There’s blood in the water. Dislocations popping up across the markets. A massive supply and demand imbalance in the credit space. With regional banks potentially looking at years of trouble ahead and interest rates well above the historic lows that has been the ‘new normal’ since the Great Recession of 2008, funding for real restate projects across the US is very much in question with the expectation of many ‘distressed’ properties coming on the market in the latter half of 2023. That’s the recent news in the commercial real estate (CRE) markets.
And it’s great news. That’s also the news we’re hearing about the commercial real estate markets. Everything is looking wonderful. Or, rather, about to look wonderful. After it falls apart. It’s the news for the usual suspects when things fall apart: Private Equity, which is palpably excited about all the distressed real estate that’s bound to come on the market now that regional banks are reeling and interest rates have caused borrowing costs to spike. All signs are pointing a whole lot of ‘dislocation’ in the commercial real estate credit markets. The kind of supply and demand dislocation that can turn blood in water into a gold laced silver lining for the entities with cash on the sidelines. As we’ve seen, being the ‘cash on the sidelines’ opportunistically waiting for things to fall apart or blow is a big part of the ‘Heads we win, tails you lose’ private equity business model.
Of course, as we’ve also seen, the ‘Heads we win, tails you lose’ business model of the private equity industry is also rooted in the fact that the fund managers charge high fees whether they’re investments pan out or not. It’s a ‘Heads we win, tails you lose’ client relationship. Including the growing number of pension fund clients lured in with promises of double digit yields in a historically low interest environment. Charging giant public public pension funds with opaque fees a very big part of today’s private equity industry. And growing.
So it should come as no surprise to learn that one of the big investment opportunities private equity has been steering billions of dollars of public pension money into in recent years is...*drumroll*...commercial real estate! Yes, the same sector that has private equity licking its chops over distressed debt and deals gone sour is the same sector private equity has been pouring tons of client cash into in recent years. Because of course that’s the case. Heads we win, tails you lose.
So does this mean pension funds are about to take a big bath on their commercial real estate investments? Probably. But don’t worry, their private equity fund managers are going to be paid handsomely either way. And they have a plan to turn this commercial real estate lemon into lemonade and for their pension fund clients: double down on their commercial real estate investments.
Now, on the one hand, that could end up be a decent way of recouping the commercial real estate losses pension funds have incurred and will incur as the regional banking crisis continues to weigh on commercial real estate credit markets. If they buy the decent commercial real estate options at a reasonable point in this whole ‘market dislocation’ event, and not overpay for the lemons.
But with this crisis in the commercial real estate credit markets expected to potentially play out for years to come, and some warning it could be worse than the Great Recession of 2008 for office buildings specifically thanks to the post-pandemic shift to remote work, and pension funds already deeply invested in this sector and ready to invest more, we have to ask to what extent we’re going to see the pension fund giants end up getting wielded as some sort of market support pool for commercial real estate sector, and whether or not that’s really going to be in the best interests of those pensioners. Should we be worried about such a scenario? Well, the head of JP Morgan’s commercial real estate division, Alfred Brooks, predicted earlier this month, he didn’t foresee the complete collapse of the commercial real estate market happening. Why? Well, he cited the Blackstone Real Estate Partners X, recently created fund that raised $30.4 billion to take advantage of emerging deals in the commercial real estate market. As we’re going to see, that’s fund’s clients consist of a bunch of large public pension funds. The same ones that are already reeling from growing CRE losses from their private equity-led CRE investments made over the last few years. So with the head of JP Morgan’s commercial real estate division pointing to big private equity-led pension funds create a floor for a market that otherwise looks poised for years of turmoil, shouldn’t we be concerned? It didn’t sound like he was advising his own clients to jump into commercial real estate. Just that they shouldn’t worry about it dropping too far thanks to pension funds.
And as we’ll also see, when Alfred Brooks gets into the nitty gritty, he does admit that, yeah, actually a lot of commercial real estate might end up experiencing something as bad as 2008 or worse. Just not necessarily the best real estate which will presumably get bought up by the pension funds and others look for deals. That was Brooks’s prediction eerily this month on the great CRE bloodbath of 2023: don’t worry, public pensions are here to catch this falling knife. How worried should those pensioners be? And how about the rest of us? Let’s not forget that ‘the public’ is potentially on the hook here if the pension funds of public employees experience some sort of emergency and need to be bailed out. Might we be seeing the set up for a public bailout of the commercial real estate sector by tying it the fate of pension funds? These are just some of the disturbing kind of questions we have to start asking.
Oh, and it turns out private equity has also been directing billions of public pension dollars into residential rental properties, turning public pensions into landlords. Rather cruel landlords in many cases as rent-controlled properties have been bought up and effectively cleared of rent-controlled tenants in one case after another, all justified, in part, in the premise of earning the high returns public pension funds need (and please just ignore the high private equity fees). Kick out grandma to save grandma’s pension. That’s kind of investor dynamic. So while public pension funds are getting ready to get even more deeply intertwined with the commercial real estate crisis, keep in mind that it’s also getting even more deeply intertwined with the housing affordability crisis in the US too.
Ok, here’s a quick review of the article excerpts we’re going to cover:
* June 1, 2023: How Private Equity Plans to Capitalize on Commercial Real Estate Distress
An article in the Commercial Observer about the ‘blood in water’ already detected in the commercial real estate market. “We’re in a meaningful period of dislocation,” as the co-chief executive officer of Morgan Stanley Real Estate Investments put it at a recent forum. “We’re seeing risk and asset values repriced before our eyes, and I think that’s true across the entire investable universe and certainly across all of private real estate, every sector, virtually every global market.” But Blackstone President and COO Jonathan Gray had a far cheerier way of describing the moment: “We think there’s a real opportunity to deploy more capital,” Gray said. “I think the private credit area is really at a golden moment because we do see tightening out there.” A golden moment for private equity. A golden moment created by a regional banking crisis, rising rates, a $1.5 trillion in CRE loans coming due by the end of 2025, with $500 billion maturing in the next 6 months. Is it really a “golden moment” like Blackstone’s Gray predicts? The clients who just invested $30.4 billion in Blackstone’s new commercial real estate fund had better hope so.
* June 5, 2023: Blackstone will help prevent an office market ‘catastrophe’, says JPMorgan’s commercial real estate chief
Following up on Blackstone President Jonathan Gray’s “golden opportunity” moment about the commercial real estate sector, JP Morgan’s head of commercial real estate, Alfred Brooks, had some commentary Gray might find reassuring. Brooks predicted that, while the market distress in the commercial real estate sector could go on for a while, we probably won’t see a huge fall at least for the higher quality properties. Why? Brooks cites Blackstone’s new $30.4 commercial real estate fund as an example of the money waiting on the sidelines. So the “Class A” properties should avoid mass declines. The Class B and Class C, on the other hand, could go “down to the last bottom,” in reference to 2008. In other words, this is a market filled with some gems and a lot of ticking time bombs so if you’re going to pick through it you better pick wisely.
* April 11, 2023: Blackstone closes $30.4 billion opportunistic real estate fund
A short report from Pension & Investment noting the closing (off to new funds) of the Blackstone Real Estate Partners X fund at $30.4 billion, significant growth over the $20.5 billion raised in 2019 for the Blackstone Real Estate Partners IX fund. Investors in the news fund include the California State Teachers’ Retirement System (CalSTRS); the State of Wisconsin Investment Board; the North Carolina Retirement Systems; the Virginia Retirement System; the Pennsylvania State Employees’ Retirement System. This a fund for public pensions.
* October 31, 2022: Pension funds scale back on CRE investing
An article from Halloween of 2022 with news that might sound rather spooky to pensioners today: pension funds were scaling back their commercial real estate investing after record levels of investing in the sector in the first half of 2022. In other words, the public pension funds were making record investments right before this CRE market turmoil. Oops. But the private equity managers get paid either way.
* April 24, 2023: Banks aren’t the only ones that hold risky commercial-real-estate debt. Pension funds are about to feel the pain, too.
A Business Insider report from a couple of months ago about the looming pain for pension funds in the CRE market. Pain many pension funds were already feeling, with California State Teachers Retirement System (CalSTRs), one of the investors in the Blackstone Real Estate Partners X fund, announcing it would be writing down the value of its $52 billion in real estate holdings, with a 20% drop in the value of those holdings due to the Fed’s interest rates moves alone. That’s a 20% drop that presumably hit a lot of pension funds’ newly acquired CRE holdings purchased over the last couple of years.
* March 2, 2020: Pension fund money is getting tangled in some controversial housing deals
A look at the other pension fund dive into the real estate space: multi-family rental properties. Yes, pension funds have increasingly become landlords. Mean stingy landlords who kick out tenants and thwart rent controls in the pursuit of the high yields needed to pay for public pensions.
* August 4, 2022: Private Equity Doesn’t Want You to Read This
A NY Times column by Farhad Manjoo written in the wake of the private equity industry’s multiple victories in the big congressional fights over what was going to go into the Democrats’ big ‘Inflation Reduction Act’ thanks to the holding out by Senator Kyrsten Sinema acting as private equity’s champion. As we saw, those victories included keeping the ‘carried interest loophole’ and the provision that allowed the many smaller business owned by private equity giants to dodge a new 15 percent minimum corporate tax. As Manjoo reminds us, this is all part of private equity’s broader capture of more and more the of economy despite the fact that its track record as owners and managers and been a disastrous legacy of bloated dead companies, laid off workers, and increasingly kicked-out tenants. And, of course, the overpaid fund managers who will be paid large fees no matter how their investment decisions go. Because it’s not their money. It’s their clients’ money. Because the “Head We Win, Tails You Lose” dynamic of this industry applies to the client relationships too.
