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PREA Changing Investment Mgt Business



Prof. Joe Pagliari, Jr. of Chicago Booth recently moderated a PREA roundtable.

Prof. Joe Pagliari, Jr. of Chicago Booth recently moderated a PREA roundtable.



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PREA Changing Investment Mgt Business Document Transcript

  • 1. 2fall 0 01 COVER economic enviRonment Pagliari: Let’s start with your firm’s take on the general investment climate, your views on the Investment Risk capital market as a precursor to how we think about changing real estate investment man- agement practices. Keith, could you give us your view or your firm’s view? barket: Our firm’s view is not dissimilar from the general consensus, which is that this has been a long, deep recession and will be a slow recovery for all the obvious reasons. We do believe there will be a recov- ery, whether there is a second dip or not. I don’t think we have a better vision than anyone else, but the signs are pretty clear that we have been in the early stages of recovery for six months or more. almost all the indicators—retail sales, industrial produc- tion, manufacturing capacity, auto sales, even employment, as much as we are all disappointed by employment—are all positive, though they are weaker than one might expect at this stage of a reces- sion. We constantly watch for signs of a double dip, and if we saw such signs, we would reevevaluate our investment approach accordingly. However, we’ve been very active buyers for the past 12 months, and I don’t think we will come to regret it. In terms of what the recession means for real estate: first, it means that for the first time in 20 years, you have an enormous amount of distressed assets working The Changing Investmen A R o u n d t A b l Joe Pagliari Keith Barket Jon Braeutigam 34 PREA Quarterly, Fall 2010
  • 2. their way through the system. The estimates of $500 double-dip recession on the horizon. My general view billion to $1 trillion of loans that won’t be able to be is that the economy is on track for a positive growth refinanced at today’s levels are consistent with our pro- of perhaps 2% for the third and fourth quarters of ... this has been jections. Many of these loans will default, and a lot of 2010—admittedly unexciting but growth nonetheless. a long, deep them already have defaulted. They will work through Probably, like Jon, I don’t think we are seeing a period recession and the system as those real estate assets become recapital- of sustained deflation pressure on the horizon, but that will be a slow ized. from that perspective, we think it is going to be a is something to continue to monitor. I don’t want to recovery for tremendous opportunity. shine too optimistic a light on things, but calendar year all the obvious 2011 may contain the seeds of a more promising year reasons. I don’t Thanks. Jon, the view from Michigan? for the U.S. economy, particularly if policy errors can think we have braeutigam: I’ll give you my view, not Michigan’s view. be avoided. That is one of the key things that we feel a better vision I won’t speak for all of Michigan, but I think double-dip has been a problem over the last 12 to 18 months. Our than anyone recessions are rare historically, so our base case would forecast is for GDP growth to reach around 3% in 2011. else, but the not be a double-dip recession. Our view is probably We do think unemployment rates will start to decline signs are pretty similar to consensus, which is we are in the “new nor- from the 9½-ish range that they are at right now and clear that we mal,” or slower growth, camp. In terms of the broader hope they will end up closer to the 8¼% range by year- have been in the market, bear markets over the last 50 years have aver- end 2011. Some interesting developments will start to early stages aged about 14 months. average bull runs are 68 months, create job growth. One of the key ones is that labor of recovery for and we’re about 17 months into that, so we think we productivity has declined. Typically and historically, six months could be in a longer-term bull market, which would be stronger forces of job recovery follow that, albeit with or more. good for the economy. Commenting on deflation and a lag. We’re hoping that that starts to transcend itself in Keith barket inflation: We don’t think we will see deflation, but we 2011 because in real estate, we are all concerned about are going to see very low inflation for quite some time. the job growth outlook to an acceleration in job cre- ation. We hope to see a bit more positive trend line in Pat? that going forward. It is actually interesting; people are Halter: We are definitely seeing a period beset by os- complaining about where the jobs are, but if you look cillating views of both risk aversion and risk taking at the current trajectory of private-sector job growth, as we look at the markets today. We don’t really see a what we are experiencing now in the last 12 months t Management Business: e d i s c u s s i o n Pat Halter Glenn Lowenstein Jamie Shen Marc Weidner PREA Quarterly, Fall 2010 35
  • 3. 2fall 0 01 COVER coming out of this recession is pretty similar to the last in, you’re down to 10% to 20% of the traditional loca- two post-recession recovery periods. So private-sector tions for investment. It is going to take us a while to job growth is not really out of pattern from past reces- deleverage and get real productivity back online. sionary periods. How about inflation versus deflation? Do you I’d like to drill in a little bit further. You men- have a firm view on that? tioned policy errors. What specifically concerns lowenstein: We are not economists, but I would say you from a policy standpoint? we see a three-year period where it is really difficult to Halter: It is predominantly the uncertainty from the raise prices, broadly speaking. There will be some price Obama administration and the continued anti-busi- increases and niches here and there in different parts ness attitude the Obama administration has toward of the economy. I don’t see super deflation. Then, ulti- businesses. Obviously, health care has created a lot mately to deleverage, we will need to have inflation. In of uncertainty in terms of the cost of business, the summary, we do not see deflation, but minimal infla- cost of hiring people, and that is a significant factor tion, 0% to 1% once again for three years and then some in terms of businesspeople thinking of adding or not real inflation. adding people. Jamie, a view from Callan? Do the forecasts of deficits enter into that think- shen: We believe that this is, as Keith started off say- ing as well? ing, a long, deep recession with a slow recovery. as there Halter: forecasts of deficits are definitely a long-term is so much capacity in the system right now, we don’t consideration, but obviously, the low level of interest think there is an immediate threat of inflation, but we rates and the continued accommodating policy of the also agree that the supply of money can become a factor fed right now are pro-productive in