Friday, December 19, 2008

Curtains for Private Markets?

Yesterday I commented that most funds of hedge funds will have a hard time surviving in 2009. Not only are hedge funds folding at a record rate, but their extra layer of fees and the Madoff scandal will hit many of them very hard.

Today, I want to closely examine the private asset classes, namely private equity and real estate. I know they are going to get clobbered in 2009 and their lagged valuations will only prolong their pain.

I will, however, end this post with a comment from a former colleague of mine, Jean-René Guilbault, who is an expert in institutional real estate. He was a Real Estate Manager and member of the investment and management real estate committee at PSP Investments. He has since moved on to better things but I asked him to share with me his thoughts on the US real estate market.

Let's first begin with private equity. Last week, Jeremy Coller, the chief investment officer of Coller Capital, said that underperforming private equity companies will disappear and large buyout houses will be forced to scale back their funds as investors balk at new commitments:

Jeremy Coller told Reuters some general partners (GPs) -- the managers of private equity companies -- who fail to meet investor expectations will struggle to raise new funds.

He said: "It's inevitable that there will be damaged GPs and that there will be a contraction in the overall number of GPs."

Coller was speaking after his company, which specialises in buying secondary private equity assets, released its bi-annual survey of the private equity market.

The survey of 107 Limited Partners (LPs) -- or private equity investors -- found four out of five in the U.S. and nearly two-thirds of those in Europe were refusing to plough money into new fundraising from private equity companies they had previously backed if their funds had underperformed, diverged from their core focus or lost some of their key members staff.

Coller said the number of funds likely to disappear will only become clear in six- to 12-months time when the extent of the damage caused by recession and over-leveraging emerges.

"Whereas before you did your due diligence and you were careful, LPs now have to be very careful, they are now looking much more challengingly at requests for money," he said.

In separate research, also released on Wednesday, by the Economist Investment Unit for consultancy firm Celerant, private equity firms picked out improving the operational performance of portfolio companies as one of their main concerns.

A third of the 220 respondents said the credit crunch had made them more likely to intervene in the running of their portfolio companies, while 17 percent said their most pressing recruitment issue was the appointment of operational specialists.

"Shrewd executives realise that maximising their operational efficiency will ensure their short-term survival and guarantee long-term growth," said the head of private equity and M&A at Celerant in a statement.

Coller Capital said although some two-thirds of investors expect to have reached or exceeded their target allocations by the end of 2009, 57 percent intend to maintain their allocations to private equity throughout the year as they look to adjust their portfolios to emerging opportunities at the smaller end of the deal spectrum.

Investors expect lower mid-market funds to outperform their larger rivals on deals done since the start of the credit crunch.

In addition, some 83 percent of investors in funds of less than $500 million expect GPs to draw down as much or more capital over the next 12 months as in the previous year against just 31 percent in buyout funds larger than $3 billion.

While Coller does not expect any of the big name buyout houses to vanish, he does see them scaling back the size of their funds. "The size of the deals they can do will be smaller and so the funds will be smaller," he said.
Clearly the landscape for private equity is changing. Leveraged private equity deals will deepen the recession:

There’s no doubt that if the recession is as deep and as long as feared, the continuing failure and bankruptcy of leveraged private equity portfolio companies will result in far greater unemployment, and in and of itself, has the potential to deepen the recession on an inordinate scale.

There’s too much greed and far too much power in the form of private equity firms. Their greed has encumbered American banks with significant CLO and leveraged loan exposure and encumbered American companies with too much debt. Now, they threaten to undermine sound banking (wait a minute, that’s already been done by the banks themselves) by investing capital into them in order to control them.

Until concrete underpinnings replace the glue and duct tape that’s holding together the banking system, and until leverage is wrung out of companies, investment vehicles and households, banks and private equity firms will both be on a slippery slope.

ivate equity is not dead. It will once again play a pivotal role but with a lot less leverage and more focus on improving the operational efficiency of companies.

