by Peter Linneman and Stan Ross
FINANCE TRENDS: The Enron fallout is increasing investor pressure on opportunity funds to provide more transparent reporting and performance standards.
Having raised more than $100 billion from investors since the late 1980s, real estate opportunity funds have become a permanent part of the real estate investment landscape. Despite the industry’s size, diversity, and complexity, however, it remains largely without the standards and guidelines necessary to help investors determine whether funds are consistently performing as expected. Even before the Enron fiasco, investors were pressuring opportunity funds to provide more transparent reporting and to adopt performance standards. The Enron fallout has added to that pressure. The wide variation in reporting practices among funds clearly demonstrates a need for greater transparency and consistent standards across funds and sponsors.
Real estate private equity fund sponsors are compensated by 1 to 2 percent fees on committed capital, perhaps a transaction fee, and a carried interest that is subordinated to a preferred return on investors’ money (including money invested by the sponsor). Sponsors receive no additional fee income if their properties rise in value. The fact that the bulk of their compensation comes in the form of a subordinated carried interest (generally 20 percent of all profits) based on absolute return creates a strong alignment of interests. Should the fund fail to exceed the preferred rate of return, the fund sponsor’s carried interest is worthless. Equally important in terms of incentive compatibility is the fact that fund sponsors invest side by side with the fund’s investors. Generally 2 to 25 percent of all of the capital committed to a real estate private equity fund is committed by the sponsor. In a few cases, the sponsor’s own investment is even subordinated to those of other investors.
Nevertheless, investors should be aware of several potential shortcomings of all private equity funds.
If a fund registers only mediocre investment performance, a 20 percent share of profits provides the sponsor with disproportionate compensation. To address this shortcoming, structures are used so that the sponsor’s carried interest is not automatically 20 percent of profits once the preferred return is achieved, but instead ratchets upward toward 20 percent as the investors’ return approaches 20 percent.
For assets with “events” (for example, loan restructuring, development, redevelopment, or significant retenanting efforts), much of the return is achieved only upon successful execution of the event. Subsequent to this, the annual equity return profile drops to the normal real estate return of 10 to 14 percent based on then-current value (rather than original cost). Sponsors may hold these assets too long to allow their carried interest to grow, even though, at the margin, these assets do not meet their return targets with respect to current value. Investors should carefully monitor how much of invested capital funds has been returned to investors as a way to assess if assets are being retained long after stabilization.
It is impossible for sponsors to specify exactly how they will invest, because opportunities change between when they begin to raise money and when the investment period ends (three to four years later). As a result, while fundraising, sponsors attempt to distinguish themselves via their investment track records. The problem is that since most funds have been in existence for relatively short time periods, most have yet to achieve full liquidation. (Thus, it is much easier for sponsors to demonstrate an ability to invest, rather than an ability to return capital and profits to investors.)
As it stands now, no return benchmark can be applied to real estate private equity funds. The following are some of the reasons:
The strategies and risk profiles employed by these funds vary widely in development risk, leverage, exit liquidity, international exposure, and event risk.
Funds have different investment portfolios. Some focus more on completed properties than on property under development. Others emphasize investments in office, industrial, retail, or other product types.
Funds have different investment philosophies and time horizons, and invest at different times, in different places, with different partners. They use a wide range of strategies, including development/ redevelopment, highly leveraged acquisitions, bankruptcy plays, bulk purchases from governments and leading corporations, and purchases of nonperforming loans. And they take very different risks. Since time horizons and equity investments differ, internal rates of return (IRRs) may not be comparable.
Funds seek returns well in excess of those normally associated with real estate, hence requiring nontypical investments, which makes benchmarks that use typical real estate investments almost necessarily inappropriate.
No two funds pursue the same strategy or mix of strategies.
Comparing returns across funds is complicated, as one fund may be at the mature part of the life cycle, while another may be in the early phase.
Ultimately, the most appropriate benchmark is whether funds are achieving target returns using the strategies and leverage described to investors. Simply stated, investors should evaluate whether a fund is doing what it said it would do. This requires consistent and detailed reporting of information to investors over the life of an investment so that they can assess whether the fund is performing in line with expectations.
Although fund performance reporting and benchmarking have been the subject of much debate, the fundamental issues are the methodology used in determining asset value, the manner and consistency with which it is reported, and the reporting consistency across funds. A February 2002 Ernst & Young survey of real estate private equity funds found that of the 48 respondents, 11 indicated that they report financial statements using historical cost accounting, four used income tax basis, and the rest said they provide fair value financial statements.
A large number of funds have adopted valuation policies used by other types of private equity funds, including venture capital and buyout funds, which present their financial statements on a fair value basis as required by the American Institute of Certified Public Accountants (AICPA) Audit and Accounting Guide for Audits of Investment Companies. However, these policies are not applied consistently across funds.
In the valuation of fund stabilized and postevent assets, the properties generally are leased and generating cash flows, or an event has occurred that is clear evidence of future cash flow, or comparables are available. Many funds value these assets on an “as-is” basis. This reflects the condition and status of a property as of a specific date, taking into consideration the potential for increased financial performance, completion, construction, renovation, and management change or lease-up, and recognizing the risks associated with achieving improved performance. Assumptions differ for rental housing, office, industrial, retail, and hospitality assets. Tenant terms and lease conditions, lease-up provisions, and cap rates are materially different. Also, local markets differ from one another.
For nonstabilized assets, estimating fair value at any given point during the holding period is much more subjective than with stabilized assets, as the ultimate realization of value depends greatly on the sponsor executing its value-enhancement and exit strategy. Similar challenges exist in valuing development assets and land held for development.
