Goldman Sachs and Morgan Stanley look set to stick with real estate investment despite past losses and regulatory pressures. But, asks Lucy Scott, will investors still back the big-bank model?
It is three years since the first signs emerged that all was not well for investment bank- backed private real estate businesses.
Losses started multiplying on their peak-of-the-market investments in late 2008. Since then, the viability of this breed of property fund managers – which at one time oversaw real estate worth hundreds of billions – has looked in doubt, as historic losses and regulatory challenges seeking to curtail risk ensued.
Such setbacks have contributed to a long line of wholesale bank withdrawals from the industry. The latest came this month, when Deutsche Bank, the world’s second largest property fund manager, entered exclusive talks with US-based Guggenheim Partners over the takeover of RREEF Real Estate, a global property business that manages $58.5bn (£37bn) of property.
Deutsche Bank’s move was prompted by increased regulatory pressure and associated costs, at a time when European banks face imminent deadlines to bolster their balance sheets with higher capital requirements. The sale has raised the question of whether those investment banks that still retain real estate arms have the wherewithal and the desire – to continue to withstand the same challenges.
Ironically, two names that have come to symbolise the failure of investment banks’ financial wizardry – Goldman Sachs and Morgan Stanley – are among the last men standing. Amid reports of continued losses on property investments and the threat of regulation that will curtail the financial incentives available to them through the private equity business, there are signs that the two former behemoths are determined to keep their hand in the property business.
It has emerged that both Goldman Sachs and Morgan Stanley are set to embark on fund-raising drives.
Goldman goes for property debt
Goldman Sachs is understood to be considering launching a global debt fund to provide both senior and mezzanine debt to commercial property, as well as buying loans. It is thought that the US bank is seeking to have this fund in place by the end of the year.
Meanwhile, Morgan Stanley is about to kick off a fund-raising campaign focused on North America, which it hopes will secure $1bn of commitments.
The bank still has around $2bn in uncommitted capital to invest on behalf of its MSREF VII Global fund, known as G7, but Morgan Stanley Real Estate Investing (MSREI) is reaching its self-imposed limit for the amount it can invest in US real estate through that vehicle.
Both companies declined to comment on possible fund launches. However, if successful, property vehicle launches would represent a new direction for the banks.
Goldman Sachs already has a $2.6bn mezzanine fund in the US, managed by its subsidiary Archon Group. But it is thought that the latest debt fund may be used as a new chapter for the bank’s property private equity division, Real Estate Principal Investment Area (REPIA) – which manages the troubled vehicle Whitehall Street International – as it replicates moves by US investors such as Fortress and Starwood.
Last month, the latter announced plans to raise up to £1bn for senior debt deals in the UK and Germany.
If, like Starwood, Goldman Sachs sought to undertake lending to non-prime property the assets for which it is most difficult to access debt – it could secure internal rates of return of up to 8%, even with a low-risk investment with a 50% loan-to-value ratio.
It is not known how much Goldman Sachs plans to raise, but it may need to amass multiple billions of dollars of equity commitments to provide sufficient scale to act as a diversified lender globally.
Morgan Stanley’s aim to raise a regional property vehicle will also represent a shift in focus. The bank, which raised multi-billion dollar global umbrella vehicles in the boom years, is said to be responding to calls by investors to make its funds more strategically specific in terms of risk and geographical location.
Unlike Goldman Sachs, however, sources close to the bank say they do not expect this renewed focus will involve MSREI moving into debt-focused vehicles.
As one institutional investor says: “Although the days of jumbo funds involving multiple investors are not over, they are much, much more limited. There are far fewer investors around looking to support these strategies.”
These fund raisings will be an important litmus test of whether investors still have faith in the investment-bank-backed real estate funds model, or whether they would rather place their cash with the likes of Blackstone and Brookfield. They will also demonstrate the effect new US regulations known as the Volcker rule – are likely to have on banks’ ability to raise capital.
