How to Manage Concentration Risk in Secondaries
Accord Group was recently featured in an article in PERE discussing the secondaries market.
As the real estate secondaries market has become more sophisticated in recent years, and investor demand for diversification and real estate exposure has increased, deals have gotten bigger. According to data from Landmark Partners and Preqin, $10.6 billion in real estate secondaries was transacted on the global market in 2021, a new record.
As such, managers are targeting larger fundraises to meet this competition. PERE data shows that four of the five largest real estate secondaries funds currently in market are looking to raise at least $1.5 billion in capital. And while annual fundraising has been uneven, 2020 was a record year for the market, with $7.34 billion secured.
“Every secondaries fund has grown in size to address the larger-size deals,” says Jeff Giller, partner and head of StepStone Real Estate. “They should be able to scale up to handle larger transactions and meet increasing overall market volume.”
But as deal and fund sizes have grown, with GP-led single-asset restructurings increasingly common investments, to what extent are investors facing greater concentration risk? And how can they mitigate that risk?
“Usually, the very large deals are shared by multiple secondaries firms,” explains Giller. “They [often] do it in a club format, where the various competitors will team up to buy large deals together. A single buyer will take it down and then offer pieces of the deal to other secondaries buyers, or the manager or investor will set pricing and select different buyers to acquire the interests. But funds are also getting bigger and increasingly able to take on larger-size deals.”
The emergence of bigger funds is coming about as managers look for greater efficiencies and economies of scale, says Desi Co, managing partner at San Francisco-headquartered Accord Group.
“We’ve been saying for a while that we think the world will coalesce to not only a dozen or two mega-funds, but a dozen or two specialist funds,” Co explains. “New niches will always emerge, but at the end of the day, it’s all about being the national champion or international champion in your specialist area.”
Understanding the risk
There are several ways secondaries investors can ensure they are not caught out by concentration risk. Due diligence, for example, is the primary way to ensure that investors understand their exposure to single assets.
“Large, sophisticated investors – especially those that also have direct investment arms – are increasingly willing and able to undertake such an exercise,” says Philip Chapman, real estate secondaries specialist at investment bank Lazard. “The diligence required for syndicate parties can be somewhat lighter as they gain a degree of comfort from the work done by the lead investors that determine price and terms.”
Giller says StepStone Real Estate has found that a focus on manager-led secondaries – a part of the market where volumes have grown considerably in recent years – gives the firm better insight into the assets it owns, as it can often be challenging to perform due diligence on traditional investor-led secondaries.
“On GP-led secondaries, the manager is usually willing to provide detailed asset-level information for our due diligence, while in traditional investor secondaries, there is no incentive for the manager to do so,” he says. “Usually, the manager limits what they’ll share with buyers of investor secondaries to quarterly reports, so it’s impossible to do the kind of due diligence you would do when you’re buying an individual property or even a portfolio of properties in investor-led secondaries.”
Deep underwriting can also help increase potential investors’ understanding of a deal, says Sarah Schwarzschild, managing director and co-head of global multi-manager platform BGO Strategic Capital Partners.
“We are real estate investors first and ground every deal in real estate underwriting,” she explains. “Our proprietary traditional secondaries model allows us to do a sum-of-the-parts underwriting with projections and valuations of individual assets. “One reason we do deep real estate underwriting is because we believe risk management starts there,” Schwarzschild continues, adding that the firm also mitigates risk through careful portfolio construction and diversification across asset, manager, property type and geography.
Bigger can be better
For many in the secondaries market, the increasing number of larger deals should allow investors to side-step the issue of concentration risk.
“Secondaries investors are able to right-size their participation in large deals to manage the level of exposure to any single asset,” adds Lazard’s Chapman. “It should also be noted that real estate secondaries funds are raising larger and larger funds, which helps mitigate concentration risk – large funds are more capable of absorbing large deals without the exposure representing excessive concentration within the fund.
Investors will also typically be disciplined when it comes to the maximum exposure they are willing to take on a single asset, says Chapman. “On a large transaction, this typically results in the need for additional syndicate capital to fill any funding gap, rather than a negative pricing impact.”
To some, larger funds and bigger deals are a sign that the real estate secondaries market is maturing and should remain a long-term feature.
“It feels like, in the last five years, real estate secondaries funds have really come of age,” says Accord’s Co. “I think it’s because they’ve offered a combination of buying investor interests, as well as recapitalizing whole portfolios and large assets.
“So the logical way for a small guy to participate is to be more involved in those kinds of vehicles.
“This whole industry is moving more toward [being] bigger in all dimensions – bigger managers, bigger funds, even smaller investors trying to write bigger checks,” notes Co. “Everything is moving toward bigger, [but] that is the natural sort of countermeasure to any kind of inherent concentration that’s going on.”