An In-Depth Evaluation Of Morgan Stanley's Real Estate Portfolio - Part 1

As was pointed out yesterday, Morgan Stanley's massive Real Estate empire is starting to unravel building by building. With a building here, five buildings there, the shareholder pain, and the writedowns start accumulating. But it was not always makeshift tears and walking away from buidings when your equity is underwater. In those long ago days of 2005 it was hope and bubblemania. Which is why we dug up various Morgan Stanley Real Estate Fund documents and materials, exposing the firm's delirium just as the peak in the real estate bubble was about to set in.

First we highlight the International Fundraising document used by MSRE Fund V, as we try to trace back where it is that things got so horribly wrong for Morgan Stanely and for investors in this and its other funds.

Notable is the incentivisation structure, particularly the "acquisition fee" - a fixed fee in addition to the traditional management fee, as can be seen below, is to incentivize the group to do deals. Any deals - even really dumb deals. And the traditional approach by MS: use firm capital as an initial equity investment, then fundraise around this. At the time, MS had no problem closing on $4.2 billion of equity capital commitments. Morgan Stanley accounted for 10% of both the MSREF IV and V investor base. This money has mostly evaporated. Tough for the retail investors as well, who lost as much as MS did. And all the while MS rakes in the cash in the form of the management fee, the acquisition fee and the GP promote (of course, as long as things are going well. When they implode, like they have now, the firm can simply walk away).

And from the associated commentary:

MSREF V lnternational ('MSREF V") has closed with $4.2Bn of capital commitments

  • 76% increase in equity raised and 126% increase in the number of investors vs. MSREF lV lnternational ('MSREF lV")

Don't these investors now wish there was a minus sign ahead of that number...

  • 16 of MSREF V 24 institutional (67%) investors participated in MSREF V
  • 26% of institutional capital (c. $850MM) are new to the MSREF program

More thoughts along the same lines.

  • Largest real estate focused fund raised to date

The bigger they are, the harder they fall. And the more bailout money they receive.

Below is a detailed breakdown of who lost lots of money with Morgan Stanley failed Real Estate ventures:

  • MSREF V is more diversified in its investor base with double the High Net Worth investors and a large pool of government agency capital

Gee, and we wondered who the Fed keeps on bailing out with all those MBS purchases.

  • At the time of closing, MSREF V lnternational had already closed or committed on 40 investments totaling $1.48n of equity

I.e., there are at least 35 other buildings from which MS is about to walk away from. And this is only for the 2005 vintage. This must be "quite favorable" for rental and capitalization rates.

Looking at the broader group of all MS Real Estate products, 2004 and 2005 were good years, generating $750 and $1.2 billion, respectively. Of course, that revenue is now gone, as is the equity. We do not anticipate seeing this presentation for 2008 and 2009.

Real estate was in fact such a huge cash cow for MS, that it was "the top producing industry sector for IBD" in 2005:

And just in case anyone was wondering which bank was impacted the most from the collapse in real estate, the following league table chart should put it all into perspective:

A key question investors have had is how much capital has the firm blown down the rabbit hole. The following table should provide a broad sense.

Yup. Well over $5 billion. And this excludes all of 2006 and 2007. What was Morgan Stanley's TARP bailout amount once again?

As for future implosions after the San Francisco debacle? The list below is a rough indication. Once we obtain a full list of what the firm invested in in 2006 and 2007 we will promptly provide it.

We will leave off part 1 of this overview, with the one thing that nobody ever reads until it is far too late: the Conflicts Of Interest. These may be of particular interest nowadays, as specualtors are left to pick up the pieces on what Morgan Stanley decides to simply walk away from.

Below is the entire risk factor section from the bank's Real Estate Special Situations Fund III (yes, a different one) from November 2005. Grab a coffee - it's a fun (and long) read.

POTENTIAL CONFLICTS OF INTEREST

GENERAL

Investors should be aware that there will be occasions when Morgan Stanley, the General Partner, their affiliates, directors, partners, trustees, managers, members, officers and employees (collectively, for purposes of this “Section VI: Potential Conflicts of Interest,” “Morgan Stanley”) encounter potential conflicts of interest in connection with Special Situations III. These conflicts may arise in part because, as a diversified financial services firm, Morgan Stanley engages in a broad spectrum of activities, including financial advisory services, merchant banking, lending, arranging securitizations and other financings, sponsoring and managing private investment funds, engaging in broker-dealer activities, conducting an asset management business and other activities, some of which may be conducted on behalf of clients. In the ordinary course of its investment banking business, Morgan Stanley engages in activities where Morgan Stanley’s interests or the interests of its investment banking clients may conflict with the interests of the SS III Limited Partners, notwithstanding Morgan Stanley’s participation as a Limited Partner of the Fund. By acquiring SS III Units, each SS III Limited Partner will be deemed to have acknowledged the existence of, and to have consented to, such actual and potential conflicts of interest between the proposed activities of Special Situations III and the business activities of Morgan Stanley, and to have waived any claim with respect to the existence of any such conflict of interest.