Blood is in the CRE Waters. Sharks Report Great Times Ahead
Ok, first, years that article in the Commercial Observer about the ‘blood in water’ already detected in the commercial real estate market. “We’re in a meaningful period of dislocation,” as the co-chief executive officer of Morgan Stanley Real Estate Investments put it at a recent forum. “We’re seeing risk and asset values repriced before our eyes, and I think that’s true across the entire investable universe and certainly across all of private real estate, every sector, virtually every global market.” But Blackstone President and COO Jonathan Gray had a far cheerier way of describing the moment: “We think there’s a real opportunity to deploy more capital,” Gray said. “I think the private credit area is really at a golden moment because we do see tightening out there.”
A golden moment for private equity. A golden moment created by a regional banking crisis, rising rates, a $1.5 trillion in CRE loans coming due by the end of 2025, with $500 billion maturing in the next 6 months. Is it really a “golden moment” like Blackstone’s Gray predicts? The clients who just invested $30.4 billion in Blackstone’s new commercial real estate fund had better hope so. Because these investors are either sharks or chum and only time will tell:
Commercial Observer
How Private Equity Plans to Capitalize on Commercial Real Estate Distress
There’s blood in the water, as hundreds of billions of proverbial dry powder sits poised to enter the financing market. Here’s how and where.
By Brian Pascus June 1, 2023 10:45 am
During a May 3 appearance on Bloomberg TV, Blackstone (BX) President and COO Jonathan Gray appeared sunny, despite his surname, as he touted his private equity firm’s recent global real estate investment fund, BREP X, which closed a $30.4 billion fundraising round in mid-April.
“We think there’s a real opportunity to deploy more capital,” Gray said. “I think the private credit area is really at a golden moment because we do see tightening out there.”
For the illiquid world of private credit — which provides debt for commercial real estate projects -– and that of private equity, the recent upheaval in the U.S. regional banking sector and issues plaguing downtown office space has sparked questions surrounding the type of returns CRE can generate for investors.
The primary question being: Is a golden moment possible in the darkest of times?
“We’re in a meaningful period of dislocation,” said Lauren Hochfelder, co-chief executive officer of Morgan Stanley Real Estate Investments and head of MSREI Americas, during a Commercial Observer forum in late April. “We’re seeing risk and asset values repriced before our eyes, and I think that’s true across the entire investable universe and certainly across all of private real estate, every sector, virtually every global market.”
The dislocation across markets and asset classes has been driven by numerous external factors, including the secular shift in office usage since COVID-19, but the largest reason for the distress has been the historically rapid interest rate hikes by the Federal Reserve. Those have caused asset values to decline as borrowing costs have spiked. The increased leverage ratios on existing loans have put pressure on borrowers, and, in some circumstances, made it impossible to keep loans current or to refinance maturing loans without an infusion of equity. Moreover, the cost of financing acquisitions or new developments has also skyrocketed, creating a pause in equity markets as they assess the fractured landscape.
The shifting of the tide and subsequent distress has been plain to see: Brookfield (BN) defaulted on $784 million in loans tied to two Los Angeles skyscrapers in February; Blackstone sent a $270 million CMBS loan on a Manhattan multifamily portfolio to special servicing in February; GFP Real Estate defaulted on a $130 million mortgage-backed securities loan for 515 Madison Avenue in December; and just last month RXR defaulted on a $260 million loan on 61 Broadway.
“The backdrop is setting up for a likely scenario where we see more distress than we’ve seen since the Great Recession, and maybe even more distress than in 2008, 2009 and 2010,” said Warren de Haan, founder and managing partner at Acore Capital, one of the largest lenders in commercial real estate. “We have a supply and demand imbalance between the demand for commercial real estate debt and the supply of CRE debt.”
An estimated $1.5 trillion in CRE debt comes due by the end of 2025, according to a report by Morgan Stanley. This maturity wave arrives just as capital markets have seen a vast reduction of liquidity driven by a retrenchment of the U.S. banking system, which has experienced the second‑, third- and fourth-largest commercial bank failures in American history since March and is gearing up for potentially more in the months ahead.
Given that regional banks (those with $10 billion to $160 billion in assets) represent nearly 14 percent of commercial real estate lending, the pullback in debt capital from the system at a time when that money is needed to pay down billions in maturities is not exactly an appetizing mix for either investors or property owners.
“If all of that plays out together, you’ll have significantly lower liquidity in debt markets, a huge wall of maturities coming due, a higher interest rate environment, meaning values decline, and you have a banking crisis at the same time, meaning that the amount of distress we expect to see in the system will be exponentially higher than what we’ve seen in the last decade,” de Haan told CO.
“That is the big opportunity for the $400 billion of private equity sitting on the sidelines,” he added.
Ah, yes, the $400 billion in private equity capital. It’s commercial real estate’s caped crusader; an underwater sponsor’s proverbial knight in shining armor; the missing layer in an empty capital stack’s billion-dollar sandwich.
The numbers differ rather widely, depending on sources – Ernst & Young counts $1.2 trillion in dry powder; 1,520 funds raised $727.3 billion in 2022, according to Private Equity International; private equity fundraising exceeded $259 billion in the first nine months of 2022, according to Pitchbook — but there’s no denying that at least hundreds of billions of dollars is ready and waiting to enter capital stacks and distressed portfolios across the country from all parts of the private equity universe.
All told, private credit investors account for 12 percent of the $6.3 trillion U.S. commercial credit market, while regional banks account for 40 percent of the total, according to Reuters.
Aside from Blackstone’s $30.4 billion fundraise in April, other heavy hitters have made headlines in recent months: Brookfield Asset Management’s flagship real estate fund, Brookfield Strategic Real Estate Partners IV, raised $17 billion in late 2022; Invesco Real Estate’s U.S. Fund VI closed above its $1.75 billion hard cap in May; and Nuveen Real Estate’s CASA Partners IV fund raised $410 million in October to renovate and reposition multifamily units.
The money appeared because capital markets, like nature, abhor a vacuum.
“De-levering has created opportunities, lack of capital has created opportunities,” said Josh Zegen, founder and managing director of Madison Realty Capital, a private real estate investment firm with more than $10 billion AUM. As for the banking sector shift, “people say it’s over. It’s absolutely not over. We’re seeing every other day a deal fall apart because a bank pulled out,” Zegen said.
As banks retreat, private equity players are prepping their well-timed pounce, sizing up debt and equity environments equally as market duress runs formerly well-capitalized sponsors to exhaustion and eventual submission.
On the credit side, Zegen noted that there’s less appetite available to re-lever positions through A notes, loan-on-loan financing and credit lines, while the debt side is beset by problems associated with the higher cost of capital and increasingly expensive short-term debt, floating-rate debt, and fixed-rate debt from single-asset single-borrower loans and collateralized loan obligations.
“There’s a perception that there’s so much liquidity, but I don’t share that opinion,” Zegen said. “This is a major opportunity for someone like us right now, particularly in the private credit area. But, really, at the end of the day, there’s a lack of supply of capital relative to the demand.”
He added that one fundamental difference between now and the 2008 Global Financial Crisis is that previous downturns carried the perception that, so long as investors or sponsors didn’t lever themselves too badly, they could hold out and wait for the cycle to invariably turn back — but now that offices have entered a structural shift in the way people work and businesses utilize space, all bets are off.
“The problem is in one very important sector of the five major food groups of commercial real estate,” Zegen said, referring to office. “And it’s something that opportunity funds, debt funds, mortgage REITs, collateralized loan obligations – just a huge section of these guys – had a 10 percent to 40 percent exposure to.”
While some sponsors may recoil at the thought of onboarding new investment partners who’ll provide either mezzanine financing or preferred equity stakes in vulnerable capital stacks, the practice will be unavoidable over the next six to 12 months as more loans mature and interest rates remain high: Over $500 billion of CRE debt comes due this year alone, according to the Mortgage Bankers Association.
“Anytime you see this level in asset value repricing and this level of capital retreating, both for structural reasons and, frankly, concern around the environment, that creates opportunities for those of us who have capital and have conviction of where we want to invest it,” Hochfelder said.
Thus, under the pall of 5 percent interest rates, significant portions of that $500 billion debt avalanche will struggle to maintain their covenants, whether that’s debt-service-coverage ratios or loan-to-value ratios, while even those loans that aren’t maturing this year carry interest rate caps that are set to double upon expiration, potentially ballooning expenses, according to David Bitner, executive managing director of global research at Newmark (NMRK). All this will create “distress and distress adjacency” for sponsors who need to pay down at least a portion of their maturing loans to maintain ownership of their properties, or generate new capital altogether for assets sunk underwater, he said.
“You’ll have to go through a loan modification, even if that is splitting into an A‑B structure, where there’s still upside for incremental equity,” Bitner explained. “These are all very sensitive negotiations, they’re going to be one by one, and they’re going to create opportunities for opportunistic capital to come into assets, but you have to have the reckoning first.”
The entrance of private capital into this world of distress is expected to take on two different guises in the months ahead, according to CEOs and analysts.