But for the next two to three years, don't expect much from private equity except within a few specific sectors like distressed debt.

As for real estate, the problems are only intensifying. As if things were not bad enough, the Madoff scandal is shaking the real estate industry:

Almost no segment of New York City’s real estate industry was spared in the Madoff scandal, which may be history’s largest Ponzi scheme: commercial brokers large and small, little-known developers and prominent families like the Wilpons and Rechlers all lost money to Bernard L. Madoff, industry executives say.

The outsize impact on the industry may have resulted largely because Mr. Madoff (pronounced MAY-doff) managed his funds much the way that real estate leaders have operated successfully for decades: He provided little information and demanded a lot of trust.

“You have a lot of wealthy people who made a lot of money on handshakes,” said Mark S. Weiss, a commercial real estate broker at Newmark Knight Frank, where several brokers had invested heavily with Mr. Madoff. There was “something about this person, pedigree and reputation that inspired trust,” he said.

Across the city, industry executives said deals had been scuttled or jeopardized because of the scandal. Residential brokers are taking calls from Madoff investors who have had to put their apartments on the market. Many developers had pledged their investments with Mr. Madoff as collateral for projects, and are now worried that their banks will call in their loans.

“The level of devastation, both financial and on a human level, is astounding,” said Robert J. Ivanhoe, a lawyer who is representing 10 developers and investors who lost $5 million to $50 million each with Mr. Madoff.
But the Madoff scandal was not the root cause of real estate's problems (not that it helps!).

According to Real Capital Analytics, at least $107 billion worth of income generating commercial property in the US is already in distress or heading that way:

This includes prestigious buildings, hotels, offices, apartment blocks and warehouses across the US but New York has more than any other city.

Data from research company Real Capital Analytics shows that the Skip to next paragraphowners of the building at 450 West 33rd Street in Manhattan, whose tenants include The Daily News, have to repay $1.2 billion in debt by the spring.

Another prestigious building at 660 Madison Avenue is listed as potentially troubled in the Real Capital Analytics report.

The distress is occurring all across the country, but New York tops the list because of the number of costly high-profile transactions that occurred during the boom years. Real Capital Analytics' list includes a total of 268 properties in the New York area, with a value of $12 billion, as already or potentially in trouble.

'It is greater than most of us expected and the size of the problem that is potentially out there is much greater than we thought,' said Robert M. White Jr, the president of Real Capital Analytics.

Many of the difficulties did not become apparent until mid-September, when the financial world suffered a series of jolts, including the collapse of Lehman Brothers.

It is the first time that such comprehensive data has been compiled. It includes loan defaults connected with commercial mortgage-backed securities, condominium construction loans, bank loans that were not securitized and debt issued by insurance companies and so-called mezzanine lenders, which hold junior debt positions.

The report indicates that more than 1,000 properties are clearly in trouble. Owners of about 200 properties have surrendered the keys to their lenders. Another $21.2 billion worth of buildings are categorized as troubled based on one or more of the following criteria: foreclosure proceedings have been started, the property owner has received a notice of default, a receiver has been appointed, or the landlord or sole tenant has filed for bankruptcy protection.

Heading towards distress are more than 3,700 properties, valued at $80.9 billion, Real Capital Analytics said. This includes $40 billion worth of properties whose owners are suffering financially. It also covers $26 billion worth of buildings with loans maturing next year, when credit is expected to remain tight and borrowers will probably be unable to refinance their properties unless they accept much more onerous terms.

White said he expected values to decline by 25 to 30% when owners who have been holding out are actually forced to sell.

He added that even his estimate of $107 billion in actual and potential distress did not tell the whole story. Real Capital Analytics also calculated that another $84 billion worth of developments have been abandoned or stalled.