terms of getting down the road. We are talking with our clients about economic activity going again. how to be thinking about inflation. Though no asset class is a perfect hedge for inflation, some asset classes Thanks. Glenn? might perform better in an inflationary environment, lowenstein: Out of 100% probability, there is a 40% and real estate is obviously one of those. We are looking probability that we are in anemia, which is just flat to 1%; at client portfolios and looking at adding asset classes a 40% probability that we have a double dip and possi- that could perform better in an inflationary environment, bly will go negative on some of the key indicators; and like real estate, timber, agriculture, TIPS, commodities, a 20% chance that we come out of this OK. If we had to and private energy funds. attach one word to what we are going to experience over the next six months to three years, it is anemia. Thank you, Jamie. Marc, please finish off this discussion. But either way, you are pretty bearish. You put Weidner: I would differentiate between the developed only a 20% probability … markets and the emerging markets that continued to lowenstein: Yes. I don’t call that bearish—I call it realistic. benefit from high growth rates.We are cautiously opti- mistic on the U.S. economy and, at the very least, are OK, fair enough. One man’s realism is another underwriting a very modest recovery in the U.S. and in man’s bearish. … Europe. The double-dip probability has gone up recently, lowenstein: Sorry to be so direct, but I don’t see the but it is still a relatively modest and low probability. What creation of quality jobs. Most of the profits coming out is interesting is that the center of gravity of the world of corporate america are not being generated in the economy is shifting to the East. While the U.S., Europe, United States; they are being generated internationally. and other developed countries have experienced a very If you look at who is really creating value, what loca- hard recession, there have been many places where it tions in the United States real estate investors can invest was barely a blip on the radar screen, including australia, 36 PREA Quarterly, Fall 2010
  • 4. China, and India. That shift is likely to continue, but that lio. at some point, you need income so you can help pay may actually have a positive impact on the U.S. economy, the benefits. That is one reason we have an emphasis on which to a large extent is still very integrated into the current return. When we look at the market, it could be global economy. So we are cautiously optimistic over the attractively priced in the U.S. if you look at the spread of long term, and we certainly see today’s environment, in cap rates over ten-year Treasuries, which are near historic which there is a lot of uncertainty, as an opportunity to highs. We know we are buying real estate assets below re- ... the center of take advantage of market inefficiencies. placement cost. We know we are not in a period similar to gravity of the world In the debate between deflation and inflation, the glass 2006–2007; today, the cap rates aren’t including paying foreconomy is shifting has been either full or empty and there has been a back the vacancy; there is no assumed lease-up on that vacancy to the East. While and forth between fear of inflation and fear of deflation. the U.S., Europe, and in today’s market. all that makes for a fairly attractive asset It seems we passed from a scenario where inflation was class for a part of a broader portfolio. other developed at the top of everybody’s agenda to a scenario where de- countries have flation is now at the top of everybody’s agenda. That shift Jon, just as a frame of reference, how does the experienced a very was only a few months ago if you look at headlines and 5% payout today that you mentioned compare hard recession, there research papers; now everybody is focused on deflation. to where it was five or ten years ago? have been many We are likely at some point to get out of the deflation and braeutigam: Since becoming CIO, have I have not places where it was depression mood that we are in and start worrying about gone back to look at the net payout over the last decade. barely a blip on the the deficits and higher interest rates again. Therefore, But many times, states—and Michigan is no different— radar screen. ... inflation might become an issue again, which to Jamie’s look to solve their general fund budget deficits with That shift is likely point, might be actually very good for real assets, like early outs. That helps the immediate need of the general to continue, but infrastructure, as well as for real estate. fund of a state, but it puts more burden on its pension that may actually system. So those payouts could even increase a little bit have a positive Thank you, Marc. further with early outs. Michigan just had an early out impact on the for our public school employees, and 17,000 people U.S. economy. ReAl estAte stRAtegies took it. a normal year would be much fewer than that Given everyone’s economic backdrop, let’s in terms of retirees. move to real estate investment strategies and talk about how the strategies themselves are Thanks. Pat, how are the real estate strategies changing. I’ll ask Jon to comment first. changing at Principal? braeutigam: first, in the market, there definitely has Halter: In general, opportunities for core exist today, been a shift toward core and value-added, especially after and you should be truly accumulating core properties; many opportunistic investments over the last few vintage we believe we are either at or near the market bottom. Marc Weidner years have really been troubled. But investors are still put- accumulation is more favorable with dollar cost averag- ting money toward opportunistic strategies, definitely in ing approaches; that is our view of how to implement the distressed or fixed income side or direct loan side of and put money into the market right now. It is clear the equation; everybody is looking there for opportunity that a couple of indicators truly are substantiating put- and higher returns. They are also looking internationally, ting money into the market now. One, over the last but I would say asia and maybe Brazil; they are not look- three or four years, property values have declined much ing toward Europe right now. Michigan has mirrored that faster and further than income on properties, which we as well. We’ve always had an emphasis on core and value- think suggests a buy signal for core. Obviously, current added, and we have some opportunistic. for us, it is re- spreads of cap rates to risk-free rates are at their widest ally no shift; the strategy would be continuing that. I think level probably in eight or nine years. So core is where there is an emphasis on current income versus total return. we are focusing a lot of our energy right now. I think the Right now, the State of Michigan Retirement System has other thing that is important is where transaction and to pay out net of employer contributions about $2.4 bil- volume are right now. Our view is that the broader uni- lion every year; that is about 5% plus of our whole portfo- verse of buying opportunities is likely to expand over PREA Quarterly, Fall 2010 37