One route private equity can take is buying distressed loans – loans that are in default or foreclosure – at a significant discount and taking control of a property and riding it out into a high rate of return. Another route is buying performing loans from distressed sellers, who sell loans backed by performing commercial properties at a significant enough discount that private equity firms step into the position with the ability to generate high rates of return, usually in the 15 to 20 percent range. The first avenue offers the chance to buy debt notes on the cheap and foreclose on the entire capital structure once payments are missed. The other allows investors to purchase good properties from desperate sellers willing to sell for 80 cents on the dollar.
“The question is: What price or cost of capital will people look for to step into the fulcrum of distress?” said Ronald Dickerman, president and founder of Madison International Realty, a real estate private equity firm with over $8 billion in capital commitments. “Make no mistake, the equity investors are licking their wounds from their office exposure and, generally speaking, have written down other parts of their office portfolio. There isn’t as much exuberance to dive into the market as quickly as one might think and people are super cautious, especially about the office sector.”
To be fair, there’s a less rapacious side to private equity. That’s specifically found in the preferred equity space, which has seen opportunity funds at Cerberus and Rockpoint, among others, help sponsors deliver loan payments upon maturity through recapitalizations, refinancings, or mezzanine funding on assets that were initially financed at lower rates and higher values.
“A lot of people have thrown their hands up, they don’t have the money, and then XYZ fund comes in,” explained Zegen. “There’s a perception that that’s more secure than buying a piece of real estate today, that it’s more secure in the capital stack, so a lot of private equity firms are doing that.”
Dickerman added that private equity firms will pick their spots in the capital stack at risk-mitigated entry points, avoiding deep distress, and focus more on viable paths into reliable returns, like providing mezzanine loans or preferred equity financing to help roll over construction loans on attractive projects into permanent financing.
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There are several avenues for that money to follow. Different funds cater to different types of CRE investment levels, which vary by asset class, debt funding ratios, and projected rate of return. Open-ended fund vehicles will gravitate toward core and core-plus investments, while closed-end fund vehicles will risk more in the value-add and opportunistic spaces.
Core investments provide stable income with little risk and typically achieve lower annualized returns — think an apartment building in a well-populated town. Core-plus investments carry opportunities for increased returns but only so long as more leverage is used to enhance property improvements, like an occupied multifamily building that needs a new common area.
Value-add investments usually provide no cash-flow upon investment, but carry the opportunity for ample returns once debt has been used to “add value” into the property – as seen in many older, Class A office properties undergoing changes. Finally, opportunistic investments carry the most risk, require the most leverage, and generate the greatest rewards – ground-up developments, empty buildings, and land deals fall under this category.
“You look at equity funds, opportunity funds, core funds, value-add funds, all of that is dealing with struggles that are defensive in nature,” Zegen explained, emphasizing that most funds are currently paying down existing leverage. “Lots of money raised is being used from a defensive standpoint, and the question is: How do I get new money going into 2023 and 2024, and how will that money be capitalized?”
The direction that money goes upon capitalization is the next element of the equation.
With more than $57 billion in global investment capital, Morgan Stanley’s Hochfelder said that her firm is looking to buy “high-quality assets at below replacement cost” and at substantial discounts to their prices from the first quarter of 2022.
“We’re not chasing value traps,” Hochfelder said at the conference. “We’re much more focused — rather than trying to buy a Downtown L.A. office at X percent off peak values, we want to buy the highest-quality assets that we believe have the longest-term demand drivers”
To this end, Morgan Stanley is bullish on acquiring repriced core industrial assets and endorsing its “tremendous long-term conviction” around the multifamily sector, she said.
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Acore’s de Haan said his focus is on top 25 markets, specifically cities like Miami where assets can be had at deep discounts in an environment poised for future growth.
“I follow migration patterns, states and cities where we’ve got strong governance, business-friendly environments, lower cost of housing and lower taxation,” he said. “Those are migration ponds that I think are deep and broad.”
Avi Feinberg, a real estate partner at Fried Frank in New York, said that many of his private equity clients are using the distress to invest in alternative asset classes: marinas, RV parks with amenities, corporate-branded RV parks, and logistics centers.
“Anytime there’s distress, it breathes opportunities. Every cloud has a silver lining for somebody,” Feinberg said. “Some people are unfortunately scarred by the downturn, but there’s others who will find opportunities in that situation.
“As a general matter, there will be opportunity in real estate because real estate hasn’t died,” he added. “That’s what we learned from prior cycles.”
———–
““The backdrop is setting up for a likely scenario where we see more distress than we’ve seen since the Great Recession, and maybe even more distress than in 2008, 2009 and 2010,” said Warren de Haan, founder and managing partner at Acore Capital, one of the largest lenders in commercial real estate. “We have a supply and demand imbalance between the demand for commercial real estate debt and the supply of CRE debt.””
More distress than we’ve seen since the Great Recession, and maybe even more distress than in 2008, 2009 and 2010. That’s quite a prediction from the founder of of the largest lenders in commercial real estate. But that’s the message we’re getting, from a range a figures across this industry. A “supply and demand imbalance” of historic proportions is seemingly just getting is underway with no clear end in sight thanks, in part, to the recent routes in the US’s regional banking system. But it’s not just America’s teetering mid-sized banks that are at the source of this unfolding market turmoil. It’s also the fact that an estimated $1.5 trillion in commercial real estate loans set to come due by the end of 2025, with $500 billion coming due this year alone. Plus there’s the fact that the one big remaining pool of credit — the private equity sector — appears to smell blood in the water and is more than happy to allow the turmoil to ensue as prices and collapse and borrowers become desperate. So we have commercial banks — which comprise about 40 percent of the US commercial credit market — pulling back dramatically at the same time private equity and other private credit investors — which only account for around 12 percent of that market — sitting on the sidelines waiting for this financial time bomb to go off before they swoop in to feed on the ‘distressed’ assets:
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An estimated $1.5 trillion in CRE debt comes due by the end of 2025, according to a report by Morgan Stanley. This maturity wave arrives just as capital markets have seen a vast reduction of liquidity driven by a retrenchment of the U.S. banking system, which has experienced the second‑, third- and fourth-largest commercial bank failures in American history since March and is gearing up for potentially more in the months ahead.Given that regional banks (those with $10 billion to $160 billion in assets) represent nearly 14 percent of commercial real estate lending, the pullback in debt capital from the system at a time when that money is needed to pay down billions in maturities is not exactly an appetizing mix for either investors or property owners.
“If all of that plays out together, you’ll have significantly lower liquidity in debt markets, a huge wall of maturities coming due, a higher interest rate environment, meaning values decline, and you have a banking crisis at the same time, meaning that the amount of distress we expect to see in the system will be exponentially higher than what we’ve seen in the last decade,” de Haan told CO.
“That is the big opportunity for the $400 billion of private equity sitting on the sidelines,” he added.
...
All told, private credit investors account for 12 percent of the $6.3 trillion U.S. commercial credit market, while regional banks account for 40 percent of the total, according to Reuters.
Aside from Blackstone’s $30.4 billion fundraise in April, other heavy hitters have made headlines in recent months: Brookfield Asset Management’s flagship real estate fund, Brookfield Strategic Real Estate Partners IV, raised $17 billion in late 2022; Invesco Real Estate’s U.S. Fund VI closed above its $1.75 billion hard cap in May; and Nuveen Real Estate’s CASA Partners IV fund raised $410 million in October to renovate and reposition multifamily units.
...
“De-levering has created opportunities, lack of capital has created opportunities,” said Josh Zegen, founder and managing director of Madison Realty Capital, a private real estate investment firm with more than $10 billion AUM. As for the banking sector shift, “people say it’s over. It’s absolutely not over. We’re seeing every other day a deal fall apart because a bank pulled out,” Zegen said.
As banks retreat, private equity players are prepping their well-timed pounce, sizing up debt and equity environments equally as market duress runs formerly well-capitalized sponsors to exhaustion and eventual submission.
On the credit side, Zegen noted that there’s less appetite available to re-lever positions through A notes, loan-on-loan financing and credit lines, while the debt side is beset by problems associated with the higher cost of capital and increasingly expensive short-term debt, floating-rate debt, and fixed-rate debt from single-asset single-borrower loans and collateralized loan obligations.
“There’s a perception that there’s so much liquidity, but I don’t share that opinion,” Zegen said. “This is a major opportunity for someone like us right now, particularly in the private credit area. But, really, at the end of the day, there’s a lack of supply of capital relative to the demand.”
He added that one fundamental difference between now and the 2008 Global Financial Crisis is that previous downturns carried the perception that, so long as investors or sponsors didn’t lever themselves too badly, they could hold out and wait for the cycle to invariably turn back — but now that offices have entered a structural shift in the way people work and businesses utilize space, all bets are off.
“The problem is in one very important sector of the five major food groups of commercial real estate,” Zegen said, referring to office. “And it’s something that opportunity funds, debt funds, mortgage REITs, collateralized loan obligations – just a huge section of these guys – had a 10 percent to 40 percent exposure to.”
While some sponsors may recoil at the thought of onboarding new investment partners who’ll provide either mezzanine financing or preferred equity stakes in vulnerable capital stacks, the practice will be unavoidable over the next six to 12 months as more loans mature and interest rates remain high: Over $500 billion of CRE debt comes due this year alone, according to the Mortgage Bankers Association.
