Even With Clawbacks, the House Always Wins in Private Equity Funds

Bloomberg writes, Blackstone Returns Fees to Investors in First Clawback Triggered at Firm, I excerpt below:

Aug. 27 (Bloomberg) — Blackstone Group LP
is refunding some performance fees earned during the commercial real
estate boom, the first time fund investors have clawed back cash from
executives at the world’s largest private-equity company.

Blackstone and some of its managers
returned $3 million in carried interest to investors in Blackstone Real
Estate Partners International LP during the second quarter, said a
person with knowledge of the payments. They may pay back an estimated
$15.7 million this quarter to another fund, Blackstone Real Estate
Partners IV, according to the person and a regulatory filing.

Blackstone’s property buyout funds
recorded performance fees totaling $1.74 billion, some of which was
allocated to the firm’s partners, as the market for office towers,
hotels and apartments soared from 2004 to 2007. Prices have slumped
about 39 percent since then, leaving New York-based Blackstone and its
rivals in a position similar to that of venture capital firms about a
decade ago, when the collapse of technology stocks forced them to return
profits earned on Internet companies during the 1990s.

“The acute situation for clawbacks is
when you have had a very successful period of gains and then the
remaining deals don’t do well,” said Michael Harrell,
co-head of the private funds practice at the New York-based law firm
Debevoise & Plimpton LLP. “That is what happened when the Internet
bubble burst and there is certainly the potential for that with the
sharp downturn in the real estate market.”

Clawback Provisions

Private-equity funds, which raise
money from institutions including pensions and endowments, pay a share
of profits from investments, usually 20 percent, to the firm and its
investment managers. If the fund’s remaining holdings suffer a permanent
decline in value, clawback provisions can require the executives to
rebate cash distributions in order to prevent their share of profits
from exceeding the 20 percent.

Blackstone’s repayments were included in an Aug. 6 regulatory filing that didn’t name the funds.

Blackstone’s $38.7 billion purchase of Sam Zell’s
Equity Office Properties Trust in February 2007 marked the pinnacle of a
bubble inflated by easy financing. The firm sold $60 billion of real
estate assets before the market slumped in 2008, Chief Executive Officer
Stephen Schwarzman said during a July 22 conference call with analysts, according to a transcript.

Profits from some of those sales have
helped Blackstone’s funds outperform rivals. The carried interest paid
on the profits also exposed Blackstone managers to possible clawbacks
when the market fell and dragged down the value of the remaining
holdings in their funds. Potential clawbacks at the firm’s property
funds more than tripled to $299.8 million last year from $77.2 million
at the end of 2008, according to regulatory filings. The figure shrank
to $280.3 million at the end of June.

…

Equity Office Properties

While Blackstone sold $27 billion in
assets acquired in the Equity Office deal, there weren’t any potential
clawbacks from gains on those transactions, according to the person
familiar with the funds. That’s because Blackstone used the proceeds
from those real estate sales to pay down debt rather than make carried
interest payments to itself and managers.

…

Property buyout funds raised about
$262 billion from 2005 through 2009, more than double the total from the
previous five years, according to London-based Preqin Ltd., a research
and consulting firm focusing on alternative assets.

Market Sours

In some buyouts, debt reached 95
percent of the price as buyers assumed that rents and cash flow to
service the borrowings would rise with the real estate market, said James Corl, a managing director at Siguler Guff & Co. who oversees the New York-based investment firm’s distressed strategies.

Instead, the economy weakened in 2008, leading to defaults among developers such as Harry Macklowe, whose properties were overburdened with debt, Corl said.

Funds that began investing after 2004
have lost money on average, Preqin data show. Funds that entered the
market in 2007 have averaged annual declines of 33 percent.

“All of these guys invested in trophy properties at the top of the market,” said Thomas Capasse,
a principal at Waterfall Asset Management LLC, a New York firm that
invests in high-yield structured debt. “Many of these real estate
opportunity funds ended up down 30 to 75 percent.”

In April, Morgan Stanley told
investors that the firm expected an $8.8 billion international real
estate fund would end up losing about 61 percent of its assets.
Whitehall Street International, a property investment fund run by
Goldman Sachs Group Inc., lost almost all of its $1.8 billion in equity,
CNBC, Reuters and the Financial Times reported the same month.

…

Private-equity firms begin to earn performance
fees once their fund’s annual returns exceed a threshold promised to
clients, typically 7 percent to 10 percent. Real estate funds record
carried interest as they mark up the value of their holdings. The fees
don’t get paid until gains are realized through property sales.

Traditional corporate buyout funds
wait until their lifespan, usually about 10 years, is completed to make
this calculation. Real estate funds sometimes require interim clawbacks,
such as those being made by Blackstone.

“Some managers have had to write checks and some managers have had difficulty writing checks,” said Geoffrey Dohrmann,
chief executive officer of Institutional Real Estate Inc., a San Ramon,
California, publishing and consulting firm that specializes in the
commercial real estate market.

I have written extensively on this topic. For one, the CRE bubble was
obvious, but funds plowed ahead because they receive fees for deals
done as well as performance fees. I warned about Blackstone and the Sam
Zell deal blowing up back in 2007 as it was being done (see Doesn’t Morgan Stanley Read My Blog?).
It was quite OBVIOUS that the top of the market was there , but it
doesn’t matter if you get paid for both success AND failure, does it?
They are often in a win-win situation. On April 15th, 2010 I penned “Wall Street Real Estate Funds Lose Between 61% to 98% for Their Investors as They Rake in Fees!”
wherein I espoused much of my opinion on market manipulation and the
state of CRE. I will excerpt portions below in an attempt to explain
how REITs and the bankers that they deal with get to add 2 plus 2 and
receive a sum of 6, or worse yet have 4 subtracted from their 6 and
get to sell 5!!! Straight up Squid Math!