The Advisory Committee will consider and, on behalf of the Limited Partners (excluding the General Partner), approve or disapprove, to the extent required by applicable law, including Section 206(3) of the U.S. Advisers Act, principal transactions and certain other related party transactions.

The following discussion enumerates certain potential conflicts of interest which should be carefully evaluated before making an investment in Special Situations III.

CLIENT RELATIONSHIPS

Morgan Stanley has existing and potential relationships with a significant number of corporations, institutions and individuals. In providing services to its clients and Special Situations III, Morgan  Stanley may face conflicts of interest with respect to activities recommended to or performed for such clients, on the one hand, and Special Situations III, the SS III Limited Partners or the entities in which the Fund invests, on the other hand. In addition, these client relationships may present conflicts of interest in determining whether to offer certain investment opportunities to the Fund.

In acting as principal or in providing advisory and other services to its other clients, Morgan Stanley may engage in or recommend activities with respect to a particular matter that conflict with or are different from activities engaged in or recommended by the General Partner on behalf of the Fund.

REAL ESTATE AND INVESTMENT BANKING ACTIVITIES

Morgan Stanley is involved in a broad range of investment banking activities, as described under “— General” above. For example, Morgan Stanley often represents potential purchasers and sellers in real estate related transactions or parties in corporate transactions. Morgan Stanley will continue to accept such assignments after the establishment of Special Situations III. In these cases, such Morgan Stanley client relationships may result in the Fund not being able to pursue certain investment opportunities. Accordingly, no assurances can be given that all potentially suitable real estate investments will be offered to the Fund.

From time to time, Morgan Stanley’s investment banking professionals may introduce to the Fund a client that requires an equity investment to complete an acquisition transaction. If the Fund pursues the resulting equity investment, Morgan Stanley could have a conflict in its representation of the client over the price and terms of the Fund’s investment. Furthermore, the Fund will not generally purchase securities being underwritten by Morgan Stanley, thereby limiting the ability of the Fund to make such investments.

In addition, Morgan Stanley could provide real estate and investment banking services to  competitors of companies in which the Fund invests, in which case it will take appropriate steps to safeguard the confidential information of each client. Such activities may present Morgan Stanley with a conflict of interest vis-à-vis the companies in which the Fund invests and may also result in a conflict with respect to the allocation of investment banking resources to such companies.

From time to time, Morgan Stanley may come into possession of material, non-public information or other information that could limit the ability of the Fund to buy and sell investments. The Fund’s investment flexibility may be constrained as a consequence.

MORGAN STANLEY AS LENDER

Morgan Stanley engages in a variety of activities involving the origination, funding and purchase of loans relating to real estate through its Securitized Products Group (“SPG”). Situations may arise where the Fund is one of several bidders for an investment property and SPG or another Morgan Stanley affiliate is financing a bid of another bidder for the same property. SPG or another Morgan Stanley affiliate may hold a loan on a property and such loan may be repaid in connection with an equity investment by a client advised by Morgan Stanley or an affiliate (including the Fund). SPG or other Morgan Stanley affiliates may originate loans to facilitate the Fund’s investment in companies, or purchase existing loans to companies in which the Fund has invested until they can be securitized or resold. In these and other situations, the interests of SPG or the other relevant Morgan Stanley affiliate may conflict with those of the Fund. For example, the situation may arise where SPG is required to take action or make decisions with respect to loans relating to one or more companies in which the Fund has invested (such as renegotiating the terms of a loan, deciding whether to grant a consent or waiver with respect to such loan or taking action due to a default under such loan) that were originated by or pledged to SPG in the course of its business activities. These activities (such as loan origination or purchase) will be undertaken by Morgan Stanley in its own capacity, will not require the consent of the Fund or the SS III Limited Partners, and may conflict with the interests of the Fund. In any event, in connection with the foregoing activities, appropriate safeguards will be maintained to preserve the confidentiality of the  respective clients’ information.