Both Goldman Sachs and Morgan Stanley will structure their vehicles to comply with the Volcker rule’s aim of capping a bank’s overall co-investment in its private equity and hedge funds to 3% of its tier-one capital.
In February, US regulators delayed the introduction of the regulations after the Securities and Exchange Commission and other agencies received more than 17,000 public comments about the proposals, which had been mandated by Congress to be operative from this July.
However, despite this delay in the introduction of the rule, which is part of the Dodd-Frank US financial regulation reforms aimed at strengthening banks’ balance sheets, new vehicles being raised are falling into line with the proposed regulation. The rule will affect not only funds raised in future, but current investments too.
Although sources close to the banks play down the impact of the Volcker rule, institutional investors believe these new barriers will prevent banks from providing the alignment of interests between banks and investors that the latter are seeking. It is also argued that investors could be nervous about committing new capital when the regulations are yet to be finalised.
Some investment banks have previously provided a large portion of co-investment for property opportunity funds, both to make them more attractive to investors and to profit from the high returns promised. Figures from Goldman Sachs show that as of January 2011, the bank would typically provide around 30% of a private equity fund’s capital.
Investors demand banks’ commitment Such ownership interests have not prevented funds from suffering losses – Goldman Sachs took a $1.76bn loss on its real estate principal investments in 2009. In early 2010, Morgan Stanley told co-investors in MSREF VI that they might lose two-thirds of their $8.8bn equity.
However, investors are still seeking financial commitments from both banks, as well as from the individual fund manag-ers who run those vehicles, as part of their increased demands for greater alignment of interest, in addition to substantial cuts in management fees.
Morgan Stanley’s 12-month extension to the investment period of its G7 fund in December was hard won; in exchange for investor approval to that extension, the firm agreed to cancel $700m of the fund’s $2.7bn of remaining committed capital and cut various associated fees.
“Limited partners are looking for sponsors and if banks do not commit, then investors will not support them,” says one institutional investor.
As Philip Feder, chair of the global real estate practice of law firm Paul Hastings, points out: “It isn’t just the Volcker rule that may have an impact on the motivation of banks. Investors are negotiating lower levels of carried interest and promote, which previously could be more lucrative for a bank than putting in its own capital.”
As well as being a wider test for the viability of investment bank-backed funds following the introduction of the Volcker rule, Goldman Sachs’ fund raising will be instructive on whether the bank can raise capital from its former investor base – crucially its relatively high percentage of wealthy private clients, who typically account for 30% of the capital in its private equity funds.
Sources familiar with the situation say such investors have been dissatisfied following poor performance of funds. Last summer, it was reported that Whitehall Street International, the bank’s international real estate investment fund, lost almost all of its $1.8bn of equity after its property investments went sour.
Real estate “is not sexy”
“Real estate was sold to the bank’s clients as a safe bet,” says one source. “But these investments have performed poorly. Tapping these investors again for property invest-ment will be like pushing water uphill. Real estate is not sexy like it was five years ago.”
Private equity sources say that Goldman Sachs is likely to remain a significant investor in real estate, but its authority to act on opportunities is not as straightfor-ward as it was in the days when Whitehall was at its peak.
Those close to the bank say its heads of the business – Jim Garman, managing director and head of European real estate in the merchant banking division, and Alan Kava, co-head of REPIA in the Americas – face a difficult task in getting any new property investments signed off by senior Goldman Sachs principals.
“If Goldman Sachs saw an interesting opportunity, it would find the capital for it without a doubt,” says one. “It wouldn’t have to be through a fund – they would do it on the balance sheet.
“But the senior leadership of the bank has had a bad experience with property. So it is tough for the bank to back new ideas. It comes down to the ability of the people running the real estate business to rebuild that confidence, which is not easy.”
According to one source, management is demanding to see a watertight business case before signing off any new initiatives which includes evidence that there is enough internal resources to manage the investment. Goldman Sachs still has $900m of equity left to invest in Europe through its Whitehall 8 fund, launched in 2008.