And wait there is more. Moody's Investors Service warned today that $76 billion in U.S. commercial real estate collateralized debt obligations face possible multi-notch downgrades due to deteriorating market conditions:
The breadth of the warning harkens back to similar alarms on subprime mortgages at the start of the credit crisis. While the pain accompanying the rapid weakening in commercial real estate will be severe, few expect it be as deep as the residential real estate debacle.

That's because many still see the economy as the driving force behind the deterioration rather than negligent lending standards present in the subprime market.

The ratings agency said the magnitude of the potential downgrades will depend upon current ratings, portfolio distribution and other factors. The ratings of the highest-rated Aaa CDO tranches may be cut between two and six notches. For other investment-grade and junk-rated tranches, ratings could be lowered by four to eight notches, Moody's said. Moody's expects to complete ratings actions on the CDOs, which are from 109 transactions, by February, starting with transactions that have more than 75% concentration of commercial mortgage-backed securities collateral.

Market participants said they expected to see such downgrades, and much of this already had been accounted for in the dramatic widening of the index that tracks commercial mortgage bonds last month.

Then the benchmark Markit CMBX index referencing triple-A credits weakened to a record 842.5 basis points. It has since crept to higher ground, and is now trading around 520 basis points.

"It's no surprise," said Precilla Torres, managing director at New York-based investment advisory firm New Oak Capital. She added that "the market expects to see an increase in delinquencies on commercial real estate loans."

These CDO structures, in addition to commercial mortgage-backed securities also include whole loans, including those used to fund construction and development of properites. Whole loans, unlike bonds backed by the mortgages, don't include cushions against possible losses.

"These loans are extremely vulnerable to fundamental performance of properties," she said. They are directly impacted by store closures, or tenants' inability to keep up with rent payments, or a declines in property revenue.

The deepening recession and reduced availability of financing have raised the risks for the U.S. commercial real estate sector, notes Moody's, and the headwinds facing retail tenants in particular appear to be strengthening as a slowdown in consumer spending makes for a gloomy holiday shopping season.

The hotel sector, office sector and multifamily segment have also been hit hard.
"Retail and hotel properties are most susceptible to the economic downturn," said Susan Merrick, managing director and head of Fitch's U.S. CMBS group.

Moody's said it expects the aggregate default rate on CMBS loans, which was 0.75% as of November, to revert to its long-term historical average of 1.5% to 2% next year and surpass that level as the market begins to find a bottom in 2010 and 2011.

It expects commercial property values, which have already fallen about 10% from their peak in October 2007, to fall another 10% to 20% over the next 18 to 24 months.

The ratings agency said CMBS issued in 2006, 2007 and this year will see even more downward pressure on ratings than earlier vintages.
In Canada, Reuters reports that faced with rising redemption requests, two units of insurance holding company Great West Lifeco said they are not allowing redemptions from segregated funds that invest in real estate because their holdings are less liquid than other asset classes and cannot be sold quickly:

Great-West Life Assurance Co and its subsidiary London Life Insurance Co said they have temporary halted redemptions from the Great West Real Estate Fund and the London Life Real Estate Fund, respectively.

Both hold diversified portfolios of high-quality income producing properties, but redemption requests have recently increased "given the current economic environment," both companies said in separate statements.

In accordance with the terms governing the funds, "it has been determined that a temporary moratorium on redemptions is necessary to ensure equitable treatment for all investors," Great-West Life Assurance and London Life said.

They did not specify how long the moratorium will last.

According to the website of GWL Realty Advisors, a real estate brokerage subsidiary of Great-West Life Assurance, the Great-West Life Real Estate Fund is Canada's largest real estate segregated fund, with a gross value of C$4.4 billion ($3.7 billion) at Sept. 30.

The Great-West fund is invested in 170 properties diversified by type and region in Canada. Its largest holdings are office buildings in the western provinces of Alberta and British Columbia, and residential and office buildings in Toronto, according to GWL Realty Advisors.

As of Sept. 30, the London Life Real Estate Fund had a gross value of C$2.2 billion, and was invested in 116 properties in Canada, just over half of them office properties, according to GWL Realty Advisors.

