Thursday, May 9, 2013

Funds Doubling Down on Distressed Debt?

Leanna Orr of aiCIO reports, Oregon Doubles Down on Distressed Debt via Apollo & Lone Star:
Who says US public funds can't get anything done?

In one morning, the five-member Oregon Investment Council, which manages the state's $63 billion employee retirement fund, signed off on three new private equity allocations totaling almost $1 billion.

Two of the allocations focus on distressed debt. The council committed $300 million to Apollo Global Management's new fund (number VIII), which will "target opportunistic buyouts, corporate carve-out transactions, and distressed investments," according to council documents. This is Oregon's third investment with Apollo since 2006—a relationship now worth nearly $1 billion to the private equity giant.

With the next investment decision of the day, the council didn't diversify, but instead doubled down on its last bet. Lone Star Partners, a $33 billion distressed assets specialist, secured $300 million from Oregon for its new fund. According to the investment proposal, Lone Star VIII will "seek to invest in distressed investment in loans and securities, including single family residential, corporate and consumer debt products, as well as financially-oriented and asset-rich operating companies.

The pension fund has an even longer relationship with Lone Star than Apollo: it has invested in every offering since 1995, committing a total of $2.17 billion over the last 18 years.

Finally, the council rounded out its morning with a $250 million allocation to Blackstone's tactical opportunities program. The managed account will pursue "a highly flexible investment approach" across nearly any asset type, "in order to generate superior risk adjusted returns with a focus on capital protection."

Blackstone and the New Jersey pension fund created the first such program together in 2011. While it is too soon to tell if the "tac-ops" structure is a robust, profitable one for the long term, Blackstone's launch of a full program indicates the funds have been a success thus far.
As for distressed debt, a number of CIOs and public pension investors have told aiCIO that the so-called "low hanging fruit" has largely been picked. However, according to Segal Rogerscasey data, $350 billion in corporate loans and bonds will need to be refinanced over the next six years.
Tim Sickinger of the Oregonian also reports, Oregon Investment Council puts $1 billion of PERS funds into private equity:
Wednesday was a power breakfast morning for managers of state pension fund investments as several giants of the private equity industry successfully pitched new funds and went home with nearly $1 billion in commitments from Oregon's Public Employee Retirement Fund.

The Oregon Investment Council, the five-member citizen council that oversees pension investments, has slowed its pace of investing in illiquid private partnerships since the global downturn, as its allocation to the sector is above its target. But council members haven't lost their enthusiasm for private equity, and are anxious to diversify their investments by vintage year and cement relationships with top managers by investing each time they raise a new fund.

On Wednesday, the council made a $300 million commitment to a $12 billion buyout and distressed debt fund being raised by Apollo Global Management. It committed up to $400 million into a fund being raised by Lone Star to invest in distressed debt and real estate assets. And it committed $250 million into a "tactical opportunities fund" being raised by the Blackstone Group to make opportunistic investments.

Oregon has history with all three firms. It has invested in two prior Apollo funds. One is showing promising results, while the other is underperforming its target, in part because it badly overpaid in its bubble-era buyout of the casino company Caesar's Entertainment. Apollo undertook that $31 billion deal in 2008 in partnership with a buyout fund managed by Texas Pacific Group. Oregon was an investor in the TPG's fund, too, so it has exposure to the deal from both sides.

Apollo's slightly rumpled chairman, Leon Black, said Apollo was historically a conservative buyer, paying lower buyout multiples than competitors, and thriving during periods of market distress. He said the firm lost its discipline in the Caesar's deal. It is hoping to salvage a decent return by cutting costs and buying back discounted debt to de-leverage Caesar's balance sheet. It has also bundled Caesar's highest growth businesses into a separate entity to raise capital without the taint of company's current debt load.

During its public comment period, the council heard from a representative of the union that represents hotel workers at Caesars. Alyssa Giachino said workers were appalled that Apollo and TPG had paid themselves several hundred million dollars in transaction and monitoring fees from Caesar's for ongoing advisory and management services since the acquisition. In effect, Giachino said, the private equity funds had recovered their own investments in the Caesar's deal, while limited partners such as Oregon were left with a stinker of an investment, and hotel workers were losing their jobs.

The council voted unanimously to invest $300 million in Apollo's new fund, on the condition that all transaction and monitoring fees in the new fund are refunded to limited partners.

