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FEATURE: Recapping on a second(aries) chance

New research from Clairvue Capital Partners reveals that, in an illiquid market, opportunities in two forms of special situations investments – recapitalisations and secondaries – are rising. PERE Magazine, December 2011/January 2012 issue.


Special situations funds, which cover virtually all non-prime loan and investment scenarios in the real estate market, have become hot properties (pardon the pun) in the wake of the credit crunch and ensuing global financial crisis. New research from San Francisco-based Clairvue Capital Partners asserts that two special situations strategies that were unpopular as recently as two years ago, recapitalisations and secondary market investments, are on the rise as these funds seeking new pools of opportunity. 

As Colony Capital principal Kevin Traenkle pointed out in a recent conversation with PERE, special situations encompass investment opportunities in which there’s over-leverage and/or “debt that needs to be restructured”. Indeed, special situations are simply a means to provide capital to an illiquid situation, and recapitalisations and secondaries are prime examples of such investments. 

Of course, that hasn’t always been the case. Conventional wisdom in the wake of the global financial crisis was that the real estate market would grow out of its debt problem, and recapitalisations were not a solution. In addition, there weren’t a great deal of opportunities to be found within the secondary market. Although opportunities in secondaries were in fact scarce in 2009, the industry’s mindset about recapitalisations turned out to be only half correct. 

Fast forward to 2011, where recapitalisations are picking up steam and opportunities in the secondary market are starting to re-emerge. Indeed, with a large number of maturing loans in an economic environment facing slow growth, the re-emergence of debt capital available for refinancing is resulting in a growing number of recapitalisations, argues Clairvue’s managing partner and chief investment officer Jeffrey Giller in a new white paper on the subject.

Clairvue’s paper, entitled Specified Indirect Investments: Providing Liquidity to Private Equity Real Estate Vehicles and Their Investors, describes ‘specified indirect’ investments as a special situations investment in which a real estate vehicle’s underlying investments have been substantially made. Because of this, these types of investments typically offer higher returns than direct property investments due to the pricing discounts typically associated with illiquidity and limited control. Generally, these types of special situations take the form of either recapitalisations or secondaries, both of which are becoming increasingly popular among investors and managers. 

The rise of recaps

Recapitalisations, according to the white paper, are made to provide fresh capital to real estate vehicles for a “variety of liquidity needs, including paying off or paying down maturing debt, financing discounted loan payoffs, covering leasing costs and capital expenditures and possibly to provide capital for new investments”. These types of investments typically are structured as subordinated debt or preferred equity, which can create attractive returns with downside protection through equity subordination.

Giller writes that, although recapitalisation volume is on the rise, the most pressing need for liquidity continues to be to either pay off or pay down maturing debt. “The big presumption that we were going to grow out of our debt problem turned out to be a fallacy,” he says. 

Indeed, there is a substantial amount of maturing debt heading the market’s way. Citing data from Property and Portfolio Research, Clairvue’s white paper reveals that there is $1.9 trillion in commercial real estate debt scheduled to mature through 2014. However, recapitalisation activity to date has been curbed because, in many cases, lenders have been willing to extend maturities. 

To illustrate that point, in 2008, there was roughly $450 billion in commercial real estate debt estimated to mature in 2011. By 2010, however, there was about $850 billion of debt estimated to mature in 2011. This implies that about $400 billion in loans maturing in 2008 through 2010 had been extended to 2011. And since debt maturities are being delayed, the time has come for recapitalisation to be imperative. 

Although some limited capital has returned to the market to address the tremendous need in the market for refinancing, property owners will need to seek additional sources of capital to cover the shortfall in current loan balances due to the low loan-to-value ratios currently applied to properties. 

This maturing debt also has created a considerable equity gap in the US. The equity gap currently is estimated to be $191 billion in private equity real estate funds. While the entire amount of the equity gap will not be filled through recapitalisations, the slow economic growth should drive up recapitalisation volume. 