THE FUND AS A POTENTIAL CREDITOR

The Fund may invest directly or indirectly in debt securities or obligations of other Morgan Stanley affiliates or clients, in which case potential conflicts of interest would arise insofar as the Fund would have an interest in structuring the financial and other terms (such as interest and  repayment terms, covenants and events of default) to be more restrictive than the Morgan Stanley affiliate or client, as equity owner, may desire. In addition, further conflicts could arise after the closing of the investment. For example, conflicts would arise if a company is unable to meet its  payment obligations or comply with covenants relating to securities held by the Fund. If additional funds are necessary as a result of financial or other difficulties, it may not be in the best interests of the Fund to provide such additional funds. If the obligor would lose its investment as a result of such difficulties, the General Partner may have a conflict of interest relative to the other Morgan Stanley affiliate in recommending actions that are in the best interest of the Fund.

BUYING AND SELLING ASSETS

The Fund may purchase assets from or sell assets to the General Partner and its affiliates (including other Morgan Stanley sponsored funds). These transactions generally will not require the approval of the SS III Limited Partners. Any such purchases and sales could involve conflicts of interest with respect to price and other terms applicable to the transactions.

The General Partner may, without the consent of the SS III Limited Partners, determine to have the Fund make (i) any investment relating to any transaction in which Morgan Stanley has entered into an agreement or an agreement in principle prior to the date of the initial Subscription Date or (ii) any investment which Morgan Stanley shall have purchased on the Fund’s behalf prior to such date. The Fund will acquire any such investment from Morgan Stanley at Morgan Stanley’s total cost (including all acquisition costs) plus interest thereon at 9% per annum.

FEES FOR SERVICES

It is contemplated that Morgan Stanley will normally seek to perform investment banking and other services for, and will expect to receive customary investment banking compensation from, the Fund, the entities in which the Fund invests or other parties in connection with transactions related to the Fund’s investments. Such compensation could include financial advisory fees or fees in connection with restructurings and mergers and acquisitions, as well as underwriting or placement fees, financing or commitment fees, proxy solicitation fees and brokerage fees. These fees will not be shared with Special Situations III or the SS III Limited Partners, will not reduce the Management Fees and Incentive Allocation payable by or on behalf of the Fund and the SS III Limited Partners, and may not be the result of arm’s-length negotiations.

In addition, from time to time, the General Partner may request that various Morgan Stanley business units, or entities in which Morgan Stanley business units have an economic interest, provide services to the Fund for customary compensation. Morgan Stanley may provide the Fund with certain data processing, legal or insurance purchasing or administrative services (but excluding accounting services) which would otherwise be performed for the Fund by third parties and, in such event, Morgan Stanley will be reimbursed by the Fund therefor.

INVESTMENTS BY MORGAN STANLEY AND OTHER MORGAN STANLEY FUNDS OR SEPARATE SCCOUNTS

Morgan Stanley Related Persons will not make principal investments in securities of any Applicable Real Estate Company that are acquired in privately negotiated transactions, subject to certain exceptions, without first offering them to Morgan Stanley Real Estate for allocation among its clients as described below. The exceptions include, among other things, investments in connection with the operation of Morgan Stanley’s other businesses; investments made in connection with any co-investment with a Morgan Stanley Real Estate client, provided that such investment is not on terms more favorable than those applicable to the Morgan Stanley Real Estate client; investments made in connection with certain underwriting, broker-dealer, real estate brokerage or capital market activities of Morgan Stanley; investments offered as compensation for advisory services; investments offered exclusively to Morgan Stanley; investments made in connection with originating, purchasing as agent or principal, trading, restructuring, repackaging or otherwise dealing in portfolios of mortgage loans (other than portfolios of nonperforming loans) relating to the real estate and debt capital markets operations of Morgan Stanley; investments in connection with the purchase of a portfolio of securities, investments made in connection with any  discretionary or managed client accounts in an immaterial amount as determined by the General Partner in its sole discretion, investments of not more than $10 million; and other investments that the General Partner determines in good faith, after disclosure to the Advisory Committee, not to be in competition with Morgan Stanley Real Estate’s clients.