...
Adding to the potential distress is the fact that even loans that aren’t coming due soon are still potentially facing a doubling of interest rates next year. In other words, the demand for new capital in this sector over the next couple of years is probably going to be much higher than the $1.5 trillion in expiring loans. Rising rates alone on existing loans is going to effective push many borrowers into a crisis:
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“Anytime you see this level in asset value repricing and this level of capital retreating, both for structural reasons and, frankly, concern around the environment, that creates opportunities for those of us who have capital and have conviction of where we want to invest it,” Hochfelder said.Thus, under the pall of 5 percent interest rates, significant portions of that $500 billion debt avalanche will struggle to maintain their covenants, whether that’s debt-service-coverage ratios or loan-to-value ratios, while even those loans that aren’t maturing this year carry interest rate caps that are set to double upon expiration, potentially ballooning expenses, according to David Bitner, executive managing director of global research at Newmark (NMRK). All this will create “distress and distress adjacency” for sponsors who need to pay down at least a portion of their maturing loans to maintain ownership of their properties, or generate new capital altogether for assets sunk underwater, he said.
“You’ll have to go through a loan modification, even if that is splitting into an A‑B structure, where there’s still upside for incremental equity,” Bitner explained. “These are all very sensitive negotiations, they’re going to be one by one, and they’re going to create opportunities for opportunistic capital to come into assets, but you have to have the reckoning first.”
...
Taken together, it’s not hard to see why so many in the private equity space are viewing the upcoming period as a potential “golden moment”. And yet, as we’re also seeing, many of the players in the private equity space aren’t exactly in a position to simply wait and exploit the upcoming distressed opportunities. Instead, they’re operating from a defensive position. Because private equity isn’t a new player in this space. So the private equity sector isn’t just systematically waiting on the sidelines for things to get worse and more distressed in this space. It’s already experiencing that distress, which, in turn, suggests we might see a lot more hesitancy in the private equity space to pile onto more commercial real estate investments. At least until things get a lot worse:
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For the illiquid world of private credit — which provides debt for commercial real estate projects -– and that of private equity, the recent upheaval in the U.S. regional banking sector and issues plaguing downtown office space has sparked questions surrounding the type of returns CRE can generate for investors.The primary question being: Is a golden moment possible in the darkest of times?
“We’re in a meaningful period of dislocation,” said Lauren Hochfelder, co-chief executive officer of Morgan Stanley Real Estate Investments and head of MSREI Americas, during a Commercial Observer forum in late April. “We’re seeing risk and asset values repriced before our eyes, and I think that’s true across the entire investable universe and certainly across all of private real estate, every sector, virtually every global market.”
The dislocation across markets and asset classes has been driven by numerous external factors, including the secular shift in office usage since COVID-19, but the largest reason for the distress has been the historically rapid interest rate hikes by the Federal Reserve. Those have caused asset values to decline as borrowing costs have spiked. The increased leverage ratios on existing loans have put pressure on borrowers, and, in some circumstances, made it impossible to keep loans current or to refinance maturing loans without an infusion of equity. Moreover, the cost of financing acquisitions or new developments has also skyrocketed, creating a pause in equity markets as they assess the fractured landscape.
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The entrance of private capital into this world of distress is expected to take on two different guises in the months ahead, according to CEOs and analysts.
One route private equity can take is buying distressed loans – loans that are in default or foreclosure – at a significant discount and taking control of a property and riding it out into a high rate of return. Another route is buying performing loans from distressed sellers, who sell loans backed by performing commercial properties at a significant enough discount that private equity firms step into the position with the ability to generate high rates of return, usually in the 15 to 20 percent range. The first avenue offers the chance to buy debt notes on the cheap and foreclose on the entire capital structure once payments are missed. The other allows investors to purchase good properties from desperate sellers willing to sell for 80 cents on the dollar.
“The question is: What price or cost of capital will people look for to step into the fulcrum of distress?” said Ronald Dickerman, president and founder of Madison International Realty, a real estate private equity firm with over $8 billion in capital commitments. “Make no mistake, the equity investors are licking their wounds from their office exposure and, generally speaking, have written down other parts of their office portfolio. There isn’t as much exuberance to dive into the market as quickly as one might think and people are super cautious, especially about the office sector.”
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“You look at equity funds, opportunity funds, core funds, value-add funds, all of that is dealing with struggles that are defensive in nature,” Zegen explained, emphasizing that most funds are currently paying down existing leverage. “Lots of money raised is being used from a defensive standpoint, and the question is: How do I get new money going into 2023 and 2024, and how will that money be capitalized?”
The direction that money goes upon capitalization is the next element of the equation.
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And then there’s the somewhat puzzling cheeriness of Blackstone President and COO Jonathan Gray, who recently observed that “the private credit area is really at a golden moment because we do see tightening out there.” Now, on the one hand, it’s not hard to understand why Gray would be excited on behalf of private equity players who aren’t yet invested in this space. But on the other hand, what about all of Blackstone’s clients who are already heavily invested in commercial real estate? Like the clients who had a $270 million loan on Manhattan rental properties go into “special service” in February? It’s hard to see how it’s a ‘golden moment’ for them. It’s the kind of juxtaposition that serves as a reminder that the interests of the private equity giants like Blackstone don’t always align with the interest of their clients:
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During a May 3 appearance on Bloomberg TV, Blackstone (BX) President and COO Jonathan Gray appeared sunny, despite his surname, as he touted his private equity firm’s recent global real estate investment fund, BREP X, which closed a $30.4 billion fundraising round in mid-April.“We think there’s a real opportunity to deploy more capital,” Gray said. “I think the private credit area is really at a golden moment because we do see tightening out there.”
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The shifting of the tide and subsequent distress has been plain to see: Brookfield (BN) defaulted on $784 million in loans tied to two Los Angeles skyscrapers in February; Blackstone sent a $270 million CMBS loan on a Manhattan multifamily portfolio to special servicing in February; GFP Real Estate defaulted on a $130 million mortgage-backed securities loan for 515 Madison Avenue in December; and just last month RXR defaulted on a $260 million loan on 61 Broadway.
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So we have figures predicting potentially more market distress for commercial real estate than was experience during the Great Recession of 2008 at the same time Blackstone’s Jonathan Gray is seeing a “golden moment” for the private equity sector. It’s that seemingly contradictory mix of ominous warnings and enthusiastic anticipation that captures the dynamic unfolding here: the worse things get for the existing owners of commercial real estate property, the better it’s eventually going to be for private equity investors sitting on the side-lines.
Blackstone is Coming to the Rescue! But Only for the Best. And Not Just Yet. They Just Have to Wait for Everything to Get Worse, First.
But, again, what about all of Blackstone’s clients who aren’t simply sitting on the sidelines but have been investing in this space for years? It doesn’t sound too “golden” for them? And that brings us the following June 5 article, published two weeks ago and just a few days after the above article, that has another notable figure in this space with some optimistic predictions of his own: According to Alfred Brooks, head of JP Morgan’s commercial real estate group, all the predictions about a collapse of the commercial real estate sector, and office buildings in particular, are just wrong. Why? Well, according to Brooks, the private equity space has all sorts of cash sitting on the sidelines waiting to swoop in and create a market floor. Brooks specifically pointed to the $30.4 billion Blackstone Real Estate Partners X fund, closed to new funds back in April, as evidence of this office saving force getting underway.
Of course, the devil is in the details on matters like this, as we see with some of the conditions Brooks gives on his optimism, like the fact that he’s only predicting sunny days ahead for the highest quality “Class A” commercial office properties. The Class B and C office properties could go “down to the last bottom,” according to Brooks, an apparent reference to price levels not seen since 2008 .
So back in May, we have Jonathan Gray of Blackstone seeing a “golden moment” for private equity in this sector, less than three months after one of Blackstone’s existing CRE funds sent a $270 million loan into “special services”. And a month later, the head of JP Morgan’s commercial real estate division is pointing to Blackstone’s newly created CRE fund as evidence that private equity is waiting in the wings to save the commercial office space...or at least the highest quality commercial office space. The lower quality offices are pretty doomed, Brooks admits. Yes, the big players have a plan and they’re excited to talk about: a plan to wait for everything to fall apart and scoop up the best deals when it happens. Sure, it will be a catastrophe, but not for everyone:
Insider
Blackstone will help prevent an office market ‘catastrophe’, says JPMorgan’s commercial real estate chief
Al Yoon
Jun 5, 2023, 4:00 AM CDT* Reports on the death of offices are “just wrong,” JPMorgan’s commercial real estate chief said.
* Despite rough times today, Blackstone is eyeing opportunities to snap up deals, he said.
* But the market bottom isn’t yet in sight, with delinquencies just starting to ramp up.Office buildings are losing value as more people opt to work from home and companies need less space.
Debt defaults by investors such as Brookfield and Pimco have signaled that even the most prominent holders of the properties have given up on certain buildings. Office-building prices fell nearly 7% in April, year over year, and that drop is accelerating, according to MSCI.
But some investors are preparing to strike as valuations drop, according to Alfred Brooks, who as head of JPMorgan’s commercial real estate group oversees more than $30 billion of annual originations. That’s likely to prevent prices from tumbling into the abyss.
No ‘catastrophe’ for the office market
“You get the headline written that the office market is a catastrophe,” Brooks said during a JPMorgan outlook webinar on June 1. “That’s just wrong.”
