Tuesday, 29 December 2009 00:00

Wall Street is Back to Paying Big Bonuses. Are You Sharing in this New Found Prosperity?

As a followup to“Doesn't Morgan Stanley Read My Blog?”, I would like to focus on the private investment fund structures of the big banks and the incentives that they have to do deals that may lose money. Institutional real estate investors, many of whom have been severely
burned over the last couple of years, can rightfully point a chiding
finger at the so-called "big league managers" who not only failed to
foresee the commercial real estate (CRE) collapse as professional and
experienced money advisors, but also benefitted from positive cash
flows by putting investors' money at stake. CRE investors have, through
institutional funds, basically given these money managers a cost free
"call option" on the real estate market by funding the vast majority of
equity in acquisitions and allowing fund managers to benefit from
upfront acquisition and management fees as well as a share of
investment gains contingent upon success. The fee structure
incentivizes management in certain circumstances, to raise as many
funds and do as many deals as possible, in lieu of focusing on being as
profitable as possible. This is one of possible explanations for the
flurry of fund raising and deals executed between 2004 and 2007, when
the CRE market reached the crescendo of a bubble peak.

CRE prices have corrected sharply since the peak (nearly 45% from October 2007) and have substantially reduced, if not eliminated investors' capital in highly reputed real estate funds such as MSREF, floated by Morgan Stanley. The multiple conflicts of interest between the fund sponsor (the manager) and investors is illustrated clearly in such funds, and arose from the fact that fund sponsor was compensated on the basis of deals done (acquisition fees) and funds under management (management fees), making them extremely aggressive in fund acquisitions. Consequently, the aggressive deals (in an attempt to rake in huge amounts in fees), which were done at highly unreasonable and unsustainable valuations, are now standing as underwater holdings, liable for foreclosure and liquidations due to the illiquid capital markets, and high LTVs that are the inescapable result of such rampant speculation.

Operational Underperformance versus the Implicit Call Option: Does the Funds' "House" Always Win Scenario Cause GPs to Pursue Deals Regardless of Profitability?

While the aggressive acquisitions made during the bubble phase can be taken as a flawed investment strategy, the fact that fund managers intentionally structured their products as a win-win situation for themselves should not be ignored. The fact becomes even more significant since the signs of a bubble were so obvious to objective parties. I clearly outlined the risks of the CRE bubble in 2006 and 2007, the years in which CRE funds were making their largest investments ever! In "Doesn't Morgan Stanley Read My Blog?" I recapped the risks of the Blackstone portfolio in 2007, the very same portfolio whose portions Morgan Stanley, through their MSREF V fund, was forced to disgorge at a near 100% equity loss to LP investors who did not have the benefit of an implicit "call option" on the CRE market (see sidebar on the left). Needless to say, Morgan Stanley, the GP and effective holder of the "Call Option", actually saw significant cash flow from carried interest, management and acquisition fees despite its investor's losses.

Upon a close examination of the structure of funds such as the Morgan Stanley's MSREF, it has been observed that fund sponsors, acting as the GP (general partner) collect sufficient cash flows through fees to insulate themselves from negative returns on their equity contribution in the case of a severe price correction (Please refer to the hypothetical example below, constructed as an illustration of a typical real estate fund). The annual management fees (usually 1.5% of the committed funds) along with acquisition fees provide the cash flow cushion to absorb any likely erosion in the capital contribution (usually 10% of the total equity). Further, the provision of "GP promote" (the GP's right to a disproportionate share in profits in excess of an agreed upon hurdle rate of return) rewards the fund sponsor in case of gain, but does not penalize in case of a loss. Herein lies the "Call Option"! With cash flows increases that are contingent upon assets under management and the volume of deals done combined with this implicit "Call Option" on real estate, the incentive to push forward at full speed at the top of an obvious market bubble is not only present, but is perversely strong - and in direct conflict with the interests of the Limited Partners, the majority investors of the fund!

A hypothetical example easily illustrates how the financial structure of a typical real estate fund is so tilted to the advantage of the fund sponsor as to be analogous to a cost-free "Call Option" on the real estate market.