The General Partner and its affiliates within Morgan Stanley Real Estate manage real estate assets on behalf of their clients and investors in their funds, which include a wide variety of corporations, partnerships and trusts, public and corporate pension funds, insurance companies, endowments, foundations, foreign institutions, and high net worth individuals. There may from time to time be individual assets that meet the investment parameters of both the Fund and one or more of such clients and investors. In addition, certain of such clients have or will have priority rights in respect of certain types of investments pursuant to the terms agreed upon with such clients or pursuant to applicable law, rule or regulation in the jurisdictions in which such clients are organized or operated, which may result in such investments being allocated exclusively to such clients and not to the Fund (except to the extent such clients do not exercise their rights). For example, transactions sourced internally by Morgan Stanley’s German-regulated investment funds platform (the “KAG Platform”) must be offered first to the KAG Platform, which currently only sponsors funds seeking core and core-plus returns. In addition, Morgan Stanley Real Estate Fund V International—T, L.P. and the sister partnerships that co-invest with it, and Morgan Stanley Real Estate Fund V U.S., L.P. and the sister partnerships that co-invest with it, and such programs’ respective successor funds will each be accorded priority over controlling investments in real estate-related opportunities that, at the time they are evaluated, are projected to achieve returns of an “opportunistic” nature, including minority investments if, in good faith, the fund ultimately intends to seek to acquire a control position.

After taking account of any priority rights of other funds or accounts, opportunities sourced by or presented to Morgan Stanley Real Estate are allocated to funds or other accounts that are clients of Morgan Stanley Real Estate in accordance with the Allocation Process to reduce potential conflicts of interest and to ensure that opportunities are allocated in a fair and equitable manner. The Allocation Process may change from time to time in the sole discretion of Morgan Stanley without notice to the investors but, subject to any priority rights described above, in no event will Morgan Stanley adopt an allocation process that does not allocate investment opportunities in a fair and equitable manner.

The Allocation Process is intended to ensure that all clients of Morgan Stanley Real Estate,  including the Fund, will have fair access to new real estate investment opportunities made available to such clients.

Each client of Morgan Stanley Real Estate, including the Fund, is assigned a portfolio manager who develops an annual plan detailing the client’s desired investment volume, transaction structure,  risk/return profile and, by property type, the desired physical characteristics, pricing, leasing risk and target markets.

The portfolio managers meet regularly to review current real estate investment opportunities which have been identified by or made available to Morgan Stanley Real Estate. Any portfolio manager may select from these new opportunities, for further consideration, those proposed transactions which may fit a particular client’s investment parameters. If, as a result of the meetings among portfolio managers, an investment is identified for the Fund that is also suitable for one or more of Morgan Stanley Real Estate’s other clients, an investment allocation committee (the “Allocation Committee”) will prioritize such investment among Morgan Stanley Real Estate’s clients. If an investment opportunity is suited for more than one client, the Allocation Committee will consider various factors to allocate opportunities among clients. If, after considering these factors, the Allocation Committee believes that the investment is suitable for more than one of Morgan Stanley Real Estate’s clients, the committee will generally allocate the opportunity pursuant to a rotation system, except that certain investment funds will be accorded priority rights as discussed above.

Factors considered by the Allocation Committee in prioritizing and allocating investment  opportunities include, but are not limited to: (i) the client’s investment parameters, including return objectives, size of transaction, geographic location, property type, and risk tolerance; (ii) discretionary or non-discretionary requirements of the seller or borrower; (iii) the ability of the client to meet the proposed transaction’s timing sensitivity or remain flexible in the face of anticipated changes; (iv) specific requests of the party offering the opportunities; (v) other diversification requirements, such as whether the transaction is complementary to the client’s existing portfolio; (vi) contractual, regulatory and other legal requirements, including preferences concerning investments of a particular type that may have been, or may in the future be, granted to one or more clients targeting that type of investment with the concurrence of other clients with similar investment objectives; and (vii) in the event the rotation system is required or deemed desirable by the committee, the aggregate dollar amount invested and number and timing of transactions previously closed on behalf of the client. The ultimate allocation decision is formally approved by the Allocation Committee, which will be empowered to take into account other considerations it deems appropriate to ensure a fair and equitable allocation of opportunities.