“If it was so bleak, then why do we have people like our friends in the private equity side already” raising money for the sector, he said, noting that real-estate giant Blackstone is raising funds. “So obviously, there’s going to be a bottom put under the market,” Brooks continued.
In April, Blackstone announced the final close of its Blackstone Real Estate Partners X, the largest real estate fund ever raised, with $30.4 billion in capital commitments. It noted that it has shifted its portfolio away from stressed sectors such as offices, and was favoring better performing areas like logistics, rental housing, hospitality, and data centers.
There are signals that demand could return — at least for the better buildings. According to JLL, a commercial-real-estate services firm, there are “promising signs” from corporate tenants of a gradual re-entry to offices, so much that companies could eventually find themselves short of space.
It’s unclear when office prices will bottom out
Still, a bottom in the office sector isn’t expected anytime soon.
Office delinquency rates were suppressed because tenants were locked into long-term leases. Now, they’re ticking higher. Last month, a “huge spike” in distressed office debt dragged the delinquency rate of securitized commercial mortgages higher by 0.53 percentage points to 3.62%, for the largest single-month increase since the COVID-19 pandemic was emptying buildings in June 2020, according to Trepp.
The “tipping point” that investors were waiting for on office debt appears to be here, Manus Clancy, a senior managing director at Trepp, wrote in a June 1 post to clients, suggesting delinquency data is finally beginning to reflect the long-projected distress.
For all of his measured comments, Brooks’ head wasn’t in the sand. The prices of lower tier, Class B and C office properties could go “down to the last bottom,” he noted, referring to the 2008 financial crisis. As that crisis unfolded, the delinquency rate for securitized commercial property loans topped out in 2012 at a record 10.34%, nearly three times that of today, according to Trepp.
Brooks connected his more bearish comments to the troubled large markets, like Los Angeles. In addition to some Class A properties that are retaining tenants, there are other areas that are still “okay,” such as the Sunbelt, he said.
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Buying the office dip
Even if a severe correction does emerge in commercial real estate, Brooks said there will be “victors,” — including JPMorgan — that’ll look to purchase in advance of the next upturn, which typically lasts 10 to 12 years.
There hasn’t been a true correction in the market since 2008, he said.
“Frankly, actually, Blackstone’s pretty smart,” Brooks said. “They’re probably going to be able to catch this market at a nice low point and they’re going to probably have some very good deals they’re going to be able to underwrite because there isn’t tremendous liquidity, particularly for B- and C‑grade office.”
“I don’t see that changing for a few years,” he said.
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““If it was so bleak, then why do we have people like our friends in the private equity side already” raising money for the sector, he said, noting that real-estate giant Blackstone is raising funds. “So obviously, there’s going to be a bottom put under the market,” Brooks continued.”
If the prospects for the commercial real estate market are so awful, why did Blackstone just create a new fund designed for these kinds of investments? That’s the message not from Blackstone but instead from Alfred Brooks, the head of JP Morgan’s commercial real estate group. Blackstone is going to create the ‘bottom’ for the commercial real estate market, according to Brooks. There is no catastrophe on the horizon. If there was, Blackstone wouldn’t have created its largest commercial real estate fund ever back in April, the Blackstone Real Estate Partners X. At least that’s the message JP Morgan is putting out to the public:
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Debt defaults by investors such as Brookfield and Pimco have signaled that even the most prominent holders of the properties have given up on certain buildings. Office-building prices fell nearly 7% in April, year over year, and that drop is accelerating, according to MSCI.But some investors are preparing to strike as valuations drop, according to Alfred Brooks, who as head of JPMorgan’s commercial real estate group oversees more than $30 billion of annual originations. That’s likely to prevent prices from tumbling into the abyss.
No ‘catastrophe’ for the office market
“You get the headline written that the office market is a catastrophe,” Brooks said during a JPMorgan outlook webinar on June 1. “That’s just wrong.”
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In April, Blackstone announced the final close of its Blackstone Real Estate Partners X, the largest real estate fund ever raised, with $30.4 billion in capital commitments. It noted that it has shifted its portfolio away from stressed sectors such as offices, and was favoring better performing areas like logistics, rental housing, hospitality, and data centers.
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And then we get to the many clarifications on Brooks’s optimism. Like the fact that no one is expect a bottom in the commercial real estate market any time soon and a “tipping point” appears to have been reached in terms of owners being pushed into delinquency, with the “Class B” and “Class C” lower quality properties still poised to go “down to the last bottom”, when delinquency rates were triple where they are today. Despite all the happy talk, things are poised to get a lot worse for this market:
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There are signals that demand could return — at least for the better buildings. According to JLL, a commercial-real-estate services firm, there are “promising signs” from corporate tenants of a gradual re-entry to offices, so much that companies could eventually find themselves short of space....
Still, a bottom in the office sector isn’t expected anytime soon.
Office delinquency rates were suppressed because tenants were locked into long-term leases. Now, they’re ticking higher. Last month, a “huge spike” in distressed office debt dragged the delinquency rate of securitized commercial mortgages higher by 0.53 percentage points to 3.62%, for the largest single-month increase since the COVID-19 pandemic was emptying buildings in June 2020, according to Trepp.
The “tipping point” that investors were waiting for on office debt appears to be here, Manus Clancy, a senior managing director at Trepp, wrote in a June 1 post to clients, suggesting delinquency data is finally beginning to reflect the long-projected distress.
For all of his measured comments, Brooks’ head wasn’t in the sand. The prices of lower tier, Class B and C office properties could go “down to the last bottom,” he noted, referring to the 2008 financial crisis. As that crisis unfolded, the delinquency rate for securitized commercial property loans topped out in 2012 at a record 10.34%, nearly three times that of today, according to Trepp.
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Finally, there’s the ‘pot of gold at the end of the bloody rainbow’ scenario awaiting this sector: once the commercial real estate market is distressed enough, there’s bound to be great deals. It’s a bright future ahead...at least for those not already heavily invested in the commercial real estate market. That’s the message from the head of JP Morgan’s commercial real estate investment division:
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Even if a severe correction does emerge in commercial real estate, Brooks said there will be “victors,” — including JPMorgan — that’ll look to purchase in advance of the next upturn, which typically lasts 10 to 12 years.There hasn’t been a true correction in the market since 2008, he said.
“Frankly, actually, Blackstone’s pretty smart,” Brooks said. “They’re probably going to be able to catch this market at a nice low point and they’re going to probably have some very good deals they’re going to be able to underwrite because there isn’t tremendous liquidity, particularly for B- and C‑grade office.”
“I don’t see that changing for a few years,” he said.
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There hasn’t been a true correction in the market since 2008, according to Brooks. Yikes. But that also explains the eager anticipation. The creditors have property owners over a barrel and they know it.
Blackstone’s Pension Fund Clients are Coming to the Rescue. To Save Themselves
Of course, it’s not Blackstone that’s purportedly establishing this market floor for commercial real estate prices. It’s the investors piling money into Blackstone’s funds like the Blackstone Real Estate Partners X fund Blackstone ‘closed’ to new funding in April. So who are the investors of that fund who will be helping to establish the market floor as JP Morgan eagerly awaits the arrival of the anticipated market bottom? Exactly who we should probably expect at this point: Public pension funds:
Pensions & Investments
Blackstone closes $30.4 billion opportunistic real estate fund
Arleen Jacobius
April 11, 2023 03:47 PMBlackstone on Tuesday announced the close of its largest real estate fund, Blackstone Real Estate Partners X, at $30.4 billion, a news release said.
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Blackstone has been raising the fund since 2021, according to filings with the SEC.
The latest opportunistic real estate fund surpassed its predecessor fund, Blackstone Real Estate Partners IX, which closed at $20.5 billion in 2019.
Investors in the news fund include the $306 billion California State Teachers’ Retirement System, West Sacramento; $143.3 billion State of Wisconsin Investment Board, Madison; $109.3 billion North Carolina Retirement Systems, Raleigh; $98.9 billion Virginia Retirement System, Richmond; and $33.7 billion Pennsylvania State Employees’ Retirement System, Harrisburg.
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“Investors in the news fund include the $306 billion California State Teachers’ Retirement System, West Sacramento; $143.3 billion State of Wisconsin Investment Board, Madison; $109.3 billion North Carolina Retirement Systems, Raleigh; $98.9 billion Virginia Retirement System, Richmond; and $33.7 billion Pennsylvania State Employees’ Retirement System, Harrisburg.”
Behold: all of the investors listed in record-setting Blackstone Real Estate Partners X fund are public pension funds. That’s who is ultimately creating the floor on commercial real estate prices. Hopefully! Because there’s no guarantee the floor is actually going to be created. At least not by the same pension funds trying to ‘catch this falling knife’ today unless they just keep shoveling money into commercial real estate until there’s an eventual turnaround.
And we also have to ask: so if commercial real estate is such a good investment right now, why aren’t we seeing a lot more players getting into this sector? Sure, pension funds have time horizons and risk profiles that not all investors have but that still doesn’t explain why we aren’t reading about wider interest in scoring a great market opportunity in this sector. Why just pension funds in the news? Are pension funds being set up as some sort of ‘bag holder’ in the ensuing market rout?