The council also heard from John Grayken, the founder and chairman of Lone Star. Lone Star is the largest manager of real estate investments by Oregon's pension fund. The state has committed almost $2 billion in funds managed by the firm since 1997. They have been among its most consistently profitable investments, though about half the profits are still unrealized. The new fund would continue investing in troubled loans backed by residential and commercial real estate, including assets that European banks are looking to unload as they unwind the big loan problems on their balance sheets.

Oregon's Lone Star investments have not been without controversy, however. In 2011, two public employees from Oregon sued Lone Star and trustees of the pension fund, including all the individual members of the investment council and PERS board, for breach of fiduciary duty. The lawsuit focused on the state's due diligence" or lack thereof -- before and after Lone Star and its top executive in South Korea were convicted in 2008 of stock manipulation in connection with their buyout of the Korea Exchange Bank.

At the time, the lawsuit alleged, council members essentially ignored the Korean lawsuit, accepting Lone Star's explanation that it was politically motivated and without merit. Lone Star's top executive in Korea was ultimately convicted, though the company is now suing the Korean government for interfering in its investments.

Earlier this year, Marion County Circuit Court Judge Joseph Guimond dismissed the public employees' lawsuit against Lone Star and the council members, saying the plaintiffs lacked standing. On Wednesday, council chair Keith Larson, an executive for Intel Capital, essentially apologized to Grayken, and described the lawsuit as "shameful and disgusting" and a waste of taxpayer dollars.

Jason Seibert, the lawyer for the public employees, said they agreed to drop an appeal after the state said it would waive its right to go after the several hundred thousand dollars in attorney's fees.

"DOJ essentially muffled these folks through legal extortion," Seibert said. "It's not like my clients were backed by a billion dollar hedge fund."

The lawsuit delayed Oregon's ability to commit to the new fund, which is oversubscribed by other investors looking to make investments. The council approved up to a $400 million investment in the fund Wednesday, hoping they will eventually get half that.

Treasurer Ted Wheeler was the only vote on the council against the Lone Star commitment. He said distressed real estate investing, particularly with the new fund's focus on Europe, was a riskier business than he wanted to get into at this time.
Mr. Wheeler is right, distressed real estate investing in Europe is risky but if you're going to venture into it, you want John Grayken as a partner. Lone Star is arguably the best global distressed real estate investor in the world.

At the beginning of the year, Hui-yong Yu of Bloomberg reported, Lone Star Begins Raising $5 Billion for Property Fund. Investors should be asking themselves why Lone Star and other funds are able to raise assets so easily on distressed real estate at this time.

Starwood Capital Group has raised $4.2bn (€3.2bn) of equity for its latest global investment fund, Starwood Distressed Opportunity Fund IX. And Blackstone is upping the ante in Asia, looking to raise the largest real-estate fund ever devoted to the region at a time when economic growth there shows signs of slowing.

In fact, Craig Karmin of the Wall Street Journal reports, Funds See Opportunity in Real Estate:
A glitzy Manhattan real-estate crowd gathered in March to join Barry Sternlicht, chief executive of Starwood Capital Group, at a party celebrating the launch of condo sales at the Baccarat Hotel & Residences, a new development across from the Museum of Modern Art.

The 50-story glass tower, expected to open in 2014 and feature a five-star hotel and Baccarat chandeliers in each condo, is the sort of development rarely seen in the years after the financial crisis. But riskier projects are starting to move forward again, thanks in part to a resurgence of so-called opportunity real-estate funds.

These private-equity funds invest in riskier real estate, such as half-empty office buildings, distressed properties weighed down with debt, or pricey new construction that must find well-heeled buyers to profit. The Baccarat, which is being developed by Starwood and Tribeca Associates for $400 million, is counting on selling condos for as much as $60 million each.

For most of the downturn, these real-estate funds struggled to raise money because their main source, big pension funds, were risk-averse and still licking their wounds from when these bets went wrong. The California Public Employees' Retirement System, the largest U.S. public fund with $263 billion, lost nearly half the value of its real-estate portfolio between July 2008 and June 2009—more than $10 billion.

But these days, many pension funds are reconsidering—or trying for the first time—riskier real estate in an effort to boost returns at a time of low interest rates. These funds project up annual returns as much as 20%.

