivized to generate profits. And in fact, think of $100 million under management.

You’re going to generate a million and a half in fees. You’ve got employees. You’re a person who maybe could go to work for somebody and make a million dollars. There’s no way as a private equity manager with only $100 million you’re going to get paid what you could get paid, but you’re going to get a share of the profits. Very well aligned.

As these funds have grown, you’ve got funds that have $10, $20 billion of assets under management. Well, now, you start doing what– even a 1% fee on $20 billion is $200 million. You’re going to hire a lot of analysts for $200 million.

And suddenly, you’re making enormous money as the manager, even if you never make it as an investor by the profit share. Now, that doesn’t mean they don’t want the profit share, but it reduces the alignment. So as these private equity funds have gotten large, and I mean large in their success, the economies of scale of operation have made them highly profitable, very highly profitable, even if they never generate profit for their investors that give them a carried interest.

That’s probably the worst thing that’s happened. Now, it doesn’t mean there’s no alignment, it just means– it’s just like it’s not perfect transparency, and transparency was the big gain. It’s not like there’s no alignment of interests, but the interests are not as well aligned today as they were when all these funds were small.