And that brings us to the following article from back on Halloween of 2022, discussing what was then a changing trend in pension fund investing: pension funds were starting to pull back from the record levels of investing they had been doing in the commercial real estate sector in the first half of the year. In other words, pension funds have been enthusiastically making themselves the ‘bag holders’ for commercial real estate market in the lead up to the anticipated ‘distressed debt’ firesale bonanza that investors are expecting some time later this year:
Connected Real Estate Magazine
Pension funds scale back on CRE investing
By Joe Dyton
October 31, 2022U.S. public pension funds have started to scale back on their investments into the commercial real estate industry, The Wall Street Journal reports. The reversal comes after these funds had invested money into CRE at a record rate during the first half of 2022.
The retirement funds made $32.6 billion of new financial commitments to offices, buildings, warehouses and other CRE properties in the first half of this year—an approximate 40 percent increase from the same time frame in 2021, according to Ferguson Partners, a professional services firm that tracks the CRE industry.
The high demand for CRE property during the first half of this year was in part due to investors coming back to the market following the start of the COVID-19 pandemic, Ferguson director Scott McIntosh told The Wall Street Journal.
“Real estate was generating strong returns,” McIntosh said. “We were seeing strong rental growth and strong transaction volume through 2021 and a lot of that momentum flowed into the first half of 2022.”
Unfortunately, increased borrowing rates are not a good sign for an interest-rate sensitive industry like CRE. Plus, building owners haven’t been in the best position to raise rents because of increased concerns about a recession.
Ferguson Partners is still calculating potential third-quarter pension fund investments, but they are most certainly going to drop during the back half of 2022, according to McIntosh. He pointed to inflation, labor costs and supply-chain disruptions, which have made building more expensive, as reasons there could be fewer pension-fund commitments during the third quarter.
CRE fundraising also on the decline
Private equity funds and other CRE investors that look to pensions when they raise money for their new funds have also noticed a difference, according to The Wall Street Journal. Private equity firm managed CRE funds raised $112.8 billion from pension funds and other investors worldwide as of October 20. The time last year, almost $160 billion was raised, according to data firm Preqin. Market experts are projecting fourth quarter fundraising could fall well below the record $80 billion raised during the final three months of 2021.
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CRE sales are also down—the $171.2 billion worth of commercial property acquired during the third quarter is a 21-percent drop off from the same time period in 2021, per MSCI data. Decreased sales have made pension funds and other investors hesitant to put more money into CRE because it’s uncertain if property values will continue to fall.
A lot of pensions have now scaled back on future CRE investments because of what’s known as the “denominator effect,” The Wall Street Journal reports. They want their property holdings to only make up a certain percentage of their entire portfolio.
Meanwhile, some pensions are focusing on potential opportunities with troubled properties during an economic downturn. For example, the Connecticut Retirement Plans and Trust Funds is looking to “take advantage of the lack of capital in certain areas” as well as “distress in the market,” a spokeswoman said.
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“U.S. public pension funds have started to scale back on their investments into the commercial real estate industry, The Wall Street Journal reports. The reversal comes after these funds had invested money into CRE at a record rate during the first half of 2022.”
Yes, it was back in October, just around eight months ago, when we were getting reports that pension funds were finally pulling back from the record commercial real estate investments the sector made in the first half of 2022. That’s part of the context of the optimism we hear from JP Morgan about Blackstone’s new commercial real estate fund being an example of how the private equity sector is going to step in and provide the ‘floor’ from the commercial real estate market at the same time we’re still hearing about how commercial real estate could fall much further before truly hitting a bottom. It’s pension funds that have been ‘catching a falling knife’ in the market for all along and that hasn’t exactly stopped the fall. Sure, eventually there’s going to be a bottom, and pension funds will invariably be invested in the sector to appreciate the gains from that point. But with that bottom potentially years ago in many real estate markets, it’s hard not to see this as a relatively high risk investment:
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The retirement funds made $32.6 billion of new financial commitments to offices, buildings, warehouses and other CRE properties in the first half of this year—an approximate 40 percent increase from the same time frame in 2021, according to Ferguson Partners, a professional services firm that tracks the CRE industry....
Unfortunately, increased borrowing rates are not a good sign for an interest-rate sensitive industry like CRE. Plus, building owners haven’t been in the best position to raise rents because of increased concerns about a recession.
Ferguson Partners is still calculating potential third-quarter pension fund investments, but they are most certainly going to drop during the back half of 2022, according to McIntosh. He pointed to inflation, labor costs and supply-chain disruptions, which have made building more expensive, as reasons there could be fewer pension-fund commitments during the third quarter.
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At the same time, we can see how some pension funds were preparing to taking advantage of upcoming opportunities to snag a good deal on the expectation of a slew of distressed properties that would be coming on the markets. That’s good news for pension funds that yet aren’t invested in commercial real estate. But not so good for the funds already in this sector, which is presumably quite a few funds given the level of interest pension funds have had in private-equity-led real estate investments over the last decade:
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CRE sales are also down—the $171.2 billion worth of commercial property acquired during the third quarter is a 21-percent drop off from the same time period in 2021, per MSCI data. Decreased sales have made pension funds and other investors hesitant to put more money into CRE because it’s uncertain if property values will continue to fall.A lot of pensions have now scaled back on future CRE investments because of what’s known as the “denominator effect,” The Wall Street Journal reports. They want their property holdings to only make up a certain percentage of their entire portfolio.
Meanwhile, some pensions are focusing on potential opportunities with troubled properties during an economic downturn. For example, the Connecticut Retirement Plans and Trust Funds is looking to “take advantage of the lack of capital in certain areas” as well as “distress in the market,” a spokeswoman said.
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So as we can see from that October 2022 report, pension funds were entering into 2023 with a mix of larger exposure in this sector but also potential opportunity. It’s presumably going to be a mix for these long-term investors in the sector. But as the following Business Insider piece from Apil describes, pension funds are indeed expected to ‘take a bath’ on their commercial real estate investments. CalSTRS, the California public pension fund, is described as already cutting the valuation of its office real estate holdings by 20% based on the Fed’s interest rate hikes alone. Note that this report was from just two weeks after the above report listing the pension fund investors in the Blackstone Real Estate Partners X fund. Also note that CalSTRS is one of those investors:
Insider
Banks aren’t the only ones that hold risky commercial-real-estate debt. Pension funds are about to feel the pain, too.
Al Yoon
Apr 24, 2023, 2:01 PM CDT* Pension funds, REITs, and insurers hold more than $1.2 trillion in commercial-real-estate debt.
* CalSTRS, a California pension fund, told the FT it will be writing down its real-estate portfolio.
* “This is just the beginning” for funds, said Trepp’s Manus Clancy.Investor angst over risky commercial real estate has exploded in recent weeks with expectations that banks that hold billions of dollars in the debt are too weak to absorb any losses.
But while banks hold about half of all US commercial-real-estate debt, there are other big holders that are starting to feel the pain, especially over holdings of office properties suffering from the rise of remote or hybrid work schedules. Among them are the large pension funds, REITs, and insurance companies, together accounting for more than $1.2 trillion — or 22% — of the $5.62 trillion in total commercial-real-estate debt outstanding, according to BofA Global Research.
The holdings took on new meaning last week after the California State Teachers Retirement System, or CalSTRs, told the Financial Times it would be writing down the value of its $52 billion in real-estate holdings because higher borrowing costs on the heels of Federal Reserve interest rate hikes have sacked property values. In the office sector alone, values are likely down 20% just based on the rate move, Christopher Ailman, CalSTRS chief investment officer, told the FT.
“This is just an indication of what’s to come,” said Manus Clancy, a senior managing director at Trepp, a commercial-real-estate-data firm, said about the pension woes on the TreppWire podcast last week.
“This is the beginning of what will be a lot of this from the funds, from the private equity guys, from the insurance companies,” Clancy said. “There will be a lot of reductions in equity values over the next couple of years, or sooner. It will be heavily tilted toward office.”
As the values drop, the refinancing of some $2.5 trillion in debt over the next five years will be a tall order for landlords as they face a tightening of lending standards on top of the higher interest rates. Already, some big landlords have chosen to default, including Brookfield on $161 million in debt tied to office properties around Washington, DC, Bloomberg reported last week.
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Some pension funds were already planning to reduce their exposures to commercial real estate even before the recent bank failures magnified the risks.
In September, fund managers at Artemis Real Estate Partners and PGIM Real Estate said at a Bisnow conference that their investors indicated they’d be reducing allocations to real estate, just because the assets had been outperforming others. Asset allocations of their investors were “out of whack,” Cathy Marcus, PGIM’s head of US equity, said at the conference.
CalSTRS reported double-digit returns over a 10-year period, making it a top performing asset class, according to the FT.
International investors are bracing for the worst. Some 39% of the 100 investors from 14 countries surveyed for the Q1 2023 Pulse Report by AFIRE — an association for international investors focused commercial property in the US —said they planned to reduce their US holdings at least somewhat in 2023, compared with 27% that intend to increase their positions.
There is money on the sidelines, however. With the availability and pricing of debt impeding deals, 70% of the AFIRE respondents said they anticipated “meaningful distressed acquisition opportunities as soon as the next six months.”
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“But while banks hold about half of all US commercial-real-estate debt, there are other big holders that are starting to feel the pain, especially over holdings of office properties suffering from the rise of remote or hybrid work schedules. Among them are the large pension funds, REITs, and insurance companies, together accounting for more than $1.2 trillion — or 22% — of the $5.62 trillion in total commercial-real-estate debt outstanding, according to BofA Global Research.”