Under the Allocation Process, while Morgan Stanley Real Estate will have the discretion to allocate portions of investment opportunities to multiple funds or accounts, generally it is expected that they will be awarded to one fund or account in accordance with the Allocation Process. In  situations in which the capacity of a potential investment opportunity is limited and Morgan Stanley Real Estate determines that multiple funds or accounts, including the Fund, will make side-by-side investments, this may result in the Fund making a smaller investment than it would have absent such determination. Potential conflicts may arise in situations where the Fund and other Morgan Stanley Real Estate clients or Morgan Stanley affiliates make side-by-side investments. For example, because the Fund and such other clients or affiliates may have different investment objectives or strategies or because of other differences, Morgan Stanley Real Estate or Morgan Stanley may make different decisions on behalf of the Fund and such clients or affiliates as to the appropriate time or manner of exiting such investments, and such decisions made on behalf of the other clients or affiliates could adversely affect the value of the Fund's investment.

CO-INVESTMENTS WITH MORGAN STANLEY AFFILIATES

If the General Partner determines that the Fund should commit to invest less than the amount offered to the Fund with respect to an investment opportunity or should decline an investment opportunity, the General Partner may present to any person (including Morgan Stanley affiliates or some or all of the Limited Partners, as determined by the General Partner in its sole discretion) all or any portion of such investment opportunity remaining after taking into account the investment, if any, by the Fund.

The Fund may also make investments in transactions that have already been structured and  committed to by another Morgan Stanley affiliate. There can be no assurance that the return on the Fund’s investments will be equivalent to or better than the returns obtained by the other affiliates participating in the transaction. Morgan Stanley has made and will make large capital investments in other funds, and therefore may have conflicting interests in connection with any joint investments. It is not expected that any independent evaluation of a proposed transaction will be available.

The decision to allocate a particular investment between the Fund and other Morgan Stanley affiliates may involve conflicts of interest. See “—Investments by Morgan Stanley and Other Morgan Stanley Funds or Separate Accounts” above. The Fund may also give co-investment opportunities to certain Limited Partners, including Limited Partners with which Morgan Stanley has significant relationships and not other Limited Partners, which could present certain conflicts of interest. Further potential conflicts of interest could arise after the Fund and other affiliates have made their respective investments, including where the investment objectives, expected exit timing or financial resources of the co-investing entities differ substantially from those of the Fund.

The Fund may partner with operating companies or other entities in which a Prior Fund or other Morgan Stanley affiliate holds an investment or with which the Prior Fund or Morgan Stanley has a significant business relationship. The terms and conditions (including fees) governing the Fund’s relationship with such entities may not be the result of arm’s-length negotiations.

ASSET MANAGEMENT

Morgan Stanley conducts a variety of asset management activities, including sponsoring investment funds registered and regulated under the U.S. Investment Company Act. Such activities also include managing assets of pension funds, which are subject to federal pension law and its regulations, real estate separate accounts for institutional clients and portfolios of publicly traded securities. These activities may present conflicts of interest if the Fund pursues an investment in or transaction involving a company or property in which an entity in which Morgan Stanley’s asset management clients or investment companies have previously invested, or a company or property in which an entity in which Morgan Stanley’s asset management clients or investment companies have previously invested has an interest. In certain situations, the Fund may be restricted or precluded from pursuing an investment with respect to any such company or property due to certain regulatory considerations, such as Section 17 of the U.S. Investment Company Act. In addition, in the course of making investments or otherwise engaging in  investment or asset management activities for itself or its affiliates (including without limitation Morgan Stanley managed funds or accounts), Morgan Stanley may on behalf of itself and/or any affiliates (including without limitation Special Situations III) agree not to compete with certain parties or not to make investments in certain geographical areas, or otherwise agree to certain covenants that may place significant restrictions on the investment or other activities of itself and its affiliates, including without limitation, Special Situations III.

PROMOTION OF THE FUND

Morgan Stanley’s sales personnel have interests in promoting sales of SS III Units. Their remuneration relating to sales of SS III Units may be greater than that of other products that they might offer on behalf of Morgan Stanley and, accordingly, Morgan Stanley’s sales personnel may have an incentive to sell SS III Units.

INVESTMENT IN MORGAN STANLEY MONEY MARKET FUNDS

To the extent permitted by applicable law, Special Situations III may make short term investments of excess cash in money market funds sponsored or managed by Morgan Stanley. In connection with any of these investments, Special Situations III will pay all fees pertaining to the investments and no portion of any fees otherwise payable to Special Situations III will be offset against fees payable in accordance with any of these investments (i.e., there could be “double fees” involved in making any of these investments). In these circumstances, as well as in all other circumstances in which Morgan Stanley receives any fees or other compensation in any form relating to the provision of services, no accounting or repayment to Special Situations III will be required.