The example below illustrates the impact of change in the value of real estate investments on the returns of the various stakeholders - lenders, investors (LPs) and fund sponsor (GP), for a real estate fund with an initial investment of $9 billion, 60% leverage and a life of 6 years. The model used to generate this example is freely available for download to prospective Reggie Middleton, LLC clients and BoomBustBlog subscribers by clicking here: Real estate fund illustration. All are invited to run your own scenario analysis using your individual circumstances and metrics.

realestate_fund.png

To depict a varying impact on the potential returns via a change in value of property and operating cash flows in each year, we have constructed three different scenarios. Under our base case assumptions, to emulate the performance of real estate fund floated during the real estate bubble phase, the purchased property records moderate appreciation in the early years, while the middle years witness steep declines (similar to the current CRE price corrections) with little recovery seen in the later years. The following table summarizes the assumptions under the base case.

re_scenarios.png

Under the base case assumptions, the steep price declines not only wipes out the positive returns from the operating cash flows but also shaves off a portion of invested capital resulting in negative cumulated total returns earned for the real estate fund over the life of six years. However, owing to 60% leverage, the capital losses are magnified for the equity investors leading to massive erosion of equity capital. However, it is noteworthy that the returns vary substantially for LPs (contributing 90% of equity) and GP (contributing 10% of equity). It can be observed that the money collected in the form of management fees and acquisition fees more than compensates for the lost capital of the GP, eventually emerging with a net positive cash flow. On the other hand, steep declines in the value of real estate investments strip the LPs (investors) of their capital. The huge difference between the returns of GP and LPs and the factors behind this disconnect reinforces the conflict of interest between the fund managers and the investors in the fund.

re_fund_returns.png

re_fund_returns_tables.png

Under the base case assumptions, the cumulated return of the fund and LPs is -6.75% and -55.86, respectively while the GP manages a positive return of 17.64%. Under a relatively optimistic case where some mild recovery is assumed in the later years (3% annual increase in year 5 and year 6), LP still loses a over a quarter of its capital invested while GP earns a phenomenal return. Under a relatively adverse case with 10% annual decline in year 5 and year 6, the LP loses most of its capital while GP still manages to breakeven by recovering most of the capital losses from the management and acquisition fees..

re_fund_returns_tables3.png

Anybody who is wondering who these investors are who are getting shafted should look no further than grandma and her pension fund or your local endowment funds...

http://www.zerohedge.com/sites/default/files/images/user5/imageroot/volcker/MSREF%20V%202.jpg

Sourced from Zerohedge

Further reading:

Dec. 17 (Bloomberg)
-- Morgan Stanley, the securities firm that spent more than $8 billion
on commercial property in 2007, plans to relinquish five San Francisco
office buildings to its lender two years after purchasing them from
Blackstone Group LP near the top of the market.

[The properties were] held by the bank's MSREF V
fund. "It's not surprising this deal ran into trouble," Michael Knott,
senior analyst at Green Street Advisors in Newport Beach, California,
said in an interview. "It was eye-opening among a group of eye-opening
deals. There was almost no price too high in 2007 for office space in
top gateway markets."

The San Francisco transfer would mark the second real
estate deal to unravel this year for Morgan Stanley, which bet on the
property markets as prices were rising. The firm last month agreed to
surrender 17 million square feet of office buildings to Barclays
Capital after acquiring them for $6.5 billion in 2007 from Crescent
Real Estate Equities. U.S. commercial real estate prices have dropped
43 percent from October 2007's peak, Moody's Investors Service said
last month.

... The Morgan Stanley buildings may have lost as
much as 50 percent of their value since the purchase, Knott estimated.


From Pensions & Investments:

Morgan Stanley, once a giant in the real estate business, is in a world of hurt.

A100%mong the wounds afflicting the Morgan Stanley Real Estate group:

  • Morgan Stanley is writing down 80% of the properties in Fund V U.S. and 60% in Fund VI International.
  • Two
    investors - the $60.5 billion New Jersey State Investment Council and
    the $3.86 billion Contra Costa County Employees Retirement Association
    - backed out of their commitments to its latest closed-end fund, the
    approximately $5 billion Morgan Stanley Real Estate Fund VII. Contra Costa had committed $75 million; New Jersey, $150 million.
  • Its $5 billion open-end core real estate fund, the Morgan Stanley
    Prime Property Fund, has a line of investors asking for a total of more
    than $500 million in redemptions as of year-end 2008. The fund returned
    -19.8% for the 12 months ended March 31, underperforming the NCREIF
    Property index but outperforming the NCREIF Open-End Diversified Core
    Equity index, according to fund information provided to investors.
  • Crescent Resources LLC, a joint venture between Morgan Stanley
    Real Estate Fund V U.S. and Duke Energy Corp., filed for Chapter 11
    bankruptcy protection to reduce the debt level and improve the capital
    structure. Investors in Fund V include the $40 billion Pennsylvania
    Public School Employees' Retirement System, $119 billion California
    State Teachers' Retirement System and $6.2 billion San Bernardino
    County (Calif.) Employees' Retirement Association.
Last modified on Tuesday, 29 December 2009 00:00
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