Get ready for the pain. That was warning message blaring back in April for the big holders in commercial real estate, with pension funds being amount the biggest of those big holders. Even California State Teachers Retirement System (CalSTRs), one of the investors in the Blackstone Real Estate Partners X fund, announced it would be writing down the value of its $52 billion in real estate holdings, with a 20% drop in the value of those holdings due to the Fed’s interest rates moves alone. How much further are those holdings going to drop before the bottom is established? Time will tell, but note the time frame market experts are talking about here: years of depreciating values. Not months but years. That’s a great sign for opportunistic bottom-feeders with a lot of cash but not so great for the existing investors. And as experts also warn, a lot of pension funds are already relatively overweighted in their commercial real estate holdings, which obviously does not bode well for those funds:
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The holdings took on new meaning last week after the California State Teachers Retirement System, or CalSTRs, told the Financial Times it would be writing down the value of its $52 billion in real-estate holdings because higher borrowing costs on the heels of Federal Reserve interest rate hikes have sacked property values. In the office sector alone, values are likely down 20% just based on the rate move, Christopher Ailman, CalSTRS chief investment officer, told the FT.“This is just an indication of what’s to come,” said Manus Clancy, a senior managing director at Trepp, a commercial-real-estate-data firm, said about the pension woes on the TreppWire podcast last week.
“This is the beginning of what will be a lot of this from the funds, from the private equity guys, from the insurance companies,” Clancy said. “There will be a lot of reductions in equity values over the next couple of years, or sooner. It will be heavily tilted toward office.”
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Some pension funds were already planning to reduce their exposures to commercial real estate even before the recent bank failures magnified the risks.
In September, fund managers at Artemis Real Estate Partners and PGIM Real Estate said at a Bisnow conference that their investors indicated they’d be reducing allocations to real estate, just because the assets had been outperforming others. Asset allocations of their investors were “out of whack,” Cathy Marcus, PGIM’s head of US equity, said at the conference.
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So how soon can we expect market conditions to get bad enough that the project fire sales of distressed commercial properties starts hitting the markets? 70% of the 100 investors from 14 countries surveyed for the Q1 2023 Pulse Report by AFIRE said they expected “meaningful distressed acquisition opportunities as soon as the next six months.” Keep in mind what was saw in the first article from a couple of weeks ago: The “tipping point” that investors were waiting for had arrived. That tipping point being the expiration of long-term tenant leases on a lot of commercial properties that is now pushing a number of properties into delinquency:
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There is money on the sidelines, however. With the availability and pricing of debt impeding deals, 70% of the AFIRE respondents said they anticipated “meaningful distressed acquisition opportunities as soon as the next six months.”
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Exploitable mass distress is just around the corner for commercial real estate. That’s the prediction. And as we’ve seen, it’s a prediction that has the private equity industry brimming with anticipation. That, despite the fact that pension funds , the largest clients in the private equity space, have been piling into this same distressed market in recent years under private equity’s guidance of and will invariably be the owners of a number of those “meaningful distressed acquisition opportunities.” It’s the combination of warnings about great pain to come for the pension funds who have already invested in this space coupled with kind of enthusiasm that we’re seeing that raises the question: Are we seeing the set up for a federal bailout of the commercial real estate sector? A bail that is spun as a bailout for pension funds? Because that might explain, in part, the enthusiasm we’re hearing.
The Pre-Pandemic Pension Plan: Give Us All Your Commercial Property. And Rental Properties
But it’s not just the enthusiasm on display in the private equity sector in the face of this exploitable opportunity that is so troubling in this picture. It’s also the fact that the exploitable crisis in commercial real estate is only one example of exploitation in this story of the pension fund industry’s deepening love affair with private-equity real estate over the last decade. As the following The Real Deal article except describes, the pension fund industry has been quietly getting into another area of real estate and, fortunately for the pension funds, there’s ongoing and growing demand for these kinds of properties: the multi-family residential rental properties. Yes, pension funds are increasingly the owners of apartment builds and other residential rental portfolios.
But while residential properties fortunately aren’t facing the kind of market meltdown their commercial real estate counterparts are facing, there’s still allegation of exploitation. Except it wasn’t the pension funds getting exploited with distressed properties. Instead, it’s the pension funds seemingly doing the exploiting, although it’s technically the private equity firms managing these properties on behalf of their pension fund clients doing the exploiting. Specifically, it turns out large investments have been made in rental properties in locales with rent-control policies. And while many of these rent controlled properties have seen new capitol investments made by their new owners intended to increase the property values and maximize the return on the investment, they’ve also seen large number of evictions and in particular the eviction of rent-controlled units. The brutal management practices are, in turn, justified as necessary in order to return to the public pensions the high yields they need to stay solvent in an era of low interest rates. Yes, the retirements of public teachers, firefighters, police officers, and other state employees is increasingly getting intertwined with cruelest aspects of vulture capitalism.
Also note the date of the following article: March 2, 2020, right before the scope of the COVID19 pandemic became clear. And weeks before Bill Ackman made what has been called the most profitable trade in history as the markets swooned over the ensuing global shutdown. Keep that in mind with the following article: right before everything kind of all fell apart, one day before the Fed dropped interest rates and two weeks before the Fed’s second rate cut that took rates to historic lows and forced an even greater hunt for yield on the part of investors like pension funds. In other words, this article was published right before pension funds got really desperate. Which is ominous, because it describes what the pension fund industry had already been doing in the private-equity-led residential real estate space for the last decade out of a desperation for higher yields and it wasn’t good:
The Real Deal
Pension fund money is getting tangled in some controversial housing deals
Fraught politics and stricter housing laws are causing new concerns
By Georgia Kromrei
Mar 2, 2020, 11:00 AMMadison Realty Capital, a private real estate investment firm heavily backed by public pension money, has been stuck with a nearly half-empty rental portfolio in Manhattan’s East Village.
When the New York-based firm financed controversial landlord Raphael Toledano’s purchase of the 16 buildings in 2015, critics called the deal overleveraged. Madison lent $124 million for a portfolio that cost $97 million.
But the lender had its reasons.
The firm, led by Josh Zegen, Brian Shatz and Adam Tantleff, had just landed a $100 million commitment from the New York State Teachers’ Retirement System, which manages a $122.5 billion pension fund. And the pressure was on: If the landlord failed to renovate and convert a bunch of its 226 rent-stabilized units to market-rate, he would be unable to make his loan payments.
Of course, Toledano did fail. Low-rent tenants moved out, but renovations went unfinished — rendering many apartments unlivable. Now, the East Village portfolio is mired in bankruptcy proceedings that have dragged on since 2017, impacting all parties that invested.
“The owner of the properties demolished the vacant units a few years ago, and therefore the vacant units are not habitable at this time,” a spokesperson for Madison told The Real Deal, noting that the company still does not own them.
Toledano and his attorney declined to comment.
More than half a year since New York overhauled its rent law, multifamily landlords and their lenders — from family-run firms and local banks to larger institutional players — have been feeling the heat. But another significant group of investors is exposed to the new rent regime: public school teachers, firefighters and other state employees.
Four of the largest public pension systems in New York and California committed more than $30 billion to private real estate funds held by Brookfield Asset Management, Blackstone Group, Apollo Global Management and the Carlyle Group, according to the pension funds’ annual financial statements.
Nearly all of those private equity giants have made big investments in rent-regulated multifamily properties in recent years.
Madison, a smaller fish by comparison, has also touted its appeal to public pension funds and other institutional investors with “superior risk-adjusted returns.”
Such pitches are often made by placement agents who try to persuade pension funds to invest billions of dollars in real estate and other assets, according to several insiders. And while the funds almost never oversee the management of properties, in many cases, the returns they are seeking can drive speculative bets.
The top priority for public pension funds, of course, is to deliver the best returns to those who put their future retirement savings on the line. But since elected officials often use them to advance social causes, such as poverty reduction and affordable housing, being associated with driving out rent-regulated tenants can create more than a few public-image concerns.
Tom Hester, a managing director on the real estate team at advisory firm StepStone — which has received $200 million in commitments from the New York State teachers’ fund and consults on the retirement system’s investments — said the stakes are high for pension funds that pour money into rent-stabilized housing in today’s political environment.
Many are becoming all the more cautious when investing in cities like New York and San Francisco to avoid getting tangled up in “the business of having to evict someone,” Hester said.
Fund frenzy
Overall, pension funds are investing more aggressively in real estate as they look further beyond the stock market and fixed-income investments.
“Real estate still provides an outsize return over other asset classes,” said Jeffrey Scott, who runs the commercial brokerage Eastdil Secured’s New York City office.
In 2019, public pension funds in the “billion dollar club” — a list of 412 of the world’s largest investors tracked by private equity research firm Preqin — were the largest single source of funding for private equity firms.
Public pension funds provided a total of $704 billion to private equity, according to Preqin. The next largest source of capital, sovereign wealth funds, provided $272 billion.
“Pensions are what really drive the market at the end of the day. Their appetite or lack thereof determines a lot of transactions,” Scott noted.
And with interest rates close to rock bottom, pension funds are keeping their return expectations high, said Savills’ chief economist Heidi Learner, who added that many are targeting returns of 7 percent or higher. As a result, she noted, some are going to have to up their bets on real estate and other alternative investments to meet those goals.