INCENTIVE ALLOCATION

The General Partner’s Incentive Allocation may create an incentive for the General Partner to make more speculative investments on behalf of the Fund than it would otherwise make in the absence of such performance-based compensation. In addition, the method of calculating the Incentive Allocation may result in conflicts of interest between the General Partner and the SS III Limited Partners with respect to the management, disposition and valuation of investments. Since the Incentive Allocation is calculated on a basis that includes unrealized appreciation of the Fund's assets, such compensation may be greater than if it were based solely on realized gains and losses. There can be no assurance that the Fund’s valuation of a Fund investment will represent the value that will be realized by the Fund on the eventual disposition of such investment or that would, in fact, be realized upon immediate disposition of such investment on the date of its valuation. If the Fund overvalues an investment, the benefits to the General Partner, including higher fees and performance-based compensation, as well as to personnel of the General Partner who may be responsible for the part of the Fund’s valuation process, as members of the MSRESS III Team, to be performed by the General Partner, will be greater than if a lower value had been
used. See “Section V: Certain Risk Factors—Valuation of Fund Investments.”

MANAGEMENT OF THE FUND

The personnel of the General Partner or its affiliates will devote such time as the General Partner, in its sole discretion, deems necessary to carry out the operations of Special Situations III effectively. It is expected that the Morgan Stanley officers and employees responsible for managing the General Partner will continue to oversee the Prior Funds and other funds and separate accounts managed by MSRE.

Morgan Stanley’s activities in respect of such other funds and accounts may be competitive with the Fund's activities. In addition, conflicts of interest may arise in allocating time, services or functions of these officers and employees.

PROPRIETARY ACTIVITIES

Morgan Stanley is an active participant, as agent and principal, in the global real estate markets. Morgan Stanley may invest or trade in the equity, debt or other interests of companies in which the Fund invests without regard to the Fund’s investment objective. These activities may include, without limitation, acquiring positions that are based on the same or a different strategy than that of the Fund. For example, Fund investments in public companies may impact Morgan Stanley’s trading flexibility in those securities. In this regard, from time to time, Morgan Stanley may choose not to act as a financial advisor in particular situations, although requested to do so, in order not to circumscribe its trading flexibility. Morgan Stanley may similarly elect not to undertake certain activities on behalf of the Fund in order not to limit its trading flexibility. Morgan Stanley may retain any profits that it may make in these transactions.

ACTIVITIES OF MORGAN STANLEY EMPLOYEES

The General Partner, the Investment Committee and the MSRESS III Team will generally consist of Morgan Stanley Real Estate employees. Such personnel will be responsible for the senior  management, direction and daily operations of the Fund, and will spend such time on the business and operations of the Fund as deemed advisable by the General Partner in its sole discretion. However, such personnel will generally have other functions and responsibilities for Morgan Stanley Real Estate and Morgan Stanley, and therefore generally will not spend all or substantially all of their time on the business and operations of the Fund and the performance of the Fund may suffer as a result. From time to time and subject to Morgan Stanley’s internal policies and procedures, Special Situations III personnel may consult with personnel in other areas of Morgan Stanley. Such persons may receive information regarding the General Partner’s proposed investment activities of the Fund that is not generally available to the public. However, there will be no obligation on the part of such persons to make available for use by the Fund any information or strategies known to them or developed in connection with their own client, proprietary or other activities. In addition, Morgan Stanley will be under no obligation to make available any research or analysis prior to its public dissemination.

The General Partner’s employees are subject to Morgan Stanley’s Code of Ethics and Business Practices (the “Code of Ethics”) and internal policies which prohibit them from investing in the securities of any company whose securities are under consideration for investment or have been acquired by a client of the General Partner. The Code of Ethics requires all Morgan Stanley employees to understand and comply with the laws, regulations and internal policies applicable to them, encourages employees to ask questions of supervisors and internal counsel and requires employees to put client interests first and avoid the appearance of impropriety. Additionally, the Code of Ethics and other internal policies require employees of Special Situations III to carefully protect confidential information obtained in the course of the GeneralPartner’s business, to provide fair and truthful disclosure to the public and to maintain accurate books and records.


In addition to guidelines on business conduct, the Code of Ethics and other internal policies also contain a number of policies governing the securities trading activities of Special Situations III’s employees for their own accounts. Those policies generally require all affected Special Situations III employees to maintain their securities accounts at Morgan Stanley, and requires all personal securities transactions to be pre-cleared by senior business managers and Morgan Stanley’s Compliance Department. In addition, Morgan Stanley Real Estate’s Chief Compliance Officer or other senior business managers annually review each Special Situations III employee’s securities holdings and each quarter reviews a report of all Special Situations III employee trades for the preceding quarter. These reports are prepared to detect whether Special Situations III employees are improperly trading on client information or otherwise improperly benefiting themselves. Suspicious activity and violations of the Code of Ethics are dealt with seriously and promptly.