According to Clairvue’s research, this is primarily due to two reasons. The first is that economic growth, even if it’s slow, has given property managers a renewed optimism for the prospects of value accretion. This creates incentives for managers to refinance and continue to hold their assets rather than to turn them over to their lenders. The second is that the slow growth environment will keep property values suppressed to levels where refinancings will not cover their current principal balances, so managers will need to recapitalise to fund their equity gaps. 

As banks’ earnings and capital reserves improve and regulators have started to pressure lenders to increase reserves and mark loans to true market values, lenders have become more willing and able to sell their loans to borrowers at discounts. These discounted payoffs allow lenders to improve their risk capital ratios by removing challenged loans from their books. In turn, the payoffs enable borrowers to restore some of the equity they had lost through market value declines. 

“The equity gap needs to be resolved through a combination of banks forgiving debt and the owners coming up with capital to pay the difference between the refinanced amount and the amount the lenders require them to pay off,” says Giller. 

Managers typically set aside reserves to cover unanticipated events and future carrying costs. However, with holding periods drawing out longer than expected, operating cash flow lower than projected and a dearth of buyers for secondary and tertiary properties, a number of funds are in need of capital infusions to cover property-level carrying costs and fund-level management fees and costs. 

In most cases, fund managers intended to finance value enhancement projects such as property development, renovation or tenant improvements with debt or equity reserves. Ultimately, with debt availability still constricted for certain property types and equity reserves depleted, managers may require additional capital to finance these accretive activities. 

“The only way to solve the maturing debt problem, other than through recapitalisations,” says Giller, “is for values to rise so that properties can be refinanced at the same levels of the maturing debt.” 

A second wind 

Secondaries, which were unpopular as recently as two years ago, are also steadily garnering favourable attention from investors and fund managers. The reason for this appears to be twofold: one, because fund managers’ marks have slowly been moving down, and two, because savvy managers have been restructuring both their assets and portfolios. The result of a smart restructuring, if done correctly, is the creation of more equity. 

Clairvue’s research notes that sellers of secondaries typically seek early liquidity to reduce exposure to real estate as an asset class, reallocate their private equity real estate exposure to different managers or markets, fund their other unrelated capital requirements or comply with regulatory changes. 

During the recent market downturn, with many real estate vehicles over-levered and facing massive levels of maturing debt and capital for refinancings absent from the market, investing in secondaries posed excessive risk. The depressed fair market value led to irreconcilable bid-ask gaps for secondaries. 

However, some investors turned to the secondary market during the downturn to attempt to divest their weaker fund positions. Sure enough, upon receiving low bids, few of these prospective sellers elected to transact. Therefore, even though the downturn drove demand for secondary liquidity significantly higher, secondary volume remained steady at roughly $800 million per annum during 2008 and 2009. 

Then, during 2010, secondary volume doubled to more than $1.6 billion as a small number of secondary players sought to capitalise on certain sellers’ distress and well-capitalised LPs acquired interests at discounts in order to reduce their bases.

Secondaries, according to Clairvue, now seem to be poised for growth and to present attractive opportunities for experienced investors. “With real estate values and operating fundamentals stable to improving and savvy managers recreating lost equity value by restructuring their debt, reported net asset values have slowly been recovering,” Giller writes. 

“While most opportunistic and value-added funds are still over-levered, with debt and equity capital returning to the market, funds’ assets can be liquidated or recapitalised,” Giller adds. “Therefore, the possibility for value accretion and the clarity of exit strategies for secondary investments is more apparent.” In fact, Clairvue’s research shows that secondaries may present one of the few viable high-yield investment opportunities in the real estate sector over the medium term. 

Out of the trough

Ultimately, Giller sees the private equity real estate market “coming out of the trough,” with both secondaries and recapitalisations tending to work since there’s still enough distress in need of capital. Indeed, in the near future, the industry is going to see even more of these types of special situations investments, as there’s going to be a tremendous need for capital to recapitalise real estate platforms, primarily to service the maturing debt in the market.

Clairvue’s research charts a course where recapitalisation and secondary market investments can solve a great many problems for investors, fund managers and fund LPs alike. However, because the market is still full of risk and uncertainty, Giller stresses the need for investors in recapitalisations and secondaries to engage in due diligence and “make sure to only back vehicles with quality assets managed by strong sponsors”.