A pension fund has to "take more risk to get double-digit returns," says Bob Jacksha, chief investment officer of the New Mexico Educational Retirement Board. His $10 billion fund recently committed $50 million to Crow Holdings, which manages opportunity funds.

Pension funds also have been emboldened by the steady rise of commercial-property values since 2009 and a winnowing of some of the worst-performing funds. The economy shows signs of stabilizing after a rough period, and borrowing for real estate is cheap with rates so low.

"Many prices have fallen quite a bit, so there's now a lot of opportunity," says Edward Schwartz, a principal at real-estate consultant ORG Portfolio Management. But some pension funds, he adds, "also have short memories."

In recent months, a public-employees fund in Texas, Kentucky's main public fund and an Oklahoma City police fund all have made commitments to opportunity funds.

Such funds raised about $25 billion in 2012, nearly double the amount in 2009, according to research firm Preqin. Nearly half of pension funds and other large investors allocating to real estate expect to make commitments to opportunity funds in the next 12 months, Preqin said.

Private-equity giants KKR & Co. and TPG Capital also are in the early stages of raising their first real-estate funds, which will focus on riskier investments, say people familiar with the matter. Starwood last month closed a $4.2 billion fund, well ahead of its initial $2 billion to $3 billion target, say people familiar with the fund. Brookfield Asset Management has raised about $2.8 billion for an opportunity fund that is targeting $3.5 billion.

During the downturn, many pension funds largely spurned risk and focused their real-estate investments on the safest, well-leased properties in the healthiest markets. But now they are straining to make these strategies work as high demand for these properties drives up prices.

Calpers acknowledged last month that the shift it started in 2011 from risk and toward more-stable property investments is proving tougher than it expected. It is becoming "hard for Calpers managers to make [real-estate] investments in which they can reasonably expect to generate returns in excess of" liabilities, the pension's real-estate consultant wrote the Calpers board.

While some opportunity funds aim for gold with new projects, others try to profit by turning around troubled buildings. Blackstone Group, which recently raised a record $13.3 billion opportunity fund, last month bought London's Adelphi Building for about £265 million ($412 million). That is a 19% discount from what the building fetched in 2007, but with a tenant occupying half the building departing, Blackstone will have to find a replacement.

Pension-fund investors embracing opportunity funds say they know it isn't a risk-free bet.

"The biggest risk, of course, is the downturn in the economy," says Steven Snyder, chief investment officer for the Oklahoma City Police Pension & Retirement System, who made two recent commitments to opportunity funds. "That could be a negative for our investment."

Mr. Schwartz of ORG says he has put clients such as the Texas Municipal Retirement System and state funds in Maine, Indiana and Kentucky in opportunity funds in part because these funds responded to investor complaints that went beyond poor performance.
All this tells me that risk appetite is opening up in public and private markets. Pension funds are allocating more risk to opportunistic real estate in the US and around the world, betting on a global recovery. The biggest risk is a downturn in the economy but investors are obviously feeling more upbeat these days as US stocks hit new highs and employment growth is picking up.

In my opinion, the biggest money to be made in distressed real estate will be in Europe and other markets that got hit hard during the downturn. Of course there are risks but there are also incredible opportunities which is why Lone Star, Blackstone, Apollo and others are focusing their attention  all over the world, not just the United States.

When I look at the risks pension funds are taking across public and private markets, I try to gauge their risk appetite and always ask myself why they're investing in these sectors now. The same goes with hedge funds which are now leveraged back up to 2007 levels. Good times ahead or will all this risk-taking blow up again in a spectacular fashion once the Fed starts pulling back monetary stimulus?

I remain bullish and think pension funds are right to be taking on more risk across public and private markets. In public equities, now is the time to be rotating out of defensive (low beta) sectors into cyclical (high beta) sectors. In private markets, the shift toward opportunistic real estate and distressed debt in private equity is risky but many assets are selling at depressed levels and if a global recovery takes hold, investors will realize huge gains.

Below, Gazit-Globe Chairman and Founder Chaim Katzman discusses the global real estate market with Trish Regan on Bloomberg Television's "Street Smart."

And Christopher Ailman, chief investment officer of the California State Teachers’ Retirement System, talks about Federal Reserve monetary policy, the pension fund's decision to divest its shares in firearms manufacturers and CalSTRS' position on corporate governance.