Oh, yeah! About them Fees!

Last year I felt compelled to comment on
Wall Street private fund fees after getting into a debate with a
Morgan Stanley employee about the performance of the CRE funds. He had
the nerve to brag about the fact that MS made money despite the fact
they lost abuot 2/3rds of thier clients money. I though to myself,
“Damn, now that’s some bold, hubristic s@$t”. So, I decided to attempt
to lay it out for everybody in the blog, see ”Wall Street is Back to Paying Big Bonuses. Are You Sharing in this New Found Prosperity?“.
I excerpted a large portion below. Remember, the model used for this
article was designed directly from the MSREF V fund. That means the
numbers are probably very accurate. Let’s look at what you Morgan
Stanely investors lost, and how you lost it:

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.

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.

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.

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..

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…

More on the topic of commercial real estate in the US…

The
Conundrum of Commercial Real Estate Stocks: In a CRE “Near
Depression”, Why Are REIT Shares Still So High and Which Ones to Short?

Commercial
Real Estate Continues to Dropped into Foreclosure as the Landlords of
Said Properties Enjoy Skyrocketing Share Prices? Yep, Makes Plenty of
Sense

The Shortlist of the Shortlisted “Stocks to Short for 2010″: What We See as the Most Profitable Bear Postions for 2010

Developing Implications on Loan Accounting Law: Mark to Market, Mark to Model, or Mark to Market Crash?

Commercial Real Estate is Pretty Much Doing What We Expected It To Do, Returning to Reality

Commercial Delinquencies Rise Again, Data Goes Ignored

Wall Street Real Estate Funds Lose Between 61% to 98% for Their Investors as They Rake in Fees!

For Those Who Chose Not To Heed My Warning About Buying Products From Name Brand Wall Street Banks,

The Taubman Properties Q4-2009 Earnings Opinion: The CRE Trend Continues as Expected

CALPERs Uses Jingle Mail as a Risk Management Technique

General Growth Properties & the Commercial Real Estate Crash, pt III – The Story Gets Worse (Archived/Reggie Middleton’s Boom Bust Blog/MyBlog)

This
is part III of a IV part series on GGP. Reference parts one and two
for context. The majority of work on GGP is now done, and I will (as my
time permits) start disseminating the non-propri

Wednesday, 09 January 2008

Was I right on my call on Commercial Real Estate Crashing?
(Archived/Reggie Middleton’s Boom Bust Blog/MyBlog)

…Cometh,
and I know who is leading the way! Generally Negative Growth in
General Growth Properties - GGP Part II General Growth Properties &
the Commercial Real Estate Crash, pt III – The Story G…

Tuesday, 12 February 2008

If only more rich heiresses read my blog
(Reggie Middleton’s Boom Bust Blog/MyBlog)

The GGP story
seems to go on forever.  Hat tip to CK for pointing this one out to
me. For those that do not know,  I shorted GGP in late 2007, after
exhaustive research and it took a year to

Friday, 21 August 2009

Reggie Middleton’s 2010 CRE Outlook and Response to the Ackman/Pershing Square Presentation
(Reggie Middleton’s Boom Bust Blog/MyBlog)

…il CRE malls (Ackman’s CRE presentation). Several of my subscribers have commented on his success with GGP as well as the upward climb of REITs in general. I decided to go out of my way to create a co…

Tuesday, 15 December 2009

Comments

[Treeplanter]

No, Reggie, you're a man of honor.  You wouldn't fit in with this slimy crowd.

[Let them all fail]

Enjoy the analysis, but not exactly a shocker Reggie - no such thing as negative carry or mgmt fees...

[Gromit]

My takeaway - when stuff is going up 10% a year, LPs can be compensated enough to increase the flow of money to the PE.

But when outflow exceeds new money, LP will receive pennies on the dollar.

[Grand Supercycle]

As first suggested on Thurs 26th, further upside for DOW/SP500 is expected.

http://stockmarket618.wordpress.com

[Itsalie]

Good write-up as usual and serves well to illustrate the huge difference in returns between LPs and GPs - as well as the point I have been harping for the nth time: with megafunds (PE or hedge funds), GPs' fees alone can skew returns and leave little incentive to perform - carried interest or not, the GPs win big.

Second: I know of very few LPs who even check the distributions they actually received against the quarterly accounts and reports sent out by the LBO firms, let alone run the figures themselves to compare the GP abnd LP returns. Many GPs make figures available to LPs on a when-requested basis, but I know of no LPs who systematically run the LP and GP figures to appreciate the difference. Some very sophisticated endowments do not have people who do the laborious taks of checking - and believe me I have seen big discrepancies.

Third, most large LBO firms have lower hurdle than 10% (especially for non real-estate buyout funds): the likes of Blackstone and TPG would be closer to 8%, and for tech buyout funds like Silverlake might even be lower (they follow the VCs, which have ver low or even zero hurdle). The capital contribution of GPs for the mega funds are also much lower than 10%. For a $5b fund and above, I have not seen any with 10% contribution. If we factor these 2 points, the difference made by the fees would skew the returns even more in favor of the GPs.

[Leo Kolivakis]

Listen to this:

[Mercury]

So...Com. RE will appreciate substantially in 3-5 years because...?

[I am a Man I am...]

Oh, it won't, but nobody will remember he said that 3 to 5 years from now, and nobody will invest in real estate if he said there will be no substantial recovery.

[MarketTruth]

A rolling loan gathers no loss... plus extend and pretend. Brilliant! (not)