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Denominator effect could lead to LPs missing 'colossal' opportunity

While fund managers have been busy raising distressed property vehicles, the bitter pill to swallow is that some LPs are unable to allocate equity to such funds at the moment, according to research by a prominent private equity real estate expert.

The denominator effect may lead to LPs missing a 'colossal' buying opportunity created by widespread market distress, according to one of the most influential figures in private equity real estate.

Joanne Douvas, co-founder of US firm Clerestory Capital Partners, said those institutions encumbered with a denominator problem where there is an unintended increase in the investment allocation to real estate created by the relatively further fall in values of assets such as equities and bonds, could find themselves sidelined in the market.

In a research document published today, Douvas said: “Our research indicates that institutional investors are not generally focused on new fund commitments for the remainder of this year. Instead they are evaluating their existing portfolios in anticipation of investing new capital on a limited basis in 2009, after market volatility subsides. However, for those LPs sidelined by the denominator effect, their inability to increase real estate investments next year may mean they are missing a colossal buying opportunity created by widespread market distress.”

The research points out that many real estate fund managers see a potential “once in a lifetime” investment opportunity. This explains why despite the credit crisis and faltering economic growth, opportunistic real estate investment managers continue to attract capital, said Clerestory, with some 187 funds seeking to raise $155 billion (€121 billion) in the third quarter.

However, the firm also said that capital raising had slowed considerably in recent months: “Anecdotal evidence suggests it’s only some well-established managers who have raised their target equity amounts quickly from existing investors,” said co-founder Tommy Brown. “Many managers appear to have struggled to close a third or half of their anticipated equity raises, and some may become distressed targets themselves, especially if they are facing issues such as eroding loan-to-value ratios or debt coming due.”

Clerestory’s update on the real estate opportunity fund universe, carried out in August and September, identified 140 small-cap opportunistic funds seeking to raise approximately $65 billion in capital. A total of 47 large-cap funds seeking to raise $90 billion in capital were identified. The firm defines small cap as those raising less than $1 billion of equity and large-cap as those raising more than $1 billion.

Some 47 small-cap and 20 large-cap opportunistic funds representing $64 billion in equity had their final close during the past six months. The small-cap funds in the market tend to be first-time or second-time vehicles, said Clerestory, which are more regionally focused. Clerestory also observed over the past year that large cap funds were becoming more regional.

The acceleration of fundraising by Asia-focussed vehicles has also been noted. Clerestory observed 67 funds seeking to raise approximately $46 billion of equity. Among funds focused on Asia, 26 are India-specific and looking to raise approximately $111 billion of equity, while 10 are China-specific and are aiming for $6 billion.

In Latin America, an additional five funds have come to market, primarily focused on Brazil and Mexico. In aggregate, they are seeking to raise $3.6 billion in capital.