  • 5. 2fall 0 01 COVER the next few years both from an increased pace of reso- are low, but some of the real estate that is in high de- lution of troubled loans and from more non-distressed mand by capital and tenants is what we would call “a sellers bringing properties to the market as values begin bridge over troubled waters.” With low leverage, ex- to move off the bottom. We think a lot of that activ- actly as just was said, you can get a sustainable plus ity will be in core initially. So just from a transaction 7% cash on cash that grows nicely over ten years. We perspective, we think that is where a lot of the activ- like that as a hedge against a slow economy, and we ity will be. There is a pretty significant bid-ask spread get inflation protection. Then when it comes to value- differential for value-add and opportunistic investments add, there is a huge spread between a stabilized cap in terms of a seller’s willingness to sell at a price and a rate on a transitional asset and a core stabilized asset. buyer’s willingness to buy at that price. It is the biggest I have ever seen in my career. So you In terms of some specific areas of general focus rela- can buy a less than 75% leased asset for 50% of peak tive to core, from our perspective, trying to buy core pricing. Now granted, there are not a lot of trades, so buildings in an off market or limited-bid transactions is you wouldn’t design a whole strategy around it, but really the key to the strategy. a lot of these—whether it there are absolutely good investments to make. In the is Eastdil or CB Richard Ellis—deals are being bid out, opportunistic space, we see pricing at 20% of peak and there are 25, 30 bids on each transaction out for value, so our overall theme is “price to anemia.” If core. You want to try to avoid that, try to find off-market you take the realistic view that we are flat or down for deals if at all possible, and consistently be conservative three years with a gradual rise out, and you can price on leverage, although I think some leverage is good today, to that scenario, then you can make money and make and 30% to 50% loan-to-values for fixed-rate financial a good investment without principle risk on all three leverage on new acquisitions is a prudent strategy, as is of these categories. The most volume in the next two focusing acquisition activity on demographically strong years will be in core, then value-add, and then oppor- markets. Even though there is a history of excess supply, tunistic, in our view. the Southeast and parts of the Southwest look interest- ing to us today. We really like positioning our investment Jamie, what real estate strategies is Callan into lEED-certified properties and some geographic ar- recommending? eas with favorable supply constraints, such as the Pacific shen: We do everything on a client-by-client basis, region, because they have strong demographic drivers, and it really is dependent on the client’s objective. We yet are of interest to us. So core is where we are spend- try to meet clients’ objectives by taking on the least ing most of our focus at this point; we think that is the amount of risk. Today, we are favoring core invest- best opportunity on a risk-adjusted basis. ments because we believe they can meet the return objectives utilized in asset allocation for the asset class Pat, how does that compare to where you were by investing predominantly in core. for 2010 year-to- four years ago or so? date, through our search process, we have allocated Halter: We were doing a lot more value-add at that 82% of capital to core strategies, 9% to value-add, and point in time along with core. 9% to opportunistic strategies. And Glenn, with your “realistic” view, not your When you talk about the investment allocation “bearish” view, how are your real estate strate- models and real estate’s role within them, is it gies changing? still the case that you look at it as an inflation lowenstein: We keep the same strategies. We don’t hedge, an attractive current return, and offer- call them core, value-added, opportunistic; we call ing some diversification benefits? How has the them low risk, medium risk, and high risk. I’m actu- thinking evolved, if it has at all, with regard to ally seeing opportunity in all three of them. Here is real estate’s role in a mixed-asset portfolio? the way I would frame each of them. In the core seg- shen: We view real estate as a strategic placeholder in ment, it is true if you get a fully bid asset, your yields our asset allocation model, and that view has remained 38 PREA Quarterly, Fall 2010
  • 6. constant. We have always looked at real estate as being value-add strategy. The next few years will be a great something between fixed income and equity on both a time to pursue those strategies in the U.S. Unfortu- risk and return basis. We like the current income aspect nately, many investors fell in love with opportunistic of real estate and the potential for some appreciation. I and value-add strategies in 2005 to 2007. There was think the industry began looking at real estate as provid- too much capital chasing those strategies, and alloca- ing more alpha or more private equity type of return, tions were too heavily weighted toward opportunistic For 2010 year-to-date, but we continue to believe that real estate is more of a and value-add for many investors. I think we are seeing ... we have allocated diversification play and should offer investors current a swing back toward rebalancing where core becomes 82%, of capital to income with some low level of appreciation. the dominant part of a larger investor’s real estate port- core strategies, 9% folio. I believe that is appropriate. However, I do believe to value-add, and Thank you. Marc, let’s swing toward your view that a good manager, a manager who is really skilled at 9% to opportunistic of the real estate investment strategy world. adding value to real estate, will outperform core on an strategies. Again, give us both the domestic and interna- apples-to-apples, unleveraged basis over a long period tional views. of time and will probably significantly outperform. a Weidner: Sure. Over the last five years, we became in- manager who is not so skilled could significantly un- creasingly cautious about the United States to the point derperform. We are seeing a little bit of both right now where we stopped investing in the U.S. market altogeth- as we go through this recession. er about two and a half years ago, while our investment programs elsewhere in the world actually were being in- Keith, would you agree with this statement: In creased. We are coming back to the U.S. market. There is other parts of the capital market, the dispersion Jamie Shen obviously a great opportunity here if we are being selec- among investment managers’ performance tive. Our strategy for the U.S. market is focused on high- widens with the riskier strategies? quality assets trading at substantial