As you can see, the challenges facing private equity and real estate are manifold. These private markets were suppose to be a way for pension funds to diversify away from public equities, but now it looks like the "alpha juice" from these asset classes will disappear for the next couple of years and possibly even longer.

Finally, please take the time to read my former Jean-René Guilbault's comment on the current state of US real estate market. He is is an expert who understands the driving forces behind this asset class and he is somewhat more optimistic than I am:

*** The Current State of the US Real Estate Market ***

It is always a good time to invest in Real Estate. It all depends on how you do it. This is also true for other types of investment: like in the capital market where it is currently a good time to invest in volatility, very good money can be made from the Real Estate market.

For example, if the residential lending market is going very bad then you might find more people losing their house. But people must shelter themselves, so we can expect the multi-family rental market to be strong. We can expect the storage rental market to do the same too as people downsize their living area but not their personal belongings.

This is an example of wealth transfer from one RE sub-market to another one. The same can be observed in capital markets too where investors must find a place to put their money somewhere when big uncertainty and risk is perceived. For example, they might favor bonds for a while in periods of uncertainty.

The big difference between the RE market and the Capital Market is that the RE market is an inefficient market.

By definition, an efficient market is one where prices reflect all known information. The problem with the RE market is that information itself cannot be formatted in a matter that permits uniform usage. Location of a property which is unique, for example, biases everything. A given current LTV of 75% in Detroit does not have the same meaning as in Los Angeles.

In an inefficient market, the investment and management rules are completely different than what is taught in universities. A lot of theories taught in university are based on an efficient-market hypothesis. For example we have profitability, hedging, portfolio management and benchmarking.

Let’s take profitability as an example. If we invest in the stock of a company, we can identify its source of revenue which comes from a given efficient market. The price of the resource in the given market is known and all companies involved in this market are affected by it in the same way.

Modeling the price of the resource will permit to evaluate the profitability of all companies and determine by comparison which ones have better revenue profiles thus management. Because the prices of the companies are listed on the market then their prices should reflect properly their values.

For RE, it is a complete different story. The quality of the revenues in a RE investment depends mainly on the fundamentals, the business plan and the means used to materialize the investment. All of those are unique to a given investment.

For a RE investment, fundamentals can be location, physical characteristic of the asset and management on the property. For a business plan, we can have a core, value-added or opportunistic strategy. Market timing is an essential part of any business plan.

Everything in a business plan is very asset specific; more so for core and less significant for opportunistic. The means is everything that permits the investment to take place. Investing in an equity position in a RE asset is a different mean than investing in a debt position in the same asset.

For example, it is a very good time to invest in debt in sound RE asset. The yield is very good for the risk and if a default occurs, you can take over the asset, hold it and sell it at a future time with huge profit.

Investing in debt when we are pretty sure that the borrower will default or betting on it is actually not investing in debt but in disguised equity.

This is actually the mother of all stupidity that led us to the current credit crisis. Some very stupid individuals invested large amount of money in RE and booking those investments as debt on their balance sheet where in fact they were knowingly investing in disguised equity… yielding false risk-return disclosure which subsequently unraveled.

Here is a small table giving my 2 cents on the current of the US RE market:

Asset Type




Start Monitoring and be ready in 1 year

Not before 2 years


Start Monitoring and be ready in 1 year

Not before 2 years


Start Monitoring and be ready in 1 year

Not before 3 years


Start Monitoring and be ready in 1 year

Not before 3 years

Rental Storage

Good if coupon is good

Very Good


Good if coupon good (mid-market better)

Good (mid-market better)


Stay away

Opportunistic buying lots of unsold unit and renting them before selling

Senior Housing

Good if coupon is good. Local demographic play

Start monitoring, be ready in 2 years and new construction might have stronger revenue CF. Local demographic play


Stay away

Stay away


Good if coupon good (look out for legal structure that permits see-thru. Very strong market if government spends

Privatization which eliminates see-thru. Very strong market if government spends


Public related if coupon is good

Public related only

This is my opinion about the current state of the US RE market and it could change. There is a fair amount of other information that could be looked at in order to pick the best investment. You must remember that location is the most important factor and that the business plan can change dirt into gold.


