Breaking with Tradition
One increasingly popular non-traditional secondaries trade happening in the private real estate market today is the sale of fund positions to investors which are keen to take ownership via a new, often lower risk-return profile investment structure managed by the original investment manager. While these transactions can meet the needs of investors and managers alike, they also can come with inherent conflicts, which is where advisors like the Accord Group come in.
PERE: What exactly is a non-traditional secondary transaction?
Desi Co: There are two varieties of managers pursuing fund recapitalizations. One is managers that have assets in a fund at the tail-end of its life and have limited ability to move forward with growing their business without a recapitalization. Their challenge is to deliver on their fiduciary promise of delivering the highest value possible for their existing investors and, yet, at the same time, receive an invitation by new investors to remain as the operator. At the end of the day, some of these operators are capable, experienced and knowledgeable about the assets being sold. The new buyer recognizes that skill set and re-invites them to manage them, even if they previously faced challenges both within and outside of their control. There have been a number of managers that have used this method as a way to extend their activities in a space following hiccups from the GFC.
Next, I think you are seeing a wave of managers that have superlative track records. They are not looking at these types of executions as a way to stay alive but rather to affect some portfolio management. A lot of assets have now transitioned and been successfully brought from an opportunistic and value-add risk profile down to more of a core-plus risk profile. The manager would not typically want to sell the real estate as it’s very difficult to repurchase these assets in the open market. There is often another business plan that needs to happen now for these properties and a lot of managers would like to continue on that journey even though the returns might be lower. Through these types of situations, we have created an opportunity to allow the manager to fulfill its fiduciary obligation and also continue their property business plans, with new capital that wants a lower risk profile. That’s a very exciting evolution. We have done a number of these in the last year or so and that is where you are going to see a lot more activity going forward as the GFC begins to fade into the sunset.
PERE: How are these transactions brokered?
DC: At our shop, we run a very traditional sell-side M&A process where we have a universe of buyers who we reach out to. We have a fairly detailed instruction letter that we ask everyone to comply with, and we provide information to all interested bidders via a virtual data room. We then ask investors to provide bids by a certain deadline to get the highest and best possible prices for our clients.
PERE: How much do fund managers have to consider potential conflicts of interest in these types of non-traditional secondaries transactions?
DC: Conflicts in and of themselves can be relatively pervasive in the business. I think the key to managing those conflicts is transparency and communication. It is critical to communicate issues clearly and succinctly to existing LPs that may be on the exiting side of a given process. This is where Accord has worked for all the stakeholders, serving as objective validation for the transaction.
PERE: We discussed the manager’s motivations, but are investors generally receptive to the concept?
DC: It is growing in acceptance and that acceptance has resulted in a lot of LPs successfully exiting at a premium to the last reported NAV. In some cases, investors that have undergone this process are recommending us to have a look at other portfolios where we can unlock the real estate, on the one hand, and also provide additional growth opportunities for the GP, on the other hand.
For instance, in one European transaction, we ran a very focused, but competitive, process. We did generate a premium to NAV. I won’t say how much, but it was a significant figure. On the back end of that transaction, one of the LPs recommended us for another process that we are about to wrap up now.
Real estate is a smaller market in the secondaries space than private equity, but it is evolving quickly. It’s no longer just about LPs seeking liquidity out of the GFC, but a lot more about the tactical use of secondaries by large institutional investors, as well as smaller ones. It might be to pare back certain exposures, or free up capital in a non-distressed way, which is all helpful in showing the value of the secondaries marketplace. There is no longer a stigma when looking at the secondaries market, whereas there was one, say, five years ago. LPs now consider secondaries as just another portfolio management tool.
PERE: What advice would you give investors thinking about undertaking a non-traditional secondaries deal?
DC: For an existing investor, I think it’s important to look at what you have invested in from a 360-degree view. What I mean is that, while, of course, you should expect the best possible price, you should also consider the wider relationship with the general partner, to the extent these types of transactions give you a strong outcome on valuation and makes your general partner a stronger, more durable franchise, because they have been able to enter an adjacent business in the core-plus space. I think that could yield a win-win opportunity for both parties. In this market, there is a premium placed on portfolio size and I think it is also true that the largest check writers for these large-scale transactions tend to be folks without operating capabilities. It’s quite natural that you would see many large investors want not only a portfolio of difficult-to-assemble assets, but also the expertise of a very strong operator. So they would want to continue to use the incumbent manager, which again might create that win-win. So, to LPs, I’d say: a secondaries transaction may actually yield the better outcome relative to a 100 percent sale. Also, we are seeing non-traditional secondaries being used for partial cash out situations where it makes sense for the investors to take some money off the table now while allowing a part of the original investment continue. I think non-traditional secondaries have a very big part to play, especially at this stage of the cycle.
PERE: And advice for the fund managers?
DC: For the manager, first and foremost, you have to work with the utmost integrity and never forget your fiduciary duty. Be extremely transparent, even over-communicate. I’d say, in this environment, there is an opportunity to achieve both objectives: do all you can and should do as a fiduciary and grow your franchise. In this instance, transitioning from being a pure opportunistic or value-add manager and getting into a lower risk space is possible. But, you can never forget your fiduciary duty.
I see a lot more of this type of activity happening as long as the cycle remains supportive. That’s what we all have to think through – where are we at in the cycle and what is the best way to capitalize on behalf of all stakeholders?