discount to replace- barket: Yes. ment cost. When selecting managers today (we are multi- managers), we find managers that can capture core or Glenn? core-like assets outside of competitive bidding situations. lowenstein: Our approach starts with demand for One of the characteristics of today’s market is that a lot of space. We look at the nation in terms of locations that stressed and distressed situations reside with the owners will gain more than their share of demand over the long and/or the structure of the ownership of the assets, when term and where new supply is limited. Then we look at there is actually nothing wrong with the assets. We think relative capital scarcity. Through these two lenses, we this is a particular point in time that is unusual in a cycle see potential for investment in our low-, medium-, and where you can access well-leased, well-built, and well- high-risk strategies. located assets in these stressed or distressed transactions at a substantial discount to replacement cost. although Fee stRuctuRes volume for these types of transactions is low because it Let’s move next to fee structures. In most fall- is obviously complicated to extract these assets from the ing markets, there are downward pressures current ownership, we believe that the investors focused on fees, and real estate is not an exception on that opportunity will be handsomely rewarded on a to that general rule. Pat, will you start the risk-adjusted basis. conversation talking about where fees have moved to over the last 12 or 24 months? Keith, earlier you talked about “distressed” Halter: a perfect storm is brewing from an advi- real estate. Can you talk a little bit more sor perspective; advisors definitely have less pricing about that in light of your real estate invest- power for the reasons you mentioned, Joe. With a ment strategies? down market and performance from advisors subpar, barket: Sure. We manage a series of opportunistic and it is difficult to see fees sustaining at current levels. core-plus funds—core-plus meaning the lower-risk, from an investor perspective, many of our investors PREA Quarterly, Fall 2010 39
  • 7. 2fall 0 01 COVER are public pension plans, corporate pension plans, before the manager receives any incentive fee. We haven’t and other institutional investor plans that have ei- seen all the true issues from the previous fee structures ther unfunded issues or, if they are part of a govern- come to light. Specifically, we are going to see some chal- ment body, significant budget deficits. There is this lenges or continued challenges where some incentive fees intensive pressure on boards and vis-à-vis staffs to were taken early on in a fund’s life and how those will need renegotiate fees with advisors on existing mandates, to be paid back to the investors. as pressure builds on let alone new mandates. There is definitely a move- fees generally and fees come down, questions will be ex- ment in repricing fees in the marketplace. plored in great detail by investors, consultants, and invest- In the marketplace discussion today, and at a re- ment managers, such as “What is the right compensation cent conference I attended, much of the discussion for investment management professionals?” “How much centered around the best fee structure in alignment. can they be compensated?” “What are the firm economics a significant amount of discussion centered around with the new fee structures without embedded incentive what sort of benchmarking structures should be in fees in their current funds coupled with even more back- place relative to incentivizing the right types of be- ended fees in future funds at this point?” haviors by advisors and how they should align with Other outstanding questions are related to the tax the investment strategy and with staff compensation changes for next year and incentive fees in the future structures. This whole fee structure continues to be being taxed as regular income versus long-term gain. fluid and always have new twists and turns to it. The Will investment managers try to demand a higher per- movement in fee structures is definitely downward. centage of sharing? I don’t think the investors will sup- This is not directly associated with fee structure, but port that. Is the investment management industry going it is interesting: The financial services reform act and to have some type of wage deflation? Is it going to be the Volcker Rule will cause institutions to look at their a less-profitable business? What are the long-term im- proprietary trading investment portfolios and where pacts of that, and are we just in a new era where the they are actually putting money into funds. There is compensation is going to be lower than the promise of going to be some profound pressure and change in the compensation over the last five years? There are a lot terms of how much co-investment opportunity funds of issues related to the fee structure, and a lot has yet to in particular and other funds are going to be able to run through the system and run its course. place in terms of new investment funds. That is going to have a profound impact on investors’ willingness to Jamie, just a couple points of clarification. There were some promoted or carried inter- pay significant incentive fees if that co-investment capi- ests distributed early on in a fund, and inves- tal is less or is not offered. That is another interesting dimension to follow over the next couple of years. tors are looking to claw back those earlier dis- tributions. Was there a clawback provision in Jamie, maybe you can follow up Pat’s discus- the investment management documents? If sion about fees since, I believe, you were at the there wasn’t, are the investors just demand- same conference. ing it because they think it is the right thing shen: There is pressure on fees. any disruption in the for an investment manager to do? market highlights issues that may not have been foreseen shen: In most cases, there is a clawback provision, or that may have been foreseen but were downplayed; the however, they haven’t been triggered yet because thinking was that these situations would not occur. Over many of the funds have remaining assets. That is the next few years, we are going to continue to see some of what I mean by it still hasn’t been played through the shortcomings of the in-place fee structures and where the system, but there is an expectation that many of some of the misalignments exist. One area in particular those clawback provisions will be triggered. is on carried interest and how and when it is paid. The investors are very focused now on wanting portfolio-level Could you roughly quantify the reduction in distributions where they receive all their capital back first base fees and/or the preferences? In other 40 PREA Quarterly, Fall 2010
