General partners at private equity real estate firms, by the very nature of their profession, don't take things at face value. It's an understandable trait, particularly when they're investing millions of dollars – much of it from their own pockets – in half-empty office buildings or parcels of environmentally contaminated land. Future rental streams are scrutinized, lease agreements are questioned and construction and redevelopment plans are scoured over for possible oversights. As fiduciaries, it's their responsibility. As capitalists, it's how they earn a living.
When it comes to raising a fund, however, that dark cloak of skepticism often disappears into the closet. Like eager college graduates “polishing” their resumes, human nature dictates that GPs will want to present themselves – and their track record – in the most optimistic, rose-tinged light. Home runs are highlighted, bad investments are played down (or even excluded) and credit is taken where it may not be deserved: out of the rigmarole comes a top quartile fund.
For placement agents and industry consultants, sorting through this potential house of fog and mirrors is not altogether straightforward. The line between fraud, a violation of securities law, and simply stretching the uppermost limits of an investment's projected return is not always clear. Furthermore, deciphering what partner played what role on what deal and who bears the ultimate responsibility – or blame – for a particular transaction can be a complicated affair.
“If you've got three guys investing a $400 million fund, with clear deal leaders, it's much easier to segment,” notes Mike Hoffmann, president of San Francisco-based placement agent Probitas Partners. “If you're Blackstone and you've got a team of 15 with a more integrated approach, individual attribution becomes much more difficult.”
The level of analysis conducted on a GP's track record logically depends on the fund's history and its previous performance. Unless there has been a significant change in personnel, a firm raising its fifth fund will be under much less scrutiny than one relatively unknown to institutional investors.
“There are different degrees of due diligence that we do based on how well we know the players,” notes Jamie Shen, vice president of real estate consulting services at Callan Associates. “If it's someone we're not familiar with, we'll go into their offices and make an on-site visit. I've even gone and met with some development partners to verify that they've actually done business with the firm.”
According to many industry sources, one of the most difficult track records to analyze comes from a manager who leaves one firm to join or start another, not an altogether uncommon occurrence in today's market. In these instances, the first issue is whether or not the individual GP can claim the track record as his own – i.e. was he really the one doing the deal. The second is whether he can claim it at all, since track records legally belong to the institution, not the individual.
“The threshold question is do [GPs] have the ability to disclose their transactions,” notes Kent Richey, a real estate lawyer in the New York office of Jones Day. “If you want to go out on your own, you might be prohibited by confidentiality issues.”
Understandably, it becomes much more difficult to raise capital when you're asking investors – with a wink and a nod – to accept an anecdotal version of your past deals, even if they're able to verify those transactions, their associated capital flows and the GP's involvement through third-party sources. In isolated cases, these types of funds will be able to close, but the firm is placed at a significant disadvantage in terms of attracting potential investors – and even placement agents.
“In all but a few cases, we won't take a deal into market without a formally executed attribution agreement,” notes Probitas' Hoffmann, referring to the legal document which states what specific deals can be ascribed to a departing professional. “For the LPs, it's all about allocation of resources. If they need to make 20 different phone calls just to get comfortable, rather than do confirmatory work, they'll go elsewhere.”
For that reason, Hoffmann says that “the most valuable asset any partner takes from a prior shop is a formal attribution record.” The document not only simplifies the fundraising process by providing clarity to investors, it also lends a semblance of credibility to the GP and his past performance.
While attribution records are important, both placement agents and consultants point out that they are merely starting points for third party due diligence. Just as private equity real estate firms don't take things at face value when they're conducting deal analyses, neither do industry professional who analyze the GP. Reference calls and office visits need to be made, projected returns need to be understood and double-checked and attribution matrices, detailing what specific role on what specific deal a GP fulfilled, need to be filled out and verified.
“We have a 100-question due diligence document that is pretty exhaustive,” notes Michael Crawford, a partner at Rowaton, Connectictut-based placement agent CP Eaton. “We want to look at everything. Who did the deal? What are the projected versus realized returns? How are the projected values arrived at? Are there partially realized deals in the track record that have led to valuation mark-ups? Turnover is another concern – who is still at the company, who has left and who worked together?”
The reason for this extensive process, which can last for months, is twofold: the more work the agent can do up front, the more likely that the back-end fundraising will be successful and thus, the more likely they'll earn their success fee; additionally, placement agents have a reputation to uphold and if an LP discovers something they did not, it damages the agent's franchise value.
“Remember, we need to put our names on the cover [of the PPM],” notes Hoffmann. “So we will independently and individually call references, those that are provided by the GP as well as additional sources on our own. We'll also talk with the buyers, sellers, operators and JV partners of the underlying assets to learn who at the firm they were actually working with.”
Another issue that a GP needs to consider is how much of his track record should be presented to investors, particularly if a manager or group of managers has a track record that spans decades or for those with one-off deals in unrelated fields or strategies. The advice from placement agents: give us everything.
“The track record needs to be presented in the most transparent way,” notes Crawford. “Say you did 100 deals, 40 of which were development deals and now you're going to do a development fund. You can say that we were best at development and that's where we'll focus, but you still have to look at all the deals. The PPM is a legal document.”
Probitas' Hoffmann agrees. “Our requirement is full transparency. Every quality LP is going to get there anyway, so our job is to get them there first. And it just so happens that many of the deals that have been omitted are the ones that suck.”
Once the placement agent becomes comfortable with the GP's track record, the next step is to provide the institutional investor with that same level of comfort. For the fundraising team, that means another ride on the due diligence merry-go-round.
“I think that the due diligence binders that placement agents put together are very helpful and it does give you an extra level of comfort,” notes Callan Associates' Shen. “But we would never just use that as our own due diligence. Placement agents are an interested party. We would be negligent if we solely relied on their information.”
Investors and placement agents can take comfort in the fact that all of this work is not for naught. (GPs, of course, may have a different opinion). While out and out fraud is relatively rare, one placement agent notes that his firm's own due diligence uncovers errors, omissions or falsehoods “dozens of times a year”.
Yet, like many other aspects of the private equity real estate industry, analyzing a firm's track record is an imperfect art, with no hard and fast guidelines or established procedures to lead the way. In many respects, it all comes down to the same fundamental tenets that define the entire fundraising experience, if not the industry as a whole: people, relationships and, ultimately, trust.
“It's challenging,” notes Shen, referring to the difficulty of fully vetting a firm's track record. “But we do the best we can with the information we have and hope people aren't being fraudulent.”