Introduction
Due diligence of fund and manager operations has never been more relevant than in today’s uncertain environment. Risk management is heightened as a result of new regulatory regimes, anemic global economic growth, and the perpetual threat of financial destabilization. Despite these difficulties, interest in the alternatives industry, private equity, and commercial real estate (“CRE”) as an alternative to traditional public is more pronounced than ever before.
In this paper, we highlight some of the specific issues investors face when conducting operational due diligence on CRE managers with a particular focus on managers of real estate debt funds.
1. Key Personnel and Manager Evaluation: Long tenures are commonplace in the private fund industry. In the case of CRE, however, long tenures can be as much a curse as a blessing. The main difference lies in CRE funds’ illiquid structure. Because underlying assets cannot be easily liquidated, investors are generally prevented from redeeming capital for the life of the fund, which can be as long as 10 to 12 years. Accordingly, assessing managerial competence and integrity are of paramount importance in the CRE space, as unwise decisions can lock investors into funds with inadequate resources or subpar talent.
As it turns out, one of the greatest difficulties for investors is acquiring and verifying relevant information about CRE fund personnel. When performed correctly, the process is a challenging and time-consuming endeavor. Investors must authenticate the biographical description of principals in the prospectus by researching public source data, conducting full background checks, and examining employer references. Beyond confirming degrees and professional certifications, a thorough investigation should also insure the absence of prior securities violations, professional or regulatory disbarments, and criminal records. As important and frequently overlooked are discoverable associations with others who may be the perpetrators of criminal violations — the infamous Madoff feeder funds come to mind. Onsite manager interviews with the CEO, COO, CCO, back-office staff, and others will further enable investors to address encountered discrepancies or red flags such as corroborating ambiguous biographical information.
Investors should also check the regulatory body that oversees the jurisdiction in which the CRE fund manager or advisor is based. For example, in the United States, given the existing Form ADV registration requirement for CRE advisory firms, the SEC’s Investment Advisor Public Disclosure search would be a reliable source for compliance reviews. Moreover, the new Form PF disclosure requirements for CRE funds above $150 Million in regulatory assets under management (RAUM) should provide some transparency, although firms have discretion about data they report to investors as Form PF information is not public.
ODD Essentials – Key Personnel Evaluation:
- Confiregrees and professional certifications
- Corroborating ambiming dguous biographical information
- Utilize regulatory websites to insure advisors are properly registered
2. Manager Fund Track Record
In the hedge fund industry, there is a widely held understanding based upon empirical data that smaller, newer managers typically outperform larger, more established managers.
CRE, on the other hand, is typically better served by larger firms with long standing track records and broad access to the pool of possible investment transactions. Larger, more established managers, with solid track record simply have an advantage when it comes to sourcing, underwriting and asset managing quality transactions.
An important caveat however is that not all CRE track record is portable. The CRE industry is generally divided in four distinct quadrants:
Successful management of investment in each of these areas requires distinct sets of skills. For example, the process and skill set necessary to successfully invest in public equities in the real estate industry is extremely different than the process and skill sets necessary to successful manage a private debt platform. The lesson is that not all CRE investment is the same and investors are well advised to look at track record that is directly applicable to a given strategy.
Even within the quadrants listed above, there are subtle differences in strategy that may require a more thorough analysis of track record. For example, a manager with a strategy of investing in multifamily assets using 90% leverage with a two year average hold period is very different from a multifamily strategy using 60% leverage and a 5 year hold period. While on the surface these two strategies seem to be quite similar, they in fact are require a very different set of assumption during the underwriting process when determining assets to approve for investment. These differences need to be understood by investors when looking at track record to determine whether a particular manager in fact has experience with a particular strategy.
As always, investors should confirm that superior CRE investment results are based in fact. Recommended procedures include reviewing monthly asset reports, examining audited financial statements, substantiating IRR calculations, and confirming fund details such as inception and vintage dates. Regardless of a CRE firm’s stated claims, proper confirmation of past performance and experience are crucial inputs in selecting the right manager.
ODD Essentials – Manager Fund Track Record:
- Review monthly portfolio reports, audited financial statements
- Match past record with proposed strategy
- Confirm relevance of past performance and experience
3. Strategic and Operational Value-Add
A key difference between hedge fund and CRE management is the ability of CRE firms to impart strategic or operational advice to underlying assets.