  • 8. words, are fees down by 25 basis points? may or may not last. My final comment is that you are Have preferences gone to 10% from 8%, as going to see tiers of firms form where the top 25% that one example? How should we think about are recognized as best in the business will have pricing those two dimensions? power and the other 75% won’t. shen: Broadly speaking, the base fee in some cases has remained constant; in some cases, the Marc, you are in an interesting place, hav- ... if you want to be an committed capital fee has reduced from 25 to 50 ing the ability to look both domestically and investment manager basis points during the commitment period but internationally at a variety of investment for the next 20 years, then switched to the traditional 1.5% on invested managers and funds. What do you see with you really have to capital. In some cases, where maybe the preferred regard to fees? love this business return was at 8%, it has come up to 9%. We are Weidner: In terms of fees, our approach is really to and have to be a lifer seeing very few 8% preferred returns anymore; we align interests between the investors and the managers, because the low fruit are usually seeing 9% or 10%. We are also seeing and obviously, that is a moving target. for the base fee, has been picked in a lot of tiered structures on the promote where we like to dig into the cost structure—whatever that the past 20 years. there might be a first hurdle and then the manager structure is—and the organization of the manager and gets a lower percent of the profits, say 10%, and try to find a base fee structure that covers only the real then a second hurdle and the percentage sharing cost of operating the business and is not a significant will increase. component of the profit. One of the issues with the current model is the assumption that these managers What about co-investment and gover- will be able to raise funds indefinitely. One of the unex- nance structures? pected consequences of the current fee structure is that shen: We are seeing some more creative things be- if your current fund-raising effort is delayed (and this Glenn Lowenstein ing done to improve alignment or have more of the has been the case for almost everyone), your revenue return coming to the investors. I don’t know if it is a will go down automatically, and you may run into trou- better alignment from the manager’s perspective, but ble in your prior funds as well because the investment the investors are trying to protect themselves a little management fees they generate are actually not cover- bit more on the downside. ing the costs of managing these prior funds. They cost much more to manage than the revenue they generate, Thank you. Glenn, back to you. especially if the value of the assets has come down. In lowenstein: We just did a large transaction setting up a today’s environment, you want to be fully staffed when joint venture with a major fund, and what Jamie said was it comes to asset management, so the reality is that a lot dead on. My global comment on fees is if you want to be of managers have been forced to cut corners because an investment manager for the next 20 years, you really they cannot properly fund their operations and there- have to love this business and have to be a lifer because fore make things even worse. In the past, this operating the low fruit has been picked in the past 20 years. The deficit was sometimes funded by the incentive fees, but way I would summarize the market is that the current that is gone now. fees are going to be, as best as people can measure, ap- The incentive fees we like are the back-ended struc- proaching cost. The incentive fees are, as best as people ture and the tiered approach where performance fees go can structure them, going to create alignment, and we up progressively as realized returns go up. Something in will see a lot of creativity in this area of compensation. particular we are pushing back on quite a bit with some When it comes to discretion, there will be more struc- success is the catch-up; is it really normal for the man- tures that have partial discretion at different points along ager to benefit from a full catch-up at 12% or 13% of the deal cycle. I don’t think it is negative at all for this to realized return? It seems to us a disproportionate share happen. I think what you will see is professionals who of the profit. If real excess returns are being generated, really want to be great investment mangers stick with then perhaps, we can have a catch-up later or a higher the business, and people who are in it just for the money amount of promote. PREA Quarterly, Fall 2010 41
  • 9. 2fall 0 01 COVER I also want to comment on what Glenn just men- pay. We are in a low-return environment going forward, tioned about pricing power. at the same time that there maybe in all asset classes, especially with the ten-year is downward pressure on fees and that for the first time Treasury sitting at 2.7%. What that will do is create an in many years lPs have pricing power, the best man- environment where there is less return to pay people, agers are also only emerging today because it has been an environment where boards and chief investment difficult in an upward-only environment to differentiate officers are trying to bring more back to the fund. So the good, the bad, and the ugly managers. Everybody there is a downward pressure on fees. The push back performed well. Nobody lost money until everybody to that is that you want to invest with quality manag- started losing money on paper, and now we really are ers, and quality managers, as Marc mentioned, have starting to see which managers can weather the cycles proven themselves in this cycle when times have been and make money on a consistent basis. These managers really bad, so they will have pricing power. The market are actually going to attract more funds, more capital and will end up where it is at give or take; the lPs, such as will certainly be able to maintain or even increase their us, will be pushing for lower fees because we think we fees. It will be a mistake in this environment to focus on are in a lower-return environment. The GPs who have only cost at the expense of the quality of the manager. proven track records will bring those track records with them and say, just as Keith mentioned, “We need to at- Keith, from a value-added/opportunistic point tract highly qualified people, or they are going to go and of view, how do you see fees changing? do something else.” We do see, even in hedge fund land, barket: We actually just raised an asia fund, and it was as Keith mentioned, larger funds negotiating some lower interesting—Marc touched on this—in due diligence, fees. at the end of the day, you will see some lower fees. we had investors who wanted to understand our cost Some of the companies that have great results will keep structure compared to our fees. Every time they asked, I their fees where they are, but in general, the industry wasn’t sure whether they wanted to see if we were mak- will have lower fees, whether that is base or incentive or ing too much money or not enough. Investors were ac- a combination of both. tually concerned about both, as many wanted to make barket: The other thing people will take a look at is, sure we were making enough to adequately staff the what other sources of fee income does the manager fund. We did