The fate of Morgan Stanley Real Estate Investing’s seventh global opportunity fund lies in a vote by investors scheduled for this month. PERE Magazine December/January 2011/2012 issue.

This month, the future of one of the world’s largest private equity real estate funds is scheduled to be resolved.

The limited partners of Morgan Stanley Real Estate Fund (MSREF) VII Global, the most recent global real estate opportunity fund raised by Morgan Stanley Real Estate Investing (MSREI), will be voting on an extension of the fund’s investment period, which is scheduled to come to an end in June.

The issue for the Morgan Stanley-sponsored business, which was formed in 1991 during the time of the US savings and loan crisis, is that it has invested less than $2 billion of the $4.7 billion that it raised for the fund when it closed in May 2010 and therefore requires more time to invest the remaining capital. Having already secured internal approvals to press on, the fund’s senior executives are now trying to convince its LPs. How successful their efforts are should become known later this month.

Where else could you have received a 20 percent IRR over that period of time?
Former MSREI employee

PERE has discovered that a vote by the fund’s LP pool, which includes the likes of General Motors, the Canada Pension Plan Investment Board, China Investment Corporation and the Government of Singapore Investment Corporation, will be held over the next few weeks to determine whether it can continue to invest the remaining capital. A two-thirds majority vote by capital (larger investors carry more votes) would see MSREI granted an extension of 12 to 18 months and, crucially, additional breathing space to invest into an international real estate market still reeling from the effects of the global credit crunch.

A green light from investors also would provide a further chance for MSREI to continue to show the private equity real estate world that it still is a potent opportunistic investing force. Former and current employees attest that, having drawn criticism after revealing sizeable losses from its two 2007 vintage MSREF funds, there is little focus today on the platform’s prior glories. “It’s unfortunate with MSREF,” one ex-employee says under condition of anonymity. “It gets a bad rap because of those last vintages. Still, if you invested with MSREF over 20 years, it was a great performer,” he notes, pointing to IRRs of 20 percent-plus on more than $25 billion of invested equity over that timeframe. “Where else could you have received a 20 percent IRR over that period of time?”

Nonetheless, the tide of opinion on MSREI’s opportunistic funds series, which make up much of the platform’s current $43 billion in assets under management, has been turning of late, with one investor in the latest fund telling PERE that the vehicle was actually “doing well”. That message was further substantiated by claims that the fund currently is generating IRRs north of 20 percent from its early investments.

There also is an undercurrent of confidence within the 300-strong business itself that the necessary approvals to extend the fund will be granted. “I am highly confident, but it’s not done until it’s signed,” offers one current MSREI employee who also did not want to be identified.

MSREI itself would not comment on the matter when approached by PERE.

Changing faces

An extension of MSREF VII Global, or G7 as it is known to those familiar with the fund, also could be seen as a further endorsement of its current senior managers, led by industry veterans John Klopp and Olivier de Poulpiquet. Both men joined MSREI in 2010.

During the vehicle’s fundraising period in 2008, 13 of MSREI’s senior executives were specified as “key men” for the benefit of certain large investors. Remarkably, only one of these key men has remained with the firm – head of special situations Timothy Morris. Between the end of 2008 and September of this year, the other 12 either left of their own accord or were dismissed. Among those who departed were co-global heads John Carrafiell and Sonny Kalsi, Americas head Michael Franco, Europe head Marco Polenta and Asia head Fred Schmidt (see The G7 13 table, p. 8).

According to one law firm that PERE spoke with, when a key man stipulated in a fund’s documents departs, it usually triggers a “key man event,” which would give the fund’s investors various options, including the possibility of a vote on cancelling the remaining investment period if it has not already expired. Evidently, this did not happen at MSREI, as a new key man provision subsequently was drawn up identifying five key men. Morris remains as one of the five, and he is joined by de Poulpiquet and Klopp, as well as chief financial officer Michael Levy and Asia head Hoke Slaughter. For MSREI, the approval of an arguably more manageable, five-strong key man provision also could be regarded as an endorsement of the firm’s recent efforts, the current MSREI source suggests.

That said, the very existence of key men clauses for certain of its investors and not for the majority conceivably could become one bone of contention that MSREI might have to iron out if it is to extend its investment period, although no investors are understood to have requested the provision in the lead-up to this month’s vote.

While 12 of the 13 original key men are gone, MSREI has experienced further senior turnover as well. Last month, the firm’s India head Naresh Naik resigned to start a new business, although PERE understands he was replaced by Shirish Godbole, who was doing precisely that when MSREI came knocking. Also bolstering the ranks last month as global head of research and strategy is Paul Mouchakkaa, the ex-managing director of real estate consulting services at Pension Consulting Alliance and a man described by the MSREI source as “a major resource.” They are not expected to be the only new joiners either, with the firm due to announce a number of new senior hires over the coming months.

