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: 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...

Sourced from Zerohedge

For any who are interested in discussing this with me, I can be reached through the Reggie Middleton contact link. Happy Holidays...

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.

Comments

[Anonymous]

Reggie, do you think there is any equity left in commercial real estate? My numbers before the bust- $6.5 trillion in value, $3.5 trillion in debt. I'm not a mathematician but according to my calculations all equity in commercial real estate has been wiped out. Yet my beloved SRS keeps making new lows. I think it's the investment of the year.

[Reggie Middleton]

I can't generalize commercial real estate as a whole as not having equity. There are good and bad situations. To watch the banks and REITs that are tied to the enough of the bad situations rally for 9 months straight does cause me to look at it as an opportunity though. Capital and patience are required. As can be seen, rallies against the fundamentals have become commonplace. We shall see if this nonsense can be kept up through 2010. I doubt so, but then again I doubted it would last 3 quarters in 2009 as well.