Raising and managing institutional real estate capital differs from managing high-net-worth capital in significant ways. Here are some considerations for real estate managers and operators seeking to understand the institutional LP mindset.
The capitalization maturity curve
Before we go any further, we should start by getting some definitions on the table. For most real estate managers, the capitalization maturity curve looks like this:
You may skip a step or two, and your strategy may change along with the business cycle, but most managers we work with tend to follow that general trajectory.
Up until recently, the panacea for managers was to raise an institutional, commingled fund. Now folks aren’t so sure. The fees aren’t necessarily better, the reporting and operational burden of serving institutional LPs is significant, you put a gun to your head in terms of needing to deploy capital regardless of the business cycle, and LPs themselves are moving out of funds and into direct investments. To point, we know LPs who just in this business cycle have done almost complete 180’s from commingled fund-only investment strategies, to JV- and wholly-owned investment strategies exclusively.
Nevertheless, the allure of institutional capital is enduring and hard to resist for many. After all, this is a fee-driven business. And the dirty secret in the business is that it’s far easier to increase fees by increasing AUM than it is to knock it out of the park consistently and outperform on promote. And there’s no easier way to increase AUM than to start working with institutional capital.
So you say you want to work with “institutions”…
We can’t tell you the number of times that we hear managers say, “We work mostly with HNW investors today, but we’re starting to work more and more with institutions.” In this context, the “institution” is a real estate private equity firm like Rockpoint, Tishman, Stockbridge, or Greystar.
But the true institution in the industry isn’t the private equity firm, it’s the investor. (Protip: don’t say that you’re working with institutional capital when you’re just doing JV deals with a PE firm, especially to an actual institution. It will make you look, well, very JV.)
True institutional capital generally refers to the following types of investors:
- Public pension funds
- Private pension funds
- University endowments
- Insurance companies
- Sovereign wealth funds
- Asset managers
- Family offices
Each investor type varies in terms of how quickly they make investment decisions, how much diligence they need to do on a manager, their likelihood to be a first mover, etc. In coming posts we’ll go deep on each of these types and pull back the covers on how to approach them.
But for now, here’s a key thing you need to know: all institutions are alike in that their investment decision-making process is very different from that of HNW investors. If you want to go down the institutional path, here’s what you should expect:
- 12-24 month fundraising cycles for first-time or emerging fund managers
- Extensive diligence on your track record, your operational platform, your decision-making process, and the stability of your partnership. Keep in mind here that track record is going to refer to the intersection of the deals you and your partners have done together, not the union thereof.
- An ongoing reporting burden that isn’t insignificant. Large LPs will have their own custom reporting templates you’ll have to fill out, and they will ask for a mountain of details, not just on the investment, but on each underlying asset. Chances are, you’ll start to have to staff a team just to handle reporting.
- It won’t be just the institution you’ll be working with. More than likely, the institution will have hired a consultant like Townsend, Courtland, etc. that will help them to make decisions and monitor investments. That means one more constituency for you to serve.
- It will be tough for a first-time manager to raise a fund. The general trends in capital flows don’t favor the first-time or emerging managers. More and more capital is being concentrated in the very biggest players like Blackstone, leaving less for everyone else.
In case you don’t believe us on that last point, consider these statistics from Preqin:
- Out of the 178 real estate funds screened by each institutional investor per year, only 2 ultimately earn new commitment.
- More than a third of North America-focused capital allocated to managers in 2017 went to the 10 largest real estate funds.
Institutions give you diversity across the business cycle, and scale
So with all of the negatives of working with institutions readily apparent, why might you consider it?
Well, as we said earlier, there is simply no better way to scale your AUM than to work with institutions. Working with scale can make you less sensitive to perfection on underlying asset valuations, so you can afford to bid aggressively and move fast, giving you a deal flow advantage. And, you will want to have diversity in your capital markets strategy. When the HNWs are there with their checkbooks open, the institutions might not be, and vice versa.
But most importantly, while the trends don’t favor the smaller managers when it comes to funds, they definitely do when it comes to direct investments. Every institutional LP we talk to is trying to shift their allocation to start going direct. But even if they follow this “direct” strategy, very few LPs have the resources to staff teams to go after real estate directly; on the contrary, most need local operating partners on the ground to help them find, acquire, and manage assets. Playing this role of local operating partner can be an attractive way for managers looking to scale their AUM beyond their base of HNW investors.
But beware: it’s a different game playing with institutions. Most managers we know who are raising capital from HNW investors have a pretty good life—they do the deals they want to do, they have the freedom to sit on the beach when it’s hard to find good deals, and they don’t have a boss. On that last point especially, things will change once you start working with institutions.
It’s an exciting time to be in real estate, whether you’re backed by institutional capital or otherwise. Over the coming months, we’ll be exploring in a series of posts what it’s like to raise money from institutions—the good, the bad, and the ugly—along with strategies and tips for how to optimize your fundraises.