Adjusting alignment

Some observers have linked certain senior departures to a decision by Morgan Stanley to change how it distributed the carried interest, or ‘promote’, generated by the investments of G7 from how it was structured for the series’ previous funds. Beforehand, MSREI received 20 percent of the profits once MSREF investors received the first nine percent from a given deal. Within that 20 percent, senior management was entitled to 50 percent, while the bank received the other 50 percent. For G7, however, the original construct saw the post-hurdle promote split 60 percent for the bank and 40 percent for senior management. Understood to originally have wanted 75 percent of the promote, it has been suggested that the bank was negotiated down by MSREI senior staff. PERE also understands that further negotiation between MSREI senior management and Morgan Stanley has since resulted in the original 50:50 structure reinstated.

“The firm needs to be aligned with investors, but the team also needs to be aligned,” PERE’s MSREI source says. “If I’m an investor, I want the employees to be highly incentivised to do good deals.”

An arguably more significant alteration was made in the name of better alignment with the LPs. A deal-by-deal promote system used in prior MSREF funds has been replaced by a pooled promote system in G7. A bane to investors who previously found senior executives still able to extract generous promote even when markets had turned and their deals were losing money, G7’s promote is only paid when an investment is fully exited, all capital is returned and the overall fund’s target hurdle is exceeded. There also is a clawback provision in place, if needed, something which was not always in place before.

Added to that, MSREI has implemented a wider distribution scheme, enabling senior executives in Europe, for example, to benefit equally from deals done in Asia, with a view to incentivising staff across the firm’s network to perform regardless of the condition of their particular market. It has been argued that, had this updated system been put in place before, certain leavers might have been better incentivised to stay.

Playing for time

Meanwhile, as time runs out on G7’s original investment period, MSREI has actively been putting capital out into the market and certainly has a game plan for the remaining money. During PERE’s Asia roundtable last month (see Rebuilding the case for Asia, starting on p. 42), de Poulpiquet told PERE that the fund’s capital had been used to date to invest primarily in the US and, to a smaller extent, in Europe and Japan.

Generally, [we] would have loved to have seen them investing in 2009, but now there is no point in [focusing] on that. History is history
Unnamed G7 investor

Indeed, in the US, MSREI has closed on more than 20 investments. In October, the firm closed on the acquisition of 1107 Broadway, a 350,000-square-foot vacant office overlooking Madison Square Park in the Flatiron District of New York City. Committing more than $100 million of equity to the project, G7 will convert the property to residential condominiums with its partner The Witkoff Group. In another example, MSREI used $62 million of G7 capital to purchase a portfolio of 5,500 entitled single-family lots located primarily in metropolitan Washington DC. In that case, the fund partnered with publicly-traded homebuilder NVR. The fund also has been an active buyer of nonperforming loans, acquiring approximately $400 million by face value from various US lenders.

With the blessing of more time from the fund’s investors, Klopp and de Poulpiquet plan to shift G7’s emphasis to Europe and Asia next. In Europe, the focus will be on distressed investing as the region’s banks are forced to make disposals. In fact, MSREI was just selected as preferred bidder for a large distressed Spanish portfolio, once valued at €3 billion, being sold by Santander. Meanwhile, in China and India, MSREI is hoping to plug the gap left by various real estate lenders slated to be reducing their exposure to the asset class.

According to research from Real Capital Analytics, up to July this year, MSREI had sold $5.1 billion of assets in Asia in the previous 12 months, the most of any private equity real estate platform operating in the region. Looking forward, the firm plans to switch to be a net buyer and already has put money to work in Japan, among other countries. To place further weight behind the plan, this summer de Poulpiquet relocated to Singapore from London.

PERE heard from one G7 LP that MSREI’s investments for the fund to date are looking promising. However, there is a concern that not enough capital was put to work during 2009 when many global markets were on their knees. “Generally, [we] would have loved to have seen them investing in 2009, but now there is no point in [focusing] on that,” the investor says. “History is history.” When asked whether that would influence a decision to support an extension of the fund’s investment period, he replies: “I think it’s too early to say, but we are being open-minded.” For this investor, further consideration is required. “There is still some time, so there’s no need to rush into a decision,” he adds.

That LP perspective came in mid-November, immediately prior to press time. Weeks have since passed, and decision day is rapidly drawing near. By the time PERE next goes to press in late January, it should be known whether the new-look MSREI has done enough to convince the investors of MSREF VII Global to continue investing what is still, essentially, a mountain of capital. A nod to the affirmative would do much to quell the platform’s naysayers, while a rejection of extending the fund would conceivably add fuel to those already calling time on investment bank-sponsored platforms, of which MSREI is one.

Whichever way the vote swings, this month is a pivotal time for the fund known to many as G7 and for its sponsor too.