not get push back on our fees for this new earn? The investment management fee is very trans- asia fund compared to the prior fund. parent, but in some cases, managers were charging ac- If I were an investor, there are a few things I would quisition fees, asset management fees, financing fees, focus on. first, I would push back more on the base and investment banking fees that weren’t so transpar- fee than the incentive fee. The 1½%, 1¾% fees that ent and may have led to a misalignment of interests. most U.S. funds charge on committed capital might be My guess is that there is going to be more scrutiny aggressive. I also believe that incentive fees should be over these additional fees and costs. back-ended at the fund level, not paid on a property- by-property basis. leveRAge And Joint ventuRes On the other hand, if lPs were to push to drastically Let’s talk a bit about leverage in terms of ratios, cut fees—and I don’t see this happening—the man- fixed versus floating, and maturity. Then, with ager risks losing significant talent. The really smart tal- regard to joint ventures, we can talk a bit about ent would ultimately move to other industries—hedge preferences and promotes. In these down mar- funds or private equity shops. kets, painful lessons are often replayed. What have we learned and what are we doing differ- Jon, as an investor, what do you see? ently this time? Glenn, can you walk us through braeutigam: Real estate is just one component; you leverage and JVs? have other asset classes as well. Everybody has covered lowenstein: On leverage: There is going to be less of this topic really well, so I will try to be brief. There could it, and it will be longer term. Probably one of the best be tiering; there will definitely be changes on how to things that has come out of this is that there is industry- 42 PREA Quarterly, Fall 2010
  • 10. wide scrutiny on how managers made their money. It’s 55%, so I’m going to bet everything. It doesn’t leave you one thing to have high returns; it is another thing to in a position to recover if you are wrong. get them from leverage and cap rate compression rather than operations. In terms of joint ventures, industry By “guarantees,” you mean what? professionals today realize that any partnership arrange- barket: fund-level guarantees of debt versus non- ment needs more stress testing. Previous market norms recourse debt. I can get 50% nonrecourse debt, but Leverage ratios are will not cut it. I can get 75% with a full guarantee. If you look at coming down, but the funds that have really lost a significant amount of when we have low Jamie, as our representative from the consul- equity, most of those have fund-level guarantees that interest rates—call tant space, what is your view on leverage and brought them down. me cynical—people joint ventures? Going forward, I don’t think there should be a dif- are going to take the shen: as far as leverage, my hope is that one of the ferent strategy with respect to leverage; the amount of leverage if they take-aways from this environment will be that when as- debt you use should be responsible and largely non- can get it. ... when sets are being priced to perfection, instead of maximiz- recourse and non-crossed. Whether you fix or float somebody gives us ing leverage, we will see that as a point in time when should be dictated by the length of your expected free money, some- we should be minimizing leverage and protecting our holding period. Spreads are wide, but Treasuries are how the market will downside. We have seen what can happen and how we unusually low right now. In our view, if you have a always take that. can so quickly go outside of guidelines. longer-term hold, it is a pretty good time to fix rates, as far as joint ventures go, it seemed that people even if spreads may tighten over time. It is pretty sim- had forgotten that there is risk with joint ventures. ple when it comes to the leverage side. When we went through this downturn, there was a re- On joint ventures and club deals, I totally agree with newed highlight that joint venture partner risk exists, Jamie. I really hate doing club deals with other op- and you do have to be concerned about the partner’s portunity funds; and these are funds that are generally operations and going concern and whether or not the well-staffed and in a position to make quick decisions. It partner can make capital calls. In some ways, I think simply slows down your decision making and may lead Jon Braeutigam it was a good thing that we were reminded in this to conflicts. funds may differ in their access to capital, downturn of all the risks that you need to address in their incentives, their view on repositioning, etc., which joint ventures. If an investment manager is doing a lot can lead to deadlocks and confusion. That is a signifi- of work through joint venture partners, there is going cant risk in club deals. In terms of joint ventures, there to be more focus from the industry on whether the are lPs who are in a good position to do joint ventures, manager has the capabilities to replace a joint venture and if you look at what they pay their staff versus what partner, whether the manager is putting in appropri- they would pay a manager, they can probably save ate safeguards in case that joint venture partner can- money in some cases. The key, though, is having a large not make the capital calls, and the way the manager enough wallet to get the diversification you want and is underwriting the joint venture partner’s business. having the appropriate size and quality of staff to make There may be more of a focus on these items than it work. Some people, like Michigan, have been able to there has been in the last five years. do that over the years, but I don’t think there are a lot of investors set up to successfully operate that way. Thanks, Jamie. Keith? barket: first of all, I’d say leverage and fund guaran- Jon, Keith made a nice segue to you. What is tees were the number one sin committed over the last your view? decade, and the rationale that managers used was that braeutigam: Keith is too kind. leverage ratios are leverage was cheap—too cheap—and therefore, you coming down, but when we have low interest rates— should be on the other side of that trade. academically, call me cynical—people are going to take the leverage that is probably correct, but it is kind of like going to las if they can get it. I think we are in an area where we are Vegas and saying my odds of winning on this wheel are all saying we like low leverage, but when somebody PREA Quarterly, Fall 2010 43
