_Titans at the gate: The rise of the real estate megafunds

An industry of giants

The private equity industry has thrived in recent years: since 2012 there has been over US$3.6 trillion of private capital raised. Traditional private equity, in the form of buyout funds, still represents the largest share of the market, but real estate is firmly in second place.

Real estate-focused private equity has seen its own rapid expansion during the global real estate recovery of the past eight years. Data from Preqin shows that at US$565 billion in mid- 2017, assets under management have more than doubled since 2009, and while capital raising slowed in 2016 and 2017, this did not prevent the volume of dry powder (funds allocated to real estate but as yet unspent) from reaching a record US$266 billion at the end of March 2018. Today, numerous funds have upwards of US$10 billion under management.

Why real estate

Real estate funds have attracted capital for a variety of reasons, including the promise of diversification benefits, as a means to put relatively inexpensive debt to work, and most obviously, the lure of healthy performance. In the three years to June 2017, private real estate funds saw annualised returns of 10.7%, outperforming all other types of private capital bar traditional private equity.

However, there are clear nuances among investor types. Institutions, such as pension funds, have sought to close a funding gap created or exacerbated in the years after the financial crisis.

They have allocated capital to private real estate funds hoping for both strong returns and a greater degree of income stability than is offered by many competing asset classes. Others, such as family offices, value the privacy that private equity investment managers can offer, as well as the potential for less bureaucracy and faster dealmaking as well as diversification.

The type of funds that have been successful in raising capital has evolved as the real estate cycle has matured. Today, with yields on directly held real estate at or near record lows in many developed markets, there is a recognition that the years of truly exceptional returns from property are over for now, at least in certain locations.

Against this backdrop, some investors have sought to maintain expected performance by investing in vehicles that are further up the risk curve. In Q1 2018 only US$0.6 billion was raised for funds targeting core property, while over US$20 billion was raised for opportunistic funds.

Increasing risk has not been the only approach, however. Some investors have turned to real estate debt funds as a defensive play, reasoning that lenders are less exposed to the impact of asset value fluctuations than asset owners. Real estate debt funds raised over US$28 billion in 2017, the highest volume on record.

Consolidate to dominate

As well as changes driven by the timing of the real estate market cycle, there is a deeper structural shift at work: the consolidation of capital into larger and larger funds. The biggest funds are continuing to grow rapidly, creating a consolidation at the top, followed by a long tail of smaller funds.

In recent years, the number of real estate funds closed each quarter has declined, but the average volume of capital raised in these funds has risen: in 2016 the average was US$370 million, but by Q1 2018 it had risen to US$690 million. What’s more, this growth has not been evenly distributed.

The largest funds have continued to expand rapidly in size, creating a consolidation effect at one end of the scale, and a long tail of smaller funds at the other.

According to Preqin, firms that have raised funds of US$1 billion or more in size since 2013 have secured approximately half the total capital raised in the period, despite representing less than 10% of the number of funds closed. As a result, the market share left over for smaller funds has seen fierce competition for capital.

What has driven the shift to larger funds

One reason is that since the financial crisis, institutional investors in private equity funds have been more selective, placing a greater emphasis on track record. This has favoured established names over smaller new entrants.

Another reason is that scale brings efficiencies. Raising capital can be a long and sometimes labour-intensive process, and a burden that falls relatively more heavily on smaller funds with fewer staff. Perhaps most importantly, scale has not imposed a performance penalty.

The future: challenges of scale

The trend towards larger funds has further to run and, as if to prove the point, 2018 has begun with a number of record-breaking fund raises. Is the race for scale unique to real estate private equity? No. In fact, the shift is even more pronounced in traditional buy-out private equity.

But real estate funds that have raised very large amounts of money nevertheless face a number of challenges. First and foremost is the need to deploy capital and make a return in relatively short order (funds typically have a five-to seven-year life from close).

This means that acquiring many small assets is unlikely to be practical for the biggest funds. Purchases need to be of large individual assets, portfolios or even entire real estate businesses – a trend that has been growing over the past year.

In the longer term, we expect the largest funds to continue to invest along thematic lines, in the same way that some have targeted logistics and residential property to date.

These themes will increasingly border on light infrastructure, especially for those seeking a way to enter emerging markets, although the nature of investible stock means that fund purchases will ultimately remain focused on more traditional real estate assets in the medium term.

Indeed, suitable deals have to be sourced first, which is not always straightforward. For example, many specialist property sectors are appealing to private equity funds on paper, but in reality are rendered unviable due to the level of fragmentation in these markets. This is where smaller funds still have a place as product aggregators, especially in niche markets where a particular asset-level expertise is required.

Then there is the risk of sub-optimal deals. An opportunity to deploy capital in significant volumes could be hard to resist, even at the expense of performance. Particularly pertinent in the current market is the danger of overpaying simply to put funds to work, a hazard that private equity investors across all asset classes are alive to at present.

Looking further ahead, the assembly of worldclass real estate platforms has clearly been an attractive way to drive returns, but assets must eventually be sold to realise capital. 2017 and 2018 to date have seen numerous examples of billion dollar platform sales, but it is clear that the larger the entity, the smaller the pool of potential buyers.

Nevertheless, we remain sanguine about demand for these businesses. Many of today’s most prolific investors – sovereign wealth funds, or Asian capital exporters – were in their infancy just ten years ago.

The next decade will see these funds grow in scale, and more importantly, be joined by wealth created from the current global economic expansion and the rising savings of a growing global middle class.