Private Equity: A Remarkable Decade

Real estate private equity funds were not a new investment capital source at the start of this decade, but few expected the global explosion in capital raising that happened during the first eight years. During the formative years of the modern real estate private equity fund industry, from 1990 to 1999, the total raised by funds was just shy of $125 billion. Most of the capital flowing into real estate PE funds during those years actually came between 1997 and 1999 when funds took in more than $69 billion. But then everything changed.

From 2000 through 2003, according to industry publication Private Equity Real Estate, the industry averaged inflows of more than $37 billion per year, but, in 2004, real estate private equity came of age when investors pumped $84 billion into the sector. Between 2004 and 2008, investors poured more than $625 billion into private equity funds.

Sometime in early 2008, the sector officially topped $1 trillion in raised capital since 1990. What happened? Real estate was in an extraordinary up-cycle. Pension funds and other investors were adding real estate to their broader investment strategies or expanding their existing allocations, and private equity funds gave them the opportunity to invest large sums at attractive returns. The capital began to flow freely and this, combined with real estate emerging as a global asset class, shifted the sector into high gear.

It is easy to forget that the globalization of commercial real estate by Wall Street and large private equity houses was already well underway by 2000. But it clearly was the combination of the appeal of cross-border investing and the application of Wall Street and private equity capital raising expertise that caused the dramatic increase in the numbers.

Global expansion of the industry had begun as early as the mid 1990s, when the first global funds were formed. By early 2001, those funds and others that followed were attracting institutional capital seeking, among other things, diversification. As information on major overseas markets became more plentiful, transparent and reliable, cross-border capital flows actually began to occur in both directions, as did the deals.

In the past 10 years, we have seen German funds investing not only in Europe but in the US, in Latin America and in Asia. US funds have routinely traveled anywhere in the globe where there was opportunity, Asian funds to the US and so on. The steadily increasing size of these funds over the past decade, along with large investment banks either financing independent funds or forming their own, allowed cross-border activity to reach unprecedented levels quickly. Even the most conservative funds in Europe were now willing and able to invest in properties in India, the US and China, and the same could be said for US sponsors looking at overseas opportunities.

Beginning with Wall Street’s success working with and advising the Resolution Trust Corp. in the early ’90s, the potential of real estate private equity funds became obvious. Bankers quickly recognized the advantages of identifying and investing in both problem properties as well as core assets through the private equity vehicle. This recognition quickly transformed a good idea into a global movement.

As the sector matured, these funds attracted a broader universe of investors who realized they offered a variety of strategies: asset specific, geographic, sector specific, etc. They also realized that the funds were a good diversification tool for investors looking to spread risk. As the money came easier, so did the decision to pay higher prices and use more leverage.

Fast forward to 2008, when the first phase of the modern era of global real estate private equity finally caught its breath. The push was not immune to the global financial meltdown. In fact, the downturn may have hit some sectors of the real estate private equity industry harder than most. In the 12 months following the height of the downturn, many funds, but not all, suffered from heavy losses, dealing with investors seeking return of capital and sponsors forcing to slash promotes, their share of a fund’s profits, to appease investors as well as face the specter of “clawbacks,” the right of limited partners to reclaim a portion of funds paid to the general partner for earlier investments to offset LP losses from later fund investments.

Legacy issues at existing funds forced managers to reassess and prioritize their assets, getting back to basics at the property level to create value. Funds have had to work extra hard to nurture and sustain relationships with their investors during these trying times.

The last two years has been challenging for private equity funds, as they have for all in real estate. Looking ahead, it is important to put the downturn into perspective. The real estate sector has come through a major test, and, though not unscathed, it has survived. More important, it has adapted. Because of the downturn, the fund model has experienced some changes, and we are seeing more institutional investors looking to plan joint ventures and separate account-type investments directly with real estate operators.

Today the real estate private equity fund industry is a fundamental component of our global real estate capital market, a trillion dollar industry. In 10 years, when Globest.com’s editors circle back for a comment on the past 20 years, I’m fairly confident that someone, perhaps even I, will be writing about the next great phase in the global real estate private equity industry.

Howard Roth is the Global Real Estate Leader and a partner with Ernst & Young LLP’s Real Estate practice. You may contact him at howard.roth@ey.com. The views expressed herein are those of the author and do not necessarily reflect the views of GlobeSt.com or Ernst & Young LLP.