  • 11. 2fall 0 01 COVER gives us free money, somehow the market will always of the debt and hope they are generally consistent with av- take that. I think the fed is trying to re-inflate asset erage property lease maturities of the assets. We like to use prices to some degree, and it is going to be success- fixed-rate debt, unless it is a situation where we are near a ful at it. Keith makes a great point about how you use sale and planning to allow for a better matching of the as- leverage. Is it on a property-by-property basis? are all sets and the liabilities. To Jon’s point, you do want to avoid, these properties cross-collateralized? If you have a risky whenever possible, cross-collateralization, cross defaulting asset and it blows up, does it blow up your good assets? of loans, in order to maximize the flexibility of that sort Is leverage on the fund? So all these areas have to be of bet and put option with nonrecourse mortgage loans, looked at. We prefer modest leverage, in the 40% range meaning if you have a bad asset, it doesn’t take down all typically. Some of our assets don’t have any leverage, the good assets, also as Jon mentioned. This is obviously some of them have a little bit higher, but we try to target not as critical now with my earlier points, as we are in above 40%; that way, if bad times come, we think we a sort of a bottom of the market cycle, and we’re going can survive. In fact, that has proven to be the case with to be seeing low-leverage strategies, but I think it is very the current downturn. important from a risk management perspective to apply With regard to JVs, the industry will always have joint that sort of mind-set. ventures. There are a lot of risks with joint ventures, but Relative to joint ventures, Joe, obviously, post the what you are trying to get at is a deal pipeline where you global financial crisis, the pendulum has swung back to get expertise in sourcing and running property. Many the capital partner’s favor. administration, the monitor- times, that is at the local level. as an investor, I would ing of operating partners will increase and will become ask our joint venture partners if they are well-capital- more rigorous. There will be more established proce- ized. If they are not well-capitalized, we might still do dures to follow. The oversight governance of the joint the deal, but we know that is an additional risk. How venture is going to become more formalized, and the long have they been doing joint ventures? Do they have level of discretion definitely has been narrowed. There experienced staff? Have they retained that staff over the will be much more documentation and clarity as to how years? I think Marc has pointed out that there has been a dispute resolutions, or buy-sell provisions, work. One tiering; I think you will see a tiering on the joint venture of the things that people learned is there is a lot of nego- side too. a lot of companies have just gone away, but tiation just as to how those things worked. other companies have proven themselves by managing through this, and they will have the advantage. A lot of ambiguity in the legal documents that sometimes comes out in practice, right? Pat, your view please. Halter: I agree. Halter: People have covered this quite well, but one thing this discussion really highlights is that as a real estate in- Marc? vestment management organization, you are going to have Weidner: The typical metric that has been used in the to really demonstrate this duo excellence, not only under- past—loan to value, floating or fixed interest rates, and standing and managing the assets but also executing these debt maturity—has not been appropriate because it is leveraged strategies on the liability side of the balance not enough. It was not enough to really understand the sheet. That entails achieving the most favorable costs of true debt risk exposure and the impact that debt can debt capital available and being able to use your relation- have on these assets and how they can drive the value. ship with lenders to achieve the most flexibility. What I The devil is in the detail, and the reality of the leverage is mean by that is that loan assumptions, collateral assump- beyond these starting points. In the past, leveraged anal- tions, collateral substitution rights can all be impediments ysis was really checking the box—Was it fixed? Was it to execute sale strategies. You want to make sure you ne- floating? What’s the maturity? What’s the lTV? Today, we gotiate and manage ways to reduce those impediments. really need to peel back the onion and go much deeper We have a general philosophy of asset liability matching. into the analysis because seemingly low-leveraged debt We try to take the average life and duration characteristics can be extremely toxic if it’s associated with an asset that 44 PREA Quarterly, Fall 2010
  • 12. does not produce long-term stable cash flows or where 600 funds in the U.S. If you look at other industries, even the there is high volatility related to the future prospects of core real estate market, fewer managers stand out and domi- the assets. We pay a lot of attention to really understand- nate over time due to their proven long-term track records. It ing the details of the loan documents, including all the is the same in the venture capital industry, which has been covenants, whether the debt is recourse and, if yes, re- around for 40 years now, and the hedge fund and private eq- course to what, all of which has had far-reaching devas- uity business. This is an evolution that is good for the business. The opportunistic tating effects on some real estate funds. People are searching for an answer and wondering if it is fees, industry wasn’t really Regarding the leverage level in today’s environment, we if it is the structure, if it is the investment banking model. a born until the early believe the overall leverage level is only the starting point big part of the answer is that we needed this evolution to sim- 1990s, so there hasn’t of the analysis. We strongly believe that we need to differ- ply weed out the weaker players. been a significant entiate between the type of assets that are subject to lever- down market until age. So you cannot put in the same basket a 20-year lease Glenn? recently. ... If you look of a very good tenant credit with upward revision only lowenstein: I’d say there are two big things that I see. at other industries, and compare the leveraged level of that asset to a construc- One is that people will spend time annually remeasur- even the core real tion loan. Today, we are seeing that the traditional debt ing incentives rather than looking at them just at the estate market, fewer structure is back, as opposed to the exotic structures we beginning. There will be an annual assessment of what managers stand out experienced in the crazy years between 2005 and 2008. everybody’s position is in the deal and what everybody’s and dominate over New debt is currently slowly becoming available at incentive is. The second thing that will happen is that time due to their reasonable lTV ratios with amortization, interest pay- there will be a bigger focus on what risks are being tak- proven long-term ments, and tight covenants, none of which was present en and how returns are being generated. Deconstruc- track records. in some debt structures that are currently the most toxic. tion of returns, not just the absolute level of returns, a high level of leverage is basically not available today will become increasingly important. I think an industry for new loans. a lot of portfolios have very high lever- standard will be