DIFFERENT INTERESTS AND TERMS RELATING TO LIMITED PARTNERS

The SS III Limited Partners are expected to include taxable and tax-exempt entities and may include persons or entities organized in various jurisdictions, including non-U.S. jurisdictions. Because of the diverse investor base, SS III Limited Partners may have conflicting investment, tax and other interests with respect to their investment in Special Situations III. Conflicting interests of Limited Partners may relate to or arise from, among other things, the nature of investments, the currency in which investments are denominated, the structuring of investments and the timing of disposition of investments. Such factors may result in different after-tax returns being realized by different SS III Limited Partners. Conflicts may arise in connection with decisions made by the General Partner that may be beneficial for one SS III Limited Partner but not for another SS III Limited Partner, particularly with respect to individual SS III Limited Partners’ tax situations. In selecting investments appropriate for the Fund and structuring such investments, the General Partner will consider the investment objectives of the Fund as a whole rather than the investment objectives or particular tax or regulatory situation of any individual SS III Limited Partner.

Notwithstanding anything herein to the contrary, the General Partner reserves the right, in its sole discretion, to reduce all or any portion of or modify in any way the Management Fee or Incentive Allocation applicable to any SS III Limited Partner (including without limitation Morgan Stanley Investors and Related Funds formed for the purpose of participation by Morgan Stanley Investors) as may be agreed to by the General Partner and such SS III Limited Partners, and the General Partner may unilaterally make appropriate amendments to or supplement the Partnership Agreements (including in connection with the creation of additional classes or series of SS III Units (including, without limitation, in connection with Currency Hedging)) if required to reflect any such arrangements. In addition, the General Partner may, in its sole discretion, determine to grant certain SS III Limited Partners additional rights, including membership on the Advisory Committee, rights relating to the conversion of SS III Class R Units as discussed in “Section II: Summary Terms and Conditions of the Fund—Class R Units” and the right to receive certain additional information with respect to Special Situations III or such investor’s SS III Units without notice to other SS III Limited Partners.

BUSINESS RELATIONSHIPS OF THE GENERAL PARTNER

Morgan Stanley and its affiliates and other Morgan Stanley managed funds and accounts have long-term relationships with a significant number of property managers, facilities managers, developers, institutions and corporations and their advisors. In determining whether the Fund should invest in a particular transaction and which service providers to use, if any, the General Partner will consider these relationships in its management of the Fund. There may be certain transactions that will not be undertaken on behalf of the Fund in view of such relationships.

BROKERAGE ACTIVITIES

The General Partner has discretion to determine, without consent of the SS III Limited Partners, the broker or dealer to be used (if any) and the commission rates to be paid in cases where a broker or dealer is used.

The Fund may engage in transactions in which Morgan Stanley acts as a broker for the Fund and for another person on the other side of the transaction. In any such event, Morgan Stanley may receive commissions from, and have a potentially conflicting division of loyalties and responsibilities regarding, both parties to such transactions. The commissions charged by Morgan Stanley for such transactions may not be the lowest commission rate available. However, the General Partner will endeavor in good faith to obtain best execution of brokerage transactions for the Fund, taking into account all relevant factors in the selection of a broker, including research and other products and services that benefit the Fund,  execution capability, commission rate, financial responsibility and responsiveness. Morgan Stanley may also act as agent for the Fund and other clients in selling publicly traded securities simultaneously. In such a situation, transactions may, but are not required to, be bundled and clients, including the Fund, will receive proceeds from sales based on average prices received, which may be lower than the price which could have been received had the Fund sold its securities separately from Morgan Stanley’s other clients.

COUNTERPARTY TRANSACTIONS WITH MORGAN STANLEY

The Fund may participate as a counterparty with or as a counterparty to Morgan Stanley or an entity formed by Morgan Stanley in connection with currency, hedging, derivatives (including but not limited to swaps, forwards and options of all types) and other transactions. In this regard, the Fund may establish a prime brokerage relationship with Morgan Stanley to facilitate and improve transaction execution with respect to trading by the Fund in the fixed income, currency, equity or other markets (including with respect to derivative transactions). Morgan Stanley may retain any commissions, remuneration, or other profits which may be made as a counterparty in these transactions. In connection with prime brokerage or lending arrangements involving the Fund, Morgan Stanley may require repayment of all or part of a loan at any time or from time to time and take other commercial steps in its own interests.

