NEW YORK CITY-A new and increasingly challenging environment is emerging within the real estate private equity funds sector.
Consider the current climate. In most markets, deal flow remains slow, largely because of continued illiquidity in the capital markets. Fund-raising poses an enormous challenge because investors are wary of making commitments, especially to new funds. In addition, the number of active funds is contracting and will likely continue to do so for some time yet.
Add to that the sweeping regulatory changes coming into effect in the US and Europe and naturally, these factors are having an effect on how funds operate today and what they must consider for the future. What is important to note is that these changes are not likely to be cyclical or temporary. Rather, the sector is currently undergoing a significant structural and cultural shift.
The good news, for those able to move beyond the old rules, is that this a period in which funds can thrive. Lack of available bank debt means that deal flow is slowed to a trickle outside of gateway cities in North America and northern Europe. However, this has created new investment opportunities in the funds world.
Looming final loan maturities and broken capital structures on a large number of assets have fueled demand for refinancing capital. Indeed, a recent survey of private equity funds we conducted revealed that refinancing is expected to be the most lucrative opportunity for deploying capital in 2013, followed by bank portfolios and non-core assets.
The sector has picked up on other innovative investment opportunities as well, including secondary trading of positions in closed-ended funds. Not only have opportunistic investors found new investment potential in this space, but the trend could also help restore the confidence of skittish core investors by providing flexibility.
Additionally, senior debt funds are gaining momentum, especially in markets where bank lending for real estate is heavily restricted by regulation, like China. Raising funds, however, is still tremendously difficult. Eighteen months appears to be the new norm for achieving a final close, with the biggest obstacles being agreement of deal terms and fees, followed by investors’ due diligence requirements. To remain active and competitive, funds have to slash or even fix management fees.
To sustain and build investor relationships, they also have to show flexibility in their partnership arrangements. This means fewer comingled funds and more separate accounts where individual investors have greater oversight and decision-making power.
This new environment is forcing funds to think differently about their business vis-à-vis investor relations and how they pursue deals, and it is also causing re-examination of internal operational strategy. The pressure here is being imposed by tightening regulatory standards, primarily the Dodd-Frank Act in the US and the second phase of the Alternative Investment Fund Managers Directive in Europe.
Alarmingly, although fund managers are facing significant near-term compliance requirements from both directives, almost 40% of those surveyed still did not know what business costs they would incur to meet them.
Fortunately, new solutions are emerging to help ease the process by offering ways to improve operational efficiency and reduce costs. Increasingly, software and administrative service providers are building out platforms that are specifically designed for real estate. Outsourcing and off-shoring back-office functions are also on the rise in the funds world. Uncertainties still loom over the real estate private equity funds sector. In recent years, many funds have either opted out or been forced out of the space because of them.
But for those that have persevered, ongoing success in today’s changing climate is achievable, but it will depend more now than ever on their adaptability and creativity.
Howard Roth is Ernst & Young’s Global Real Estate Leader and a partner with Ernst & Young LLP’s Real Estate practice.