Some analysts argue that what matters is not the value of a fund’s investment portfolio at a given point in time but its return on those investments, measured on a risk-adjusted basis as well as on a cash basis. Still, risk evaluation is highly subjective. Most funds view IRR as the most appropriate performance measure. Some go further, suggesting that projected IRR, including the expected residual value, is the best proxy for interim measurement of performance. Real estate performance measurements are provided by the Association of Investment Management and Research, which provides for both IRR and time-weighted returns (TWRs). Currently, most real estate private equity funds report only gross projected IRRs and appropriately give TWRs little weight.
Accountants generally agree in their reporting to the public and the U.S. Securities and Exchange Commission (SEC) that the only consistent methodology is the lower of cost or market on a historical generally accepted accounting principles (GAAP) cost basis (or, in some instances, a modified basis), with cost being the predominant approach. This method-ology is not appropriate for measuring the comparative performance of opportunity funds. Alternatives need to be considered that would address the following questions (and focus on expanded reporting):
What are the goals and objectives of the fund, the investors, and the sponsor?
What is the fund’s strategy?
What are the key risks and complexities of the asset?
Are investors looking for major events or external factors that might have an effect on a fund’s performance?
Are investors looking to get interim measurements with respect to some form of mark-to-market?
What is the exit strategy (sale, refinance, strategic alliance, trade)?
The lack of meaningful return benchmarks for real estate private equity funds means that they must provide greater transparency and consistent standards across funds and sponsors. That is why the fair value approach with expanded reporting should be adopted, and a framework should be developed with some standards and guidelines. Such reporting would include the following:
Quarterly and annual overviews of investment activity and fund performance, which should be detailed in terms of progress on particular properties and changes in status from period to period, and include a commentary on major actions, events, and conditions that have changed.
Quarterly and annual narratives, which should describe the activity and performance of each fund investment compared with the strategy and the underwritten IRR.
A special events report (similar to a U.S. Securities and Exchange Commission Form 8-K for public companies), which would document unusual events when they occur.
Quarterly and annual summaries of cash inflows and outflows. Investment vital statistics should include condensed financial information for each fund investment.
All activity related to debt or leveraged components of the investment, which should be fully detailed and updated, including debt in partnership, underlying ventures, and details regarding compliance with underlying loan provisions and covenants.
Quarterly reports on the performance of fund assets, which should be grouped according to the following categories: assets sold, stabilized assets that are ahead of acquisition underwriting, stabilized assets on target with acquisition underwriting, stabilized assets that are below acquisition underwriting, and nonstabilized assets.
For each of these groupings, the sponsors should report, at a minimum, the asset name, date purchased, cost, equity invested, reserves, debt level, ownership percentage, net operating income (when relevant), current value (when relevant), IRR (when relevant), and equity multiple (when relevant).
For nontraditional types of investments, details about changes in market conditions, regulatory bodies, restrictions, or limitations also should be included.
Accountants have long used projections as a tool in valuating and evaluating assets on the balance sheet. These should be adopted in the reporting, consistent with management’s responsibility for setting forth its plan, all of its assumptions, cash flows throughout the holding period, and the projection of the future value of the residual.
Recommendations for measurement are as follows:
Calculations should be done on an individual asset basis as well as on a fully rolled up consolidated basis.
IRR calculations should use the projected residual value methodology where stabilization has occurred.
Nonstabilized investments should be carried at cost, and
tested for impairment on a quarterly basis.
All calculations should be done on a gross IRR basis as well as a net IRR basis after taking into consideration the fund expenses, including management fees and net carried interest of the opportunity fund sponsor.
All calculations should be done applying GAAP accounting rules with respect to consolidation of partnerships, joint ventures, and nonwholly owned corporations, essentially consolidating where effective control exists.
Multiple performance calculations should be provided, including cash-on-cash returns from inception to reporting date, cash-on-cash returns from inception to date of exit, IRR using a projected residual value methodology, and equity multiples.
Each fund investment should be assessed according to whether it is tracking on, below, or above the underwritten IRR, and why.
For the same time period, the TWR analysis, though not a meaningful financial statistic, should be reported for those investors who desire it.
Whatever methodologies are used—and more than one may be appropriate—should be applied consistently across all funds and sponsors.
If sponsors are unwilling to state the current value of stabilized assets, then investors should seriously question investing in their funds.
There is little, if any, value added by sponsors engaging in formal appraisals, as sponsors generally understand the value of these assets far better than appraisers.
Finally, all nonstabilized assets should be carried at cost, because, for these assets, it is simply too soon to ascertain whether an opportunity to create value will be realized. In the detailed asset descriptions of these properties, it is critical for the sponsor to describe the progress and hurdles these assets face.
As a possible next step, a task force representing the major real estate private equity funds could be created to further develop a fair value approach to reporting, guidelines, supplemental reporting, reporting for nonstabilized assets and the definition of stabilized assets, and other issues. The task force must have the full support of funds, sponsors, and investors and it should serve on a continuing basis. Based on preliminary discussions with leaders in the opportunity fund industry, there appears to be strong support for this idea.
If funds take the initiative in meeting investor expectations, they will play a large role in shaping their future. If not, their future could be determined by investors who are pressing for changes in the industry’s reporting practices. It is time for fund sponsors to step up to the challenge.
Peter Linneman is the Albert Sussman Professor of Real Estate, Finance and Public Policy at the University of Pennsylvania in Philadelphia. Stan Ross is chairman of the board of the USC Lusk Center for Real Estate in Los Angeles and former vice chairman of Ernst & Young LLP in New York.