Real Estate Needs to Get in the GP Stakes Game
GP Stakes is a form of financial innovation.
Critics might cringe at that statement, but most of them have never had skin in the game as a General Partner.
GP Stakes is quickly becoming an institutional asset class because it solves very real problems.
And if you haven’t noticed, real estate has some problems.
Real estate transaction volumes are finally ticking up but not enough to sustain bloated head counts. And recent vintage funds seem unlikely to deliver meaningful carry anytime soon.
Consequently, plenty of real estate PE firms should consider selling a piece of their General Partnership interests.
Real estate firms are a tiny fraction of many GP Stake funds. Most funds are chalk full of private equity firms with some infrastructure and credit firms sprinkled in for diversification.
Yet I’ve only seen a handful of real estate dedicated GPs across a number of large funds.
This is fairly odd given the size and number of large real estate focused GPs that are often only wealthy “on paper”. Or at least much more so than their private equity counterparts.
This is a especially true of real estate firms addicted to tax deferral via 1031 exchanges.
Injecting unsecured capital could be a powerful tool to level up into new real estate sectors or institutional investor relationships during a extremely difficult (but opportune) time to raise capital.
Why do real estate firms hold out? I suspect, it’s just real estate being real estate.
In other words…painfully SLOW.
Having spent most of my career in private equity real estate, I can attest the industry is hesitant to embrace change.
Plus the ethos in real estate is ownership / equity is sacred. Older partners might get ill thinking of selling a minority stake of their “baby”.
Because, unless you’re a mega firm, you invest in RE for carry. Often you need a big team to find and manage the assets so the fees just keep the lights on. But technology and software is improving margins. Outside vendors can reduce overhead. Profit margins on fees are improving in real estate.
Yet many real estate partners don’t see increased management fees from AUM as a viable pathway to boost returns and drive future fundraising. And yet, the biggest firms have the most impressive and expensive staffs.
Real estate partners should ask themselves a question. If selling a minority stake is good enough for CVC, SilverLake, Vista Equity, etc. then maybe…just maybe… it’s good enough for a portfolio of ugly (but highly profitable) industrial buildings.
This is especially true for those real estate firms with perhaps an uncomfortable amount of office exposure.
Who should take a lifeline to weather the storm.
Other Considerations:
Thriving real estate firms should sell minority stakes for the same reasons the best private equity firms do (succession, drive new AUM, accretive M&A, hire superior talent, etc.)
But perhaps the best reason to sell a stake is to fortify the business when your competitors are on defense. This is how firms leapfrog peers coming out of downturns.
And even if a RE firm is not struggling with obsolescent office, floating debt or other portfolio problems, they should still considering selling to reduce existential risk for the next crisis.
Because real estate is accident prone:
Savings & Loan crisis
Subprime crisis
COVID
2022 floating rate spike
REITs have already gotten this memo. They learned their lesson from 2008 and dramatically improved / fortified their balance sheets.
REITs obviously don’t need to sell minority interests, because they already did. Their ownership (stock) is for sale every day. They can also issue new equity (shares) on a moments notice using “At-the-Market” offerings.
Private real estate firms don’t have that luxury. If cash is low, they can find themselves pushing debt / leverage in order to win deals and maximize IRRs. They might also be doing this with a thin or largely outsourced staff. That can work in bull markets, but is not a sustainable solution.
Enterprise Value
If it’s not repeatable, it’s not sellable.
Far too many real estate GPs are a collection of properties that would be worthless once they liquidated their portfolio. The value is only in the assets.
That makes them vulnerable when capital markets freak out.
That forces them to be highly reactive to the labor market vs. keeping the team in place and active across cycles.
Such firms aren’t the sexiest targets for GP Stake firms, but even the most established real estate GPs - that would be viable stake investments - could stand to improve on this front.
Why GP Stake Funds Should Invest in RE GPs
Some GP Stake funds might be hesitant to add real estate positions because of the above or increased cyclicality of the business. The office nightmare probably isn’t helping.
I can hear some saying, “higher risk for lower returns, great where do I wire the money?!”
But I think this is would be a mistaken opportunity to add high-quality firms / management teams with a lot of growth opportunities at (perhaps) lower multiples vs. PE general partnerships.
Plus, the correlated return stream on real estate fees and promoted profits should add additional diversity and resiliency to PE heavy GP Stake funds.
Private Real Estate Diversification Benefits:
Staking firms will obviously need to pick their spots to avoid a value trap on firms with over-leveraged portfolios and declining track records. However, large investors are not going to stop allocating to real estate anytime soon.
And (right or wrong) plenty of institutional investors will ultimately give RE funds a pass on their latest vintage given the industry took the brunt of the pain from the government induced inflation debacle.
The key is to invest in the real estate firms that have an established track record of operational alpha and didn’t just ride the longest interest rate bull market.
If you’re a real estate GP and wondering if there is a little bit of truth to the above, it might be time to level-up your game with some growth (interest-free) GP capital.
Brad Johnson