In the wake of some high-profile recession-related headlines over the past couple of years, real estate pros have logically pondered the Wall Street investment banking community’s future role in opportunity fund management.
First came word that some multibillion-dollar global real estate opportunity funds, managed by the likes of Morgan Stanley, lost hundreds of millions on investments made during the prerecession bubble years. Then, as public officials looked to prevent the kinds of calamities that brought down the likes of Lehman Bros., financial regulatory reform focused on limiting bank holding companies’ exposure to risky investment activities.
The resulting new capital rules restricting holding companies’ investments into real estate (and other) funds may not be fully implemented until 2017. But it’s already become pretty clear that some of Wall Street’s household names are already playing smaller—and different—roles in the institutional real estate advisory arena than has been the case during the past couple decades.
Indeed, as a few noteworthy recent transactions illustrate, some of the big investment houses such as Citigroup and Bank of America/Merrill Lynch are divesting key components of their global real estate fund management operations. Well-heeled private equity players, and in some cases in-place management teams, are now in control of those asset management divisions.
In other cases, once-high-flying opportunity fund management teams at Wall Street banks have been dramatically downsized—although many remain committed to lower-risk “core”-type investment activities, including open-end commingled funds.
“My impression is that [holding companies] are reviewing the opportunistic sides of their operations, determining what roles they should play in the future,” observes Sara Angus, a vice president with institutional investment consultant Callan Associates. And it appears that given heavy opportunity fund losses as well as regulatory reform, some of the Wall Street players will opt to focus more on core real estate investments at the expense of higher-risk opportunistic endeavors, she adds.
Certain veteran experts who would only speak off the record suggest that poor financial performances of megafunds—along with poor alignment of adviser and investor interests—are as much a factor in Wall Street’s diminishing role as the new capital rules. The big former Wall Street banks have simply lost credibility with real estate opportunity fund investors, as one puts it.
But others believe the new rules—which generally prohibit banking organizations from holding more than 3 percent of a private investment vehicle’s capital—are the key factor driving the Wall Streeters from the opportunistic playing field.
“The new capital rules will substantially change the kinds of activities we’ll be seeing from banks and bank holding companies in the future,” says attorney Tom Pax, who heads law firm Clifford Chance’s U.S. bank regulatory practice.
Many of Wall Street’s household-name investment houses—like Goldman Sachs and Merrill Lynch, in addition to Morgan and Lehman—have invested heavily in private, mostly opportunistic funds they’ve organized over the past couple decades.
These so-called co-investment contributions to these funds have helped them raise equity from institutional investors and other limited partners—and, in many cases, generated attractive profits to the house in addition to fund management fees. Indeed, investors have encouraged liberal co-investment into these vehicles, as they demonstrate fund managers’ commitments to their investment strategies and help align interests of funds’ general and limited partners, Pax relates.
But as he and other experts suggest, it already seems clear that at least some of the former Wall Street investment banks (they’re all part of bank holding companies today) will relinquish at least some of their real estate advisory activities to investment managers not subject to the 3 percent restriction. If the bank holding companies can no longer take larger risks with fund investments, they can’t reap the potentially lucrative rewards they’ve often achieved through their opportunistic property investments.
“So you have to think it will have a huge impact on the marketplace,” Pax observes. “It’s bound to change the roster of players” in the fund management arena.
Again, a few recent transactions appear to hint at the kinds of investment management divestments likely to be seen ahead as financial reform gradually takes effect—and banking organizations look to reduce risk exposure generally. The deals also may suggest the types of investment managers poised to pounce on opportunities to fill voids left by the Wall Street firms: namely, large private equity managers and longtime real estate advisory figures.
For instance, late last year Citigroup sold its Citi Property Investors unit to big private equity player Apollo Global Management. About the same time, Merrill Lynch—now part of Bank of America Corp.—handed off management of its Asian real estate funds to another private equity giant, Blackstone Group. BofA/Merrill also spun off its European operation to its management team headed by Roger Barris.
Then earlier this year, global financial giant ING Group—in a move aimed at separating its banking and investment management operations at Dutch regulators’ behest—sold most of its non-U.S. real estate investment management operations to property services giant CB Richard Ellis, which has a sizable advisory operation. ING in early June also sold its domestic real estate advisory division, ING Clarion Partners, to its management including longtime chief Stephen Furnary, in partnership with buyout firm Lightyear Capital.
However, these moves don’t simply suggest that the former investment banks will uniformly look to divest their real estate fund management platforms, experts caution. Indeed, anticipating what’s ahead for the financial giants and other advisers can be as perplexing as the 2,300-page Dodd-Frank Wall Street Reform and Consumer Protection Act that has apparently motivated some of the strategic sales.
The former Wall Street banks aren’t about to act in haste, or in unison—and definitely tend to keep strategies close to the vest, says institutional real estate investment consultant Paul Mouchakkaa, managing director of real estate consulting services with Pension Consulting Alliance.
“I’m not sure even the key people in those business units know what to expect,” Mouchakkaa continues. “But I’ll also say we’re unlikely to see anyone do anything rash—unless it clearly makes sense” for the particular institution.
Reflecting the ongoing emphasis on the core risk profile, Goldman Sachs recently began raising investor capital for vehicles focused squarely on core properties—and through its Asset Management division, rather than Goldman’s well-known Whitehall Street family of real estate funds. Goldman brought in core-minded veteran Jeff Barclay from ING Clarion to head up this effort.
But perhaps illustrating Mouchakkaa’s observation about Wall Street’s tendency away from herdlike activities, active adviser JPMorgan Asset Management earlier this year launched an opportunistic fund management platform (dubbed Junius Real Estate Partners) separate from its existing real estate asset management business.
Whichever directions they ultimately choose, bank holding companies do have some time to adjust to the 3 percent provision contained in the so-called Volcker rule component of Dodd-Frank. It is scheduled to take effect in July 2012. But affected institutions may well have until 2017 to comply with specifics, as the legislation is subject to an automatic two-year transition period—and up to three one-year extensions.
In addition to the limit on equity investments in individual vehicles, the new regulations stipulate that holding companies’ total private equity and hedge fund exposure can’t exceed 3 percent of their Tier 1 capital. Nor will holding companies be allowed to invest into funds managed by outside parties.
Banking companies structuring and marketing new multi-investor vehicles will still be able to “seed” them with internal capital beyond 3 percent initially, but they’ll need to whittle the exposure down to the 3 percent limit within one year, Pax explains.
While it’s a bit early for Pax to speculate further about which kinds of organizations will assume the roles the former investment banks have been playing, one thing is pretty clear to him: the reduction in bank exposure to investment fund risk is exactly what Congress intended with Dodd-Frank generally, and the Volcker rule in particular.