Although most managers are careful to avoid becoming actively involved in management (contrast with Private Equity firms that may be actively involved in portfolio company management), most CRE managers have robust asset management capabilities with deep experience in property level management. CRE debt fund managers in particular must avoid any active management that would give rise to “lender liability” claims. Nonetheless, in addition to deep expertise in real estate asset management, successful debt fund managers typically have expertise in real estate credit training, loan work out experience, and CRE development. The fact is that managing CRE debt assets will at some point require expertise in all areas of CRE property development and management. The more broad the experience of fund managers in all areas of CRE, the more likely they will make appropriate investment decisions in the first instance.
Successful CRE managers will typically use this experience at the very beginning of the investment process, where a thorough review of a particular CRE business plan is undertaken. Experienced CRE investors will be able to spot potential problems in the sponsors’ plan right at the outset and structure the investment transaction in such a way as to mitigate risk of business plan failure. For example, it is not uncommon for CRE managers to suggest to sponsors of potential investment transactions that they co-partner with a more experienced development equity partner in cases where the sponsor may be “light” on experience with a particular plan execution strategy. By identify weaknesses in plans and providing potential mitigation strategies to the sponsors of those plans, successful CRE managers actively influence potential outcomes for investors.
ODD Essentials – Strategic and Operational Value-Add:
- Confirm the CRE firm’s view of structuring and asset management involvement with prior transactions
- Investigate on the breadth of skills and experience of the key principals of the CRE manager in all aspects of CRE
4. CRE Asset Valuation
The issue of CRE net asset valuation has never been more critical. CRE firms by definition hold illiquid investments with no readily accessible value benchmarks. As such, asset appraisals may vary widely depending on the methodology used.
The importance of accurately valuing underlying CRE assets in a timely manner cannot be overstated. At first glance, it may seem that net asset valuation is a secondary issue for CRE firms. After all, CRE firms typically capture performance fees after realizing gains on sale. However, interim valuations still matter to investors as a proxy for future returns.
The key from both the regulator and investor perspective is reasonableness of methodology, consistency in approach and the frequency of valuation. Difficulties arise when interim valuations are needed and a particular underlying asset is in distress. For example, fund managers can reasonably justify a wide variation in asset valuation based upon multiple work-out scenarios. It is important for investors to understand what to expect from their managers in these situations.
Because CRE firms ultimately have the final word in determining the valuation measure most fitting given the particular circumstance, due diligence should scrupulously address issues of consistency and justification. The measurement of net asset values must be carried out with reasonable constancy over reporting periods, and it is imperative that investors look to see if firms maintain valuation methodologies throughout asset and fund life cycles. Investors must also dig deeply into the efforts and assumptions of valuation methodologies themselves.
Transparency given the regulatory climate is a basic component of the due diligence process and lack of clarity by a CRE firm should be viewed with skepticism. Investors should request hard copies of valuation procedures and review updated policies for consistency and rigor. Investors should verify that there is a segregated valuation group with a detailed and independent valuation process in which no member of the investment team has undue sway over valuation figures.
ODD Essentials – Private Equity Portfolio Company Valuation:
- Verify that the CRE firm fully discloses the rationale for its choices and applies a “best practices” approach for its given strategy.
- Verify valuation methodology and its consistency over the time
- Check independent valuation of property level assets
- Use valuation specialists
- Overall, investors should get a sense of clarity in the valuation process: request hard copies of valuation procedures and review updated policies for consistency and rigor.
5. Fund Strategy:
Investors need to be sure that funds are allocated in-line with strategies outlined in the prospectus in order to avoid committing capital to investments out-of-line with preferred exposure and risk tolerance. Proper due diligence and asset verification can insure underlying assets reflect the declared market strategy.
Adherence to fund strategy is of paramount importance to investors given the complex and wide-ranging nature of CRE investments. For example, is the debt fund manager adhering to concentration issues with respect to geography or asset class of the underlying properties? Is the debt fund manager sticking to stated goals with respect to capital stack strategy (i.e. mezzanine financing or senior debt tranche investing)? How does the firm reallocate capital and avoid concentration risk if a large underlying asset is sold? Such questions necessitate thorough due diligence in comparing the strategy outlined in the offering memorandum and fund documents with corroborating evidence directly from the firm.
A particularly topical concern for investors at the moment is the existence of so-called “zombie funds.” Many CRE firms that struggled post-financial crisis now control funds that have little chance of making future profits. With the specter of diminished or nonexistent carried interest and the impossibility of raising new money, “zombie managers” exist in a kind financial limbo. At the same time, the SEC has found that investors become “less engaged” and may “devote fewer and fewer resources to monitoring the fund” as time passes because decisions to modify positions are less frequently made. Investors need to be particularly vigilant with their ongoing due diligence monitoring to protect their interests.