Former employees view Morgan Stanley’s recent extension to the G7 fund as a key sign that the bank is backing its property business, as it will require both resources and capital to run the funds, especially now that the fees have been reduced to secure that extension from investors.
Of course, the bank’s efforts could be interpreted as a move to ensure that the property business continues to function in order to prepare it for a sale.
But people familiar with the situation believe the fund’s extension was granted by the bank as a sign of confidence in the team, ahead of its North America fund raising mission. As one former employee points out: “This is not the action of a bank that wants to lose its property business. To my mind that was a big commitment.”
Investors believe that these are early steps on what will be a long road towards rebuilding confidence, however.
As one says: ‘Morgan Stanley is intent on demonstrating that it is a credible force in the real estate world, but it is well aware at there is still a lot of work to do. The key to the future of the business will be whether it can secure decent returns for G7 – and it will take a few years until that becomes clear.”
Banks fall in line today with Volcker regime of tomorrow
Pressure from the impending US Volcker reforms is already causing changes in banks’ behaviour, those monitoring the changes say, especially since the legislation will affect current as well as future investments.
“The fact that a fund came before Volcker will not matter,” says Washington based Rebecca Laird, a partner at law firm K&L Gates. “So one potential problem could result from the legislation: as firms try to conform, they may seek to dump their interests in existing funds.”
Under current proposals, existing investments will have to be brought into conformance with the rule within two years of it coming into effect.
The forthcoming legislation has already prompted banks to sell their stakes in private equity funds; research firm Preqin reported in February that banks’ share of total sales of private equity funds almost quadrupled in 2011.
Those now raising capital say that while the details of the Volcker rule are yet to be established, firms are already finding it tricky to raise new equity along the revised lines.
As well as strict rules capping a bank’s overall co-investment in private equity and hedge funds to 3% of tier one capital exposure, the rules are likely to require banks’ co-investment in individual funds to be no greater than 3% of the total ownership interest within one year of the fund’s life.
“It is absolutely having an impact on fund raisings today,” says one capital-raising professional. “Some funds have found that because they could not put in 20-30% of co-investment capital, they have not found traction with institutional investors; their legal departments are not fools.”
Safe-and-steady JP Morgan becomes a role model
Aside from Goldman Sachs and Morgan Stanley, US bank JP Morgan also continues to operate a real estate asset management business. However, because it has not suffered the fund performance problems that have dogged its peers, its has not been party to the same speculation over whether it has a future in the real estate business.
JP Morgan’s ambitions to remain in the real estate sector were underlined last month when it emerged that the bank was the under bidder for Deutsche Bank’s asset management businesses, which included RREEF Real Estate – a business that has $58.5bn of assets under management and is only second in size to the newly formed CBRE Global Investors.
JP Morgan’s fund management business is widely regarded as one of the few success stories in the bank private equity real estate world and this is down to its conservative approach. Unlike other banks, it generally does not invest its own balance sheet capital in its private equity funds.
JP Morgan Asset Management, which has been investing in European property for the past 14 years, is expected to invest more than €1bn of capital in Europe this year, in core and opportunistic vehicles. Peter Reilly, head of JP Morgan Asset Management’s European real estate group, has been running the firm’s operations in the region since their inception in 1998.
The bank bought the Bishops Square site in the City of London for £577m in 2010 and has just committed to a €508m Paris deal, and sources say it plans to begin raising capital to invest in the region during the second half of this year. Albert Yang recently joined JP Morgan from Henderson to help with this effort. The fund would add to a global portfolio of $54.2bn of real estate assets under management.
JP Morgan’s peers believe banks could look to adopt this ‘purer’ form of asset management in the future, in light of the US Volcker rule’s restrictions on co-investment capital. “JP Morgan isn’t flashy but it produces results; investors know they aren’t taking risks and they won’t be losing their dough,” says one competitor.
Another investment banker adds: “Higher-risk investment fund management, which needs co-investment, will not be done by the banks in years to come. That kind of investment will be undertaken by niche, boutique teams that have a track record and teams that get devolved from private equity shops – funds that are not governed by Volcker.”