Private equity firms looking to raise their first real estate fund face increasing challenges as investors prefer directing their money toward firms with a history of success, but attorneys can advise their clients that while there's no easy way to buck the trend, there are avenues newcomers can explore to thrive.
Only 4 percent of the combined capital raised for real estate funds thus far in 2016 has gone to first-time fund managers, according to data from research firm Preqin, compared with 11 percent in 2015. That figure is significantly lower than half a decade ago, when almost 18 percent of the aggregate money raised for real estate funds went to first-time managers in 2011.
The growing discrepancy in numbers can be attributed in part to the fact that the amount of capital raised by first-time funds doesn’t grow at the same pace as the overall market and that experienced fund managers can close their funds more quickly than beginners. But, the simple truth is that it has always been more difficult for first-timers, according to Kelly Ryan, a partner in Kirkland & Ellis LLP’s private funds practice group who focuses on real estate private equity.
“Raising a first-time fund is always a challenge,” Ryan told Law360.
The challenge extends to both the hopeful fund manager and the legal adviser, and the first issue an adviser must tackle is ensuring the client is ready to handle all that comes with being a fund manager, Ryan explained.
“We do funds for a living, so we see ones that work and ones that don’t work,” he said. “A key part of this effort is making sure everyone is communicating on the front end.”
For those seeking to enter the fray for the first time, the road to success has become materially more difficult as they compete with established players that have already earned investors’ trust and have the necessary infrastructure, explained Lior Ohayon, a corporate partner at Stroock & Stroock & Lavan LLP and chair of the firm’s private funds group.
The transition from being investors in real estate to being fiduciaries is involved, Ohayon said, noting that as a fiduciary, the client will have obligations under state law and a variety of federal laws, as well as ones imposed by investors.
“Complying with all of that is complicated,” he added.
That’s because there are a number of fixed costs related to such fundraising that are more easily spread across a larger pool of capital, Ohayon said, and limited partners often have an investment committee or board of trustees to appease. Investors may also be concerned that reporting and disclosure obligations will be overwhelming for a neophyte.
“You’re now investing other people’s money and looking after it,” he said. “People want to make sure you’re doing the right thing.”
But all hope is not lost. Despite the bleak outlook as painted by the data, there are routes private equity players itching to get into raise real estate funds can take that have a chance at success.
For one, legal advisers can recommend that private equity clients find a so-called anchor investor, which is an outside investor that agrees to buy up a sizable piece of the fund while receiving certain benefits in return, Ohayon explained. Those benefits can come in the form of a higher preferred return, a lower carried interest or a combination of the two, he said.
Another aspect of the legal adviser’s job is to make sure the client is working toward a fund structure that has market clearing terms and is put together in a way that maximizes tax efficiency for target investors, according to Ryan.
“Once that’s in place, and negotiations start, it’s our job to make sure everyone stays focused on the end game,” he said.
But Ryan warned that one of the biggest mistakes by those seeking to become first-time managers is believing that their history of success in being a private equity firm that has inked real estate deals on an individual, deal-by-deal basis has set them up to be successful as a fund manager. Legal advisers must emphasize the importance of all of the administrative aspects of being a fund manager, he said.
“Having an established infrastructure is pivotal for institutional clients,” Ryan said. “Great deals aren’t the only part of being a successful fund manager.”
Other carrots that can be dangled to potential investors include waiving management fees — although Ohayon admitted that is pretty uncommon — promising capacity rights for the next fund and agreeing that the investor will have an advisory relationship with the firm as it raises funds going forward.
“If you can deliver on that first fund, you should be able to go to the market and present your performance as having generated returns for a third-party investor,” Ohayon said.
Once a firm worms its way through the difficulties that come with raising the first fund, everything gets a little easier, and each new successful fund brings with it a higher chance of success in the next go-round, as evidenced by data.
Firms that have previously raised at least three real estate funds are increasing the percentage of combined capital raised for such funds, from 53 percent in 2011 to 76 percent thus far in 2016, Preqin data shows. Meanwhile, those that have raised six or more funds account for 63 percent of all the capital this year.
“Given increased investor concerns regarding the outlook for real estate, ... investors are trusting their capital to fund managers that have track records in good and bad markets, rather than gambling on newer firms,” Andrew Moylan, head of real estate products at Preqin said in a report exploring this trend. “Smaller, less experienced real estate firms will therefore have to work harder than ever in their fund marketing efforts in order to attract investor capital.”
REPRINTED WITH PERMISSION FROM THE JUNE 13, 2016 EDITION OF LAW360 © 2016 PORTFOLIO MEDIA INC. ALL RIGHTS RESERVED. FURTHER DUPLICATION WITHOUT PERMISSION IS PROHIBITED. WWW.LAW360.COM