In the universe of private equity real estate investing, it’s easy to imagine that the largest fund sponsors would consistently produce the best results for their investors. While there is something to be said for the consistent long-term results provided by these firms, it is actually the emerging managers who have provided the highest returns. While not clearly defined, an emerging manager is typically described as a manager that is on their first or second fund with less than $500 million in assets under management. CalPERS, one of the largest institutional investors in real estate, defines an emerging manager as less than $1 billion in AUM and currently on first, second or third fund. These managers have typically had little experience in the institutional capital market, instead, primarily raising capital from friends, family and high net worth investors. While raising money from institutions is a new concept for these firms, investing in real estate and producing results is not. Many emerging managers have been in the space for decades and are simply attempting to shift the way their deals get funded. For institutions looking for great managers, there are many benefits of utilizing these managers, but also added due diligence requirements.
According to data provider Preqin, smaller funds consistently outperform larger funds. The smallest vehicles (less than $500 million) posted a median return of 10.9% between 2005 and 2014. This number decreased to 6.9% for the larger funds. That’s a 58% increase in return by the emerging manager funds! Furthermore, Preqin goes on to say that large and medium sized funds that began in 2005 and 2006, and went through the great recession essentially lost value, while smaller funds posted positive returns. This is an interesting dynamic to dig further into. How can the large firms with so many more resources consistently under perform their younger, smaller peers? There are a variety of dynamics at work and some negative attributes of the smaller funds to explore.
It is important to look at all aspects of a firm when conducting due diligence and determining the risk/reward profile that is right. While smaller funds have provided better returns, they typically do so with more risk. Thus, in depth due diligence is crucial when investing with emerging managers. The variability of the standard of deviation of the IRRs tend to be higher, while the larger funds have lower risk/return profiles. The solution, then, for investors would seem to be diversifying among the two strategies to mitigate risk while not missing out on upside potential.
Emerging managers superior returns are counter intuitive on the surface, but upon further inspection, the benefits of working with them becomes clear. Typically, smaller managers are focused on a strategy or local market that they know extremely well. They also tend to focus on single assets, where they can use active, “hands-on” management. The deals they are looking at are usually too large for local investors and too small for larger funds. Therefore, the deal sourcing typically falls off the radar and have much less competition. First Capital Advisors, which is in pre-launch for fund II typically seeks to acquire assets in the $5-$40 million range. We focus on select property types in geographic areas that we have deep relationships and knowledge. Being a smaller fund, we will be closing on 10-12 assets from the over 500 deals we look at each year. This allows for a very thorough due diligence process in which we close on only the best assets and can be extremely selective. Our smaller size and active management capabilities give us a big advantage in how we can seek out value and maintain price discipline. This has been proven true in fund I which began in 2014 and is currently projected to return an 19.1% gross IRR. While the mega funds have a certain place in the portfolio, there is very little price discovery in the assets they acquire. They have tremendous amounts of capital and therefore must spend it on very large assets to move the needle on earnings. These assets have a lot of competition bidding for them and typically lack value-add upside as they are newer and fully stabilized.
Private real estate has continued to be represented well in the portfolios of institutional investors as we move forward from the depths of 2009. As the space continues to mature and evolve with the dynamic economy and the new impact of tax reform legislation, it is important for investors to let the sector foster, develop and encourage the growth of emerging managers. As the smaller managers grow into larger funds, this will keep the flow of newer entrepreneurial minded sponsors entering the fray. Emerging managers are very focused, typically have a lot of skin in the game and need their fund to succeed in order to survive as a company. They also tend to be specialists instead of generalists and can exploit market inefficiencies that other, larger, firms may not notice. While the returns tend to be a bit more widely distributed, the data on the out performance can no longer be ignored by investors. Added due diligence is required as these firms don’t have as long of a track record, but they should certainly not be overlooked.