I almost forgot to mention that Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses:

The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said. The new policy applies only to managing directors and directors, the two most senior ranks at the Zurich-based company, according to a memo sent to employees today.

“While the solution we have come up with may not be ideal for everyone, we believe it strikes the appropriate balance among the interests of our employees, shareholders and regulators and helps position us well for 2009,” Chief Executive Officer Brady Dougan and Paul Calello, CEO of the investment bank, said in the memo.

The securities will be placed into a so-called Partner Asset Facility, and affected employees at the bank, Switzerland’s second biggest, will be given stakes in the facility as part of their pay. Bonuses will take the first hit should the securities decline further in value.

Let me quote the Financial Ninja from his comment:
Put another way, Credit Suisse is basically admitting they've got more crap than cold hard cash... and will henceforth be paying out in crap.

'Illiquid' is Wall Street speak for 'worthless'. If you don't believe that, I've got a fund for you called the Super Hyper Madoff Ponzi Ultra fund that just can't lose...
That Ninja always has a way with words, but he is right, illiquid is the new worthless.

However, I like Credit Suisse's new bonus plan. In fact, I think pension funds that recklessly shoved billions of dollars into illiquid asset classes and illiquid securities should use illiquid CMBS and CDOs to pay their senior pension fund managers' year-end bonuses.

***Steve Felix's blog

I received an email from Steve Felix this morning and added his blog on institutional real estate to my blog roll. Steve recently left IREI, the publishers of The Institutional Real Estate Letter et al, and joined Aviva Investors, the global asset management arm of Aviva plc, the world's fifth largest insurance company.

Aviva has billions in real estate assets under management which includes real estate fund of funds and multi-manager investments. You can download their half-year report by clicking here.

I thank him for sharing this with me and I quote the following from his latest weekly comment:
Desperate to read something at breakfast this morning I thumbed through USA Today and found a short Op-Ed piece by founder, Al Neuharth (age 84). Allow me to share some excerpts with you:

• In a recession you can not only survive but thrive by practicing these two things:
o Realism
o Optimism
• The reality today is to tighten you belt as much as necessary.
• Optimism means you must understand that if you handle this problem properly, you can ride high on the wave of recovery and prosperity that follows every recession….
o That means investing now in everything worthwhile you can afford.
o It means spending only what is necessary on necessities and funneling what you can into the future. The sooner the better.
• We launched USA TODAY during the 16-month recession of 1981-82. Because it was a popular new product, it rode the recovery.
• If you invest in the future in time of recession, the best of times are ahead of you.

Having been a real estate contrarian for much of my life, I tend to agree with Al in a number of ways. But I guess, the idea of ‘riding high on the wave of recovery and prosperity’ sounds a little too much like what we’re suffering now from overdoing it.

Anyway, I leave it to you to chose your poison as we all attempt to navigate a wide and deep global unraveling. And, there are enough “What was he thinking?” type of news pieces to actually bring a smile (or a shaking of the head) to our day. I’ve always said, “Real life is much more entertaining than any TV show or movie.” Governor of Illinois. Auto execs private jet. Auto bailout…just announced by the U.S. President (where’s mine?) Wearing boots just in case you need something to throw ad someone.

There has been a lot of talk this week about the new Troubled Asset Radar report launched by RCA (Real Capital Analytics) this week and available to subscribers only. To my knowledge this is the only such aggregation of timely information on the state of and the potential opportunities in commercial real estate.
I agree with Steve, riding high on the wave of recovery and prosperity is what we are suffering from now and the risk is that we are overdoing it.

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