Last week I caught up with a peer who works in the real estate private equity fund business, and he shared with me some of the challenges he and others in his place in the real estate ecosystem are facing.
In addition to not being able to easily identify and secure transactions at reasonable prices, his fund is now being forbidden by its equity investors from engaging in joint venture transactions because of the promotes (fees) charged by the operators. The investors don’t like these right now because margins are thin as it is, and they already pay the fund fees to deploy their capital. (Imagine having to pay not one but two ATM terminal fees every time you took out money; no thanks!)
For those unfamiliar with how this works, a brief description: a joint venture is a partnership-based investment vehicle where the partners would be the private equity fund and the owner/operator of a property (the latter referred to as the transaction’s “Sponsor”), be it a development site or an existing income-producing asset. The two partner to enable the execution of the investment strategy, with the fund primarily providing capital, (and secondarily, strategic advice) and the owner/operator providing a minority share of capital, but all of the day-to-day execution.
In joint ventures, there is typically an arrangement whereby the Sponsor, in order to be aligned to strive to make the transaction achieve its potential, will be granted a share of profits above and beyond the proportion of the equity they themselves have invested in the transaction. This disproportionate allocation of cash flow can be extremely lucrative to the Sponsor (i.e., expensive to the fund and its investors).
Because capital is so constrained right now, the investors in the funds (i.e., the Clients of the funds) have leverage in the relationships with the Fund operators with respect to investment eligibility criteria.
My peer lamented at the end of our conversation: “You know, I thought I was in the real estate business, but I now realize that I am in the Client business.” And that has made his job in placing capital that much more difficult by narrowing the universe of potential opportunities.
This is concerning for those owner/operators who need capital to move forward on existing opportunities, although it potentially creates exits from their investments if the funds wish to acquire the projects outright and operate them.
What are you seeing in your markets?