The Fund will review each of the foregoing transactions and take such other steps as it may deem necessary to ensure that the terms of transactions are fair and reasonable and, if the General  Partner approves, it will consent thereto. For instance, in these circumstances, the General Partner will consider, among other things, pricing (including applicable commissions and fees), the ability to implement Fund’s objectives (including the avoidance of communicating the Fund’s objectives to the market) and the ease and speed of execution.

By executing the Subscription Booklet, a Limited Partner consents to all the counterparty  transactions with Morgan Stanley.

VALUATION OF FUND INVESTMENTS

The General Partner currently expects that market quotations will not be available for a significant portion of the Fund's investments. Valuations of such investments will be made as part of a process involving the Valuation Committee, the MSRESS III Team and the Valuation Agent, as discussed in “Section II: Summary Terms and Conditions of the Fund—Valuation.” During such process, the Valuation Committee will review and consider valuation reports prepared by the MSRESS III Team and the Valuation Agent. The Valuation Agent serves at the discretion of, and may be replaced at any time by, the Valuation Committee, and the members of the Valuation Committee, although to greater or lesser extents not members of Morgan Stanley Real Estate, are employees of Morgan Stanley, and therefore both the Valuation Agent and the Valuation Committee may have potential conflicts of interest when reviewing the proposed valuations of the MSRESS III Team and the Valuation Agent, respectively. Although the Valuation Committee will select or approve the Valuation Agent in accordance with its fiduciary duties to the Fund, it may be incentivized to choose a valuation agent that it believes will provide the most favorable valuations or which agrees to the most favorable compensation arrangement, regardless of the expected quality of such valuation agent’s services. Moreover, there can be no assurance that the Fund’s valuation of a Fund investment will represent the value that will be realized by the Fund on the eventual disposition of such investment or that would, in fact, be realized upon immediate disposition of such investment on the date of its valuation. Since the Incentive Allocation is  calculated on a basis that includes unrealized appreciation of the Fund's assets, such  compensation may be based on values that reflect incremental appreciation in assets which is not realized upon disposition and, accordingly, such compensation may be greater than if it were based solely on realized gains and losses.

If the Fund overvalues an investment, the benefits to the General Partner, including higher fees and performance-based compensation, as well as to personnel of the General Partner who may be responsible for the part of the Fund’s valuation process, as members of the MSRESS III Team, to be performed by the General Partner, will be greater than if a lower value had been used.

CROSS-COLLATERALIZATION OF FUND INDEBTEDNESS

The Fund may enter into a commitment-based credit facility with a bank or syndicate of banks that is secured by the obligation of Limited Partners to fund subscription calls. The indebtedness incurred by the Fund may be secured by the Commitment Amounts of some of the Limited Partners and may be structured on a cross-collateralized basis. Notwithstanding the foregoing, certain investors in the Fund or certain Related Funds (including Morgan Stanley employees and Limited Partners that are subject to the fiduciary rules of ERISA or the Code) may, for regulatory, ERISA or other reasons, be unable to pledge their interests in the Fund or the Related Funds to secure the Fund’s indebtedness. If the indebtedness is structured in this manner, such investors in the Fund or the Related Funds which invest directly or indirectly in the Fund will benefit from the incurrence of the indebtedness even though their commitment amounts in respect of the Fund or the applicable Related Fund will not be pledged to secure such indebtedness.

VOTING RIGHTS

From time to time, companies in which the Fund has an investment may seek the approval or consent of their investors in connection with certain matters. In such a case, the General Partner has the right to vote in its discretion the interest in the entity held by the Fund, on behalf of the Fund. The General Partner will consider only those matters it considers appropriate in taking action with respect to the approval or consent and SS III Limited Partners will not receive prior notice thereof.

LEGAL COUNSEL

Fried Frank is representing the General Partner in connection with this offering and organization of Special Situations III. Fried Frank represents Morgan Stanley and its affiliates from time to time in a variety of different matters. It is not anticipated that, in connection with the organization or operation of the SS III Fund, the SS III Fund will engage counsel separate from counsel to the General Partner and other Morgan Stanley affiliates. Prospective investors should seek individual counsel if they so desire.