developed. age levels because the equity portion has been written down, not necessarily because they had a lot of leverage Thank you, Glenn. Jon? initially. These portfolios are obviously at risk and will braeutigam: I will go with the investor side first. need new equity injections. Investors are going to have to do a little bit more Regarding fixed versus floating rates, it has always been with less. Most investors—and I’m talking about Keith Barket our preference to focus on the real estate risks and the the public fund world and maybe endowments and value that is created by the real estate as opposed to trying such—will be loath to increase staff right now. They to take a directional bet on interest rates. Our preference will be either at a head count freeze or a slight staff is therefore to get exposure to transactions with fixed rates, reduction, so you will see pressure for them to do especially in a low-rate environment like today. more with less. That is going to be the investor’s business model for the next few years for the pub- investment mAnAgement lic funds. from the 50,000-foot level, the advisor’s business models business model is going to change. You’re going to OK, let’s have our first comments on business see a lot of advisors go, some come, and some get models, changing resources, and the like stronger. from the 2007 peak, my guess is that em- from Keith. ployment is down probably 20% across the whole barket: I think what is happening in the industry, particu- industry. at the peak, about 10% of that was fat— larly the opportunistic and value-add industry, is that we are you didn’t need those employees anyway. I would evolving. Marc said this earlier, that we went through a pe- guess that about 10% of that will be hired back in riod of an up market, where it was hard to distinguish good the next few years as people put money to work in managers from weaker managers. The opportunistic industry real estate. funds will attract capital, and the inves- wasn’t really born until the early 1990s, so there hasn’t been a tor GPs will have to have staffing, so they will be in significant down market until recently. There were more than a slight hiring mode. PREA Quarterly, Fall 2010 45
  • 13. 2fall 0 01 COVER As someone who is trying to place students time, and want more information in real time. There in jobs, I’m thankful to hear that, Jon. Pat, has been an overall increase in attention and desire and how about you? need for information. Better projection, faster turn- Halter: In this global financial crisis, a lot of us missed around, deeper analysis, accurate real-time information the big picture. One of the things we have been do- is a trend we believe will continue. from a deal point In this global fi- ing is really strengthening our firm-level macroeco- of view, doing a transaction takes more time, requires nancial crisis, a lot nomic views and trying to get more of those linkages more resources and certainly more analysis than ever of us missed the and views into the various asset classes that we manage before, and we think this is going to continue in the big picture. One of from a global asset management perspective. Develop- future, which is why larger, more experienced groups the things we have ing more robust quantitative and risk-modeling tools is may have a competitive advantage in screening all the been doing is really a big part of that also, as is redoubling our commitment opportunities on an ongoing basis. strengthening our to risk management; we’ve created some dedicated risk firm-level macro- management roles within the organization and filled Thank you. And Jamie? economic views and those roles with top talent. That is very important going shen: It is a due diligence challenge for us. We have trying to get more of forward. from a personnel perspective, engaging talent been talking about how to retool areas of our due dili- those linkages and is really important. The market pressures, the business gence questionnaire to account for some of the new is- views into the various changes already discussed will unquestionably create sues that are important to uncover when you assess or- asset classes that we challenges around retaining and engaging key talent ganizations, staffing, and future resources. On the other manage. ... Devel- going forward. That is really mission critical number side of it, there is an underestimation of how much it oping more robust one for many organizations. takes in monitoring these more complex investment quantitative and programs. One thing we are looking at very carefully risk-modeling tools Marc? is that when we recommend these strategies and move is a big part of that ..., Weidner: It’s been a challenging time for all of us, to a more complex program, is the staffing level of the as is redoubling our but we have been very fortunate at franklin Temple- client appropriate? Can the strategies be supported by commitment to risk ton. During the crisis, we have been able not only the staff, and can the client get the resources it needs management. to maintain the level of resources dedicated to our to implement such a program? If you have fewer re- real estate group but also to increase it, and we think sources on the investor or plan sponsor side, you might that’s very much appropriate given the complexities not undertake a complex program or you might out- of today’s markets. We feel that going forward, there source some of the monitoring that goes along with will be very attractive opportunities, but they are not more complex programs. going to be readily accessible. So a lot of due dili- gence, a lot of work needs to be done, and the gems Thank you, everybody, for your time. It was are going to be hidden deep in the river; we will need an excellent and interesting discussion. Pat Halter to turn each stone in order to discover them. This is why we have increased the level of our resources. Keith Barket is Senior Managing Director of Angelo, Gordon Within the last 24 months, in the advisor business & Co.; Jon Braeutigam is CIO, Director of Bureau of model universe, what we are seeing is likely consolida- Investments for the Michigan Department of Treasury; Pat tion of large players that have been able to integrate the Halter is Executive Director for Principal Global Investors different expertise needed by their clients. It has been and Chief Executive Officer for the firm’s dedicated real es- a very difficult environment for start-ups and smaller tate group, Principal Real Estate Investors; Glenn Lowenstein investment managers. a couple of them might be suc- is a Principal of the Lionstone Group; Joe Pagliari is Clinical cessful, but the environment was certainly more con- Professor of Real Estate at the University of Chicago Booth ducive to smaller, niche players in the past. School of Business; Jamie Shen is Senior Vice President at The change we are seeing is that our clients are un- Callan Associates, Inc.; Marc Weidner is Managing Director derstandably asking more questions, need more face of Franklin Templeton Real Estate Advisors. 46 PREA Quarterly, Fall 2010