RE Debt special: Rules of the game

Real estate debt funds may have seen a dip in fundraising last year to $20 billion from $28 billion in 2014, according to PDI Research & Analytics, but this relatively nascent part of the financing landscape is here to stay.

“There has been a pause in fundraising,” says Anne Gales, partner at placement agent Threadmark. “But, with growing uncertainty now in the market related to concerns around peaks in real estate values, the signs are that activity is starting to pick up again as investors focus on income generation with protection. This is a market that will be around for the long term.”

With maturity comes greater standardisation of how funds are structured and the types of fees and other terms being agreed between investors and fund managers. “Agreements are still heavily negotiated, so what’s in the documentation isn’t necessarily what’s in the signed papers,” says one placement agent. But the market is moving towards models that work for real estate debt fund investors and fund managers alike.

In the early, post-crisis days in Europe, there were discussions around how best to structure real estate debt funds, with some considering open-ended hedge fund-type structures or corporate entities issuing bonds, says Ajay Pathak, partner at law firm King & Wood Mallesons.

“In part this was to allow investors to draw capital from their fixed income, rather than private equity/alternative asset allocations,” he says. “There was a question mark over how Solvency II might affect insurers’ ability to invest in limited partnership structures and, accordingly, we saw bond-type structures being considered.”

However, he adds that with a few exceptions the majority of funds in Europe are now being structured as private equity-style closed-ended limited partnerships.

Even in the US, where REITs have long provided a publicly-listed vehicle for investors, private equity-style funds are now becoming more prevalent.

“Limited partnership structures have become the predominant vehicle,” says Nat Marrs, partner in the Chicago office of law firm Latham & Watkins.

“Some of this has to do with the history of some of the players who started out on the equity side and have moved over to debt, but it’s also down to a greater appetite for private capital going into debt since the financial crisis.”
This appetite in the US has been driven in part by the growth in loan-to-own strategies since the late 2000s.

“The financial crisis clearly brought with it financial distress in real estate and many players have been able to capitalise on that,” says Marrs. “We’re now seeing further development as groups are looking at setting up specific funds that invest in certain categories, such as hotels. Often, they are looking at taking mezzanine positions in hotels that were previously acquired at high prices and that are now entering distressed territory. Limited partnership structures clearly make sense in these situations.”

And, as in Europe, increased banking regulation is creating opportunities for other types of private real estate debt funds further down the risk and return spectrum.

Given the prevalence of the limited partnership structure in the market, the starting point for economic terms has naturally been private equity. However, the different nature of debt fund investing is leading to divergence.

“The key differences in the terms and economics are driven by the characteristics of debt funds,” says Pathak. “They have shorter terms than typical private equity and infrastructure funds, for example, and their investment period is shorter. In addition, there is usually an ability to recycle funds during the investment period rather than distribute capital to LPs.”

As with any debt fund, the key determinant of the fees and incentive payments levied tends to be the risk and projected return of a fund’s strategy. For senior, secured loans, management fees are lower than in traditional private equity, at 1-1.5 percent, says Pathak.

Distressed opportunities, with loan-to-own strategies targeting returns in the teens, are more in line with private equity, with around 2 percent levied in management fees.
And while longer-dated infrastructure debt funds tend to focus less on incentive rewards, real estate debt funds often feature an element of carried interest. In the US, Marrs suggests this is often up to 20 percent; in Europe, the norm is more in the 10-15 percent range.

However, those targeting low-risk, low-return strategies (senior secured lenders seeking in the order of around 4 percent) don’t usually have carry structures, according to sources.

For those European funds that do charge carried interest, a few do so using an NAV model. “This is quite unusual and is becoming less so as investors increasingly see real estate debt as a private equity-style investment and therefore expect a realisation-based carry,” says Pathak.

There is also a move towards charging management fees on invested, rather than committed, capital as a means of incentivising managers to originate deals and deploy capital in a timely fashion.

In Europe, the arrangements are more skewed towards investors, however.

“Management fees are rarely charged on committed capital,” says Pathak. “They are usually charged on deployed capital or, sometimes, a blend of the two.”

There are two further determinants. “The experience of a sponsor can drive the terms it seeks from investors,” says Marrs. “Often, you’ll see less experienced managers come out with less aggressive terms.”

The other is a discount on management fees for either committing capital at first close or for writing large cheques, either for deployment through the main fund or via separately managed accounts.

Given the economic focus on fees as opposed to carried interest in many real estate debt funds, it is perhaps unsurprising that some are now pursuing a multi-fund, multi-strategy model in a bid to aggregate and grow fee income.

“It is now becoming quite normal for fund managers to raise funds for different strategies at the same time,” says Gales. “This generates fee income, but also allows them to pursue a number of strategies that don’t compete with each other, while offering borrowers a range of products and solutions to suit their needs.”

Nevertheless, this is something that investors are watching closely.

“Many investor requests centre around the investment restrictions on areas such as LTV ratio and restrictions on specific types of investment,” says Pathak. “Yet there are also now situations where managers are setting up separate funds across a range of strategies and asset classes. This is leading to more investor focus on how key man clauses are drawn and the time devotion requirements of key individuals generally.”

There are also discussions around how capital is allocated between the different funds to ensure investors are given access to the opportunities they are seeking and how any potential conflicts are dealt with, adds Pathak.

The growth of the real estate debt fund market has been rapid since the financial crisis. But while there may have been some experimentation with structures, terms and conditions, it looks as though norms have already been created by adapting the established private equity model to fit real estate debt fund characteristics. Investors and fund managers are relatively clear, in today’s market, what “acceptable” looks like.