ODD Essentials – Fund Strategy:
- Proper due diligence and asset verification can insure underlying assets reflect the declared market strategy
- Avoid “Zombie Funds” that have suffered from the post-financial crisis.
6. Service Provider Assessments:
Before the Madoff scandal CRE funds usually did not make use of custodians, administrators, and prime brokers as did hedge fund managers. In the case of CRE debt fund managers, most assets (notes, loan documents, mortgages, security interests) were held by the manager/fund.
Following the Madoff scandal and Dodd-Frank legislation, the SEC in 2010 instituted a rule that restricted investment advisors from keeping custody of client assets unless they reported audited financial statements from approved accounting firms.
Investors should further examine a CRE firm’s auditor to insure independence, experience, and expertise. Auditors provide a range of services to both CRE firms and their underlying property assets. They may, for example, deal with accounting and reporting matters related to the firm’s carried interest allocations and management fee income. They may also review internal controls and make recommendations on how to improve asset protection.
In Europe, the Alternative Investment Fund Managers Directive requires that all alternative investment funds appoint an independent depositary to keep custody of assets. It is therefore recommended for investors to double check the relationship between the fund and the depositary.
One unique aspect of CRE fund business is the use of property level managers for underlying assets. For debt funds, this comes into play with any assets that have been converted to equity holding of the fund through foreclosure or similar process. The use of property level managers, leasing agents, and similar property services is critical to process of working-out of the asset and realizing value for investors. It is generally advised that these providers be independent service providers and not related to the fund or its manager. If in fact the manager’s strategy is to use related entities for these services, this strategy should be fully disclosed during the due diligence process and all fees fully described and understood prior to investment.
Finally, information technology firms may also play a secondary service provider role in CRE fund management. While business continuity and disaster provisions are not as time critical in CRE as in hedge funds, they are still nonetheless important markers of preparedness. CRE firms may outsource or use licensed technology applications or their own proprietary software. In the case of outsourcing, investors should examine the importance of data being handled and whether the outsourced company has proper backup systems in place. In the case of licenses, investors should confirm that formal legal agreements are in place to use the software for a given time period. Proprietary software has its own issues, including whether the software is maintained regularly, whether there is adequate IT support internally for the software, and similar operational risk issues.
ODD Essentials – Service Provider Assessment:
- Verify that service providers are independent third parties and/or understand related party fees and expenses.
- Examine a CRE firm’s auditor to insure independence, experience, and expertise.
- Verify and confirm the reliability of outsourced technology firms
7. Compliance
One of the most important areas to investigate in a CRE due diligence audit is compliance culture at the firm. Regulation for CRE firms is a relatively new but serious change in the course of business. Investors should develop a sense of whether a specific CRE firm has instituted a top down compliance culture that promotes, in the SEC’s words, “effective implementation of risk management in key business processes, including strategic planning, capital allocation, performance management, and compensation objectives.” Newly registered entities such as CRE firms in the United States must come to terms with the National Exam Program (NEP), part of the Office of Compliance Inspections and Examinations (OCIE) at the SEC, which involves nationwide inspections of registered investment advisors. Among various provisions, investment advisors to CRE funds must implement a code of ethics, appoint a CCO, file Form ADV annually, document policies and procedures in writing, and keep accurate books and records regarding the business.
The extensive nature of compliance for newly registered CRE firms means that investors must accurately gauge the attitude of management toward compliance duties and the SEC examination process in general. CRE firms that give lip service to compliance deserve red flags from investors. The most forward-thinking firms view compliance not as a back-end cost center, but as a revenue-generating source of efficiency. They accept regulatory change as a means of gaining a strategic competitive advantage over more reactionary peers (see Exhibit B below). After all, if a CRE firm takes a cavalier approach to regulatory compliance, what type of integrity, transparency, and discipline can a reasonable investor expect on the investment side?
Exhibit B:
ODD Essentials – Compliance:
- Check that the CRE firm has instituted a top down compliance culture
The Bottom Line:
This paper has highlighted some of the major issues to consider when conducting due diligence on CRE firms. As is evident, operational due diligence of CRE is a complex and time-consuming process, but the outcome for investors in the form of understanding operational risk is well worth the effort. By using the right resources, investors can improve their odds of selecting the very best CRE managers. As always, Laven Partners’ objective is to help investors achieve their goals and ultimately transform the way they invest in funds.