The California State Teachers’ Retirement System (CalSTRS) has shown a particularly strong interest in real estate and now has nearly $35 billion invested in property around the country. After years of exceeding its real estate target allocation of 13 percent, in its January board meeting, the state pension fund solidified a plan to increase that figure to 15 percent, from which it expects a 6.3 percent return.
LCOR, a New York-based development firm controlled by the California teachers’ pension since 2012, backed a deal in January to build a large apartment building on Coney Island from the ground up. The company signed a 99-year ground lease to take over a nearly full-block parking lot on Surf Avenue that allows for about 325,000 buildable square feet.
“We are currently in the initial planning stages and anticipate a mixed-income residential development with up to 30 percent of the apartments designated as affordable,” LCOR’s senior vice president, Anthony Tortora, told TRD at the time.
While pension money has been present in New York City real estate for years — especially large office towers, rental buildings and other cash-flowing assets — it’s less common in ground-up development, which carries its own risks.
Unusual in this case is CalSTRS’ role as a partner in the development venture rather than providing capital to an outside adviser like Morgan Stanley to invest the capital, said Jeffrey Julien, a managing director in JLL’s New York office.
“Pension funds are looking to development, taking on the risk and having a higher yield on investment,” said Julien, who was part of the brokerage team that arranged the financing for the Coney Island ground lease deal.
He added that pension funds and other institutional investors, wary of the regulatory changes taking place in New York, have become more interested in funding ground-up developments covered by the state’s tax incentive program dubbed Affordable New York.
But Eric Anton, a veteran investment sales broker who leads Marcus & Millichap’s capital markets group in New York, underscored the preference among many pension funds to keep a low profile. While funds are upping their investments in real estate, they’re also keenly aware of their fiduciary responsibility and mandate for social responsibility, he noted.
“The pensions are extremely important, but it’s quiet,” Anton said. “These are the kind of people who pay publicists to stay out of the newspaper.”
A deal undone
In less than two years, Toledano’s East Village deal went bad and Madison moved to foreclose on the landlord’s firm Brookhill Properties.
But the 2017 bankruptcy proceeding came amid accusations that the lender had demanded returns that were impossible to deliver without aggressive management tactics — a move that carried both financial and reputational consequences.
Then-Attorney General Eric Schneiderman lambasted Madison’s strategy, pointing to an investor memo that stated Toledano planned to vacate, renovate and deregulate nearly half of the 279 units in the portfolio within the first two years. In some of the buildings, the required turnover rate was as high as 80 to 100 percent.
“Tenant advocates argue that landlords displace tenants,” one multifamily owner said on the condition of anonymity, “when their investors are the ones telling them to clear people out and raise the rents.”
A 2015 investor pitch to the Public Employees Retirement Association of New Mexico, obtained through a Freedom of Information Act request, shows Madison promoted returns of more than 9 percent over the benchmark S&P U.S. Leveraged Loan Index.
Madison did not comment on its pension fund holdings or the promises it made to its investors.
Aggressive investment strategies can sometimes lead to the blacklisting of some investment firms, according to Doug Weill, founder and co-managing partner at the real estate advisory firm Hodes Weill.
“There are numerous examples of pension money managers that had spectacular falls from grace,” he said. “They just kind of withered away as their clients abandoned them on future fund raises.”
One of the most notable “falls from grace,” he noted, was Broadway Partners, which made a series of high-profile acquisitions ahead of the financial crisis, flush with money from institutional investors that included pensions. After the crisis, the company defaulted on several properties and was forced to sell off the majority of its portfolio.
But that has yet to happen in Madison’s case.
The New York State teachers still have a stake in the firm’s debt deals, according to the pension fund’s most recent annual report (but that doesn’t show how that investment is performing).
The decision to invest with Madison never came up for a vote in the organization’s headquarters on the outskirts of Albany, where its board meets four times each year in a chamber behind tinted glass.
A spokesperson for NYSTRS said its $100 million commitment to Madison’s fund “did not require additional or secondary approval at a board meeting” because it did not exceed the pension fund’s limit on single investments — so it was rubber-stamped without a vote.
Last November, the Texas Municipal Retirement System made its own $100 million commitment to one of Madison’s four debt funds, which have raised more than $2.8 billion to date. Nick O’Keefe, lead investment attorney at the statewide retirement system, said a Texas statute that exempts private equity investments from the Freedom of Information law makes the state more attractive to firms like Madison.
“They say, ‘It’s more appealing for us, because you’ll protect our information,’” O’Keefe, told TRD. “There’s a certain amount of truth to it.”
But that can cause even bigger headaches when the information surfaces. Apart from the negative headlines, public pension funds are wary of being perceived as “taking fiduciary risks with other people’s money,” StepStone’s Hester noted.
“You don’t want a situation where you’re seen as gambling when the reason you exist is to put bread and milk on the table of pensioners,” he said.
The big pitch
When Blackstone’s Stephen Schwarzman opened his firm’s third quarter earnings call, he had a clear message for investors: The private equity giant’s holdings — including more than $320 billion in real estate — provide returns to public pension funds that are unattainable in fixed-income investments.
“The very strong returns we generate, particularly in the current low-interest rate environment, enable teachers, police officers, firemen and other public and corporate sector employees to retire with sufficient savings and secure pensions,” Schwarzman said.
Among public pension-backed private equity firms, Blackstone leads the pack with more than $9.7 billion in commitments, investments and assets under management from seven leading public pension funds in New York and California, according to the funds’ annual financial reports.
That includes the New York State Common Retirement Fund, which has $207.4 billion in assets under management, including $3.6 billion invested with Blackstone, records show, and the California Public Employees’ Retirement System (CalPERS), which manages $396.9 billion and has $2.7 billion invested with Blackstone.
Those investments have helped to fuel some of the world’s largest commercial real estate plays, including Blackstone’s $18.7 billion purchase of GLP’s industrial warehouse portfolio last year and the firm’s $5.3 billion purchase, with Ivanhoé Cambridge, of Stuyvesant Town-Peter Cooper Village in 2015. Ivanhoé Cambridge is a subsidiary of Canada’s second-biggest pension fund.
...
In New York, California and other states, public pensions are mandated to pay workers’ retirements based on an equation that was set when they were first hired — putting pressure on the funds to make lucrative investments.
The message wasn’t lost on Tom Bannon, who oversees the California Apartment Association, the state’s most influential real estate trade association.
Bannon told TRD in October that the calls for rent control in California may have been tempered by the state’s public pension money invested in private equity firms who generate returns for their government investors through real estate ventures.
State politicians were aware that a stricter form of rent control would “literally shut down the California economic machine,” said Bannon, who also noted that “Blackstone is where CalPERS and CalSTRS invest their money.”
Pensive plays
During a CalPERS’ investment committee meeting last year, Ben Meng, the agency’s chief investment officer, outlined a plan to meet the fund’s obligations to pensioners.
“We need private equity, we need more of it, and we need it now,” Meng said.
At the same time, private equity firms often hire placement agents and other advisers who promote real estate assets to pension funds as a safe bet.
While placement agents have been banned in some states within the past decade, they still play a big role in pension investment strategies as a whole. In 2010 — after a series of pay-to-play scandals involving elected officials steering public pension fund investments to firms — New York, Illinois and New Mexico outlawed the use of such intermediaries.
The U.S. Securities and Exchange Commission then implemented new rules to curtail the influence of pay-to-play practices by investment advisers.
But California has no such bans. Instead, placement agents are required to register as lobbyists with the state.
In other states, like New York, commercial real estate brokers and other investment advisers are still fair game as long as they don’t make or bundle campaign contributions to politicians who could influence the selection of the adviser.
And since most public pension funds don’t have in-house real estate teams to guide their investing, that task is still largely outsourced to firms with the expertise to hunt down deals.
“It’s the adviser guiding the pension fund, whether they have full discretion or not,” said Adam Steinberg, a principal at Ackman-Ziff Real Estate Group who co-heads the brokerage’s equity business. “If the recommended investments go well, they should maintain their current role and could even get a greater allocation [to advise on] — so the stakes are high.”
But Eileen Appelbaum, an economist and author who researches private equity, said the deals negotiated between advisers and pension fund managers have become an even bigger cause for concern in recent years.
“There is a conflict,” she said, “because at some point in the not too distant past, we allowed pension funds to make risky investments as long as the risk is balanced in the overall portfolio.”
That risk-reward tradeoff is becoming increasingly visible to tenants, sources say.
Jim Markowich, who lived in one of Toledano’s East Village rentals, argued that the potential returns for pension fund investors like the New York State teachers do not outweigh the potential harms to those who are evicted from their apartments.
“The goal is to make double digit returns for investors,” Markowich said. “It all makes sense except it does it at the expense of people trying to live in their own homes, which is really hard to justify.”
———-
“More than half a year since New York overhauled its rent law, multifamily landlords and their lenders — from family-run firms and local banks to larger institutional players — have been feeling the heat. But another significant group of investors is exposed to the new rent regime: public school teachers, firefighters and other state employees.”
It was the story of private equity’s ongoing foray into the real estate right as the COVID19 pandemic was about to ensue: public pension funds were already major players in the residential rental markets. In particular, the rent-regulated markets of New York and California. Ironically, these investments in rent-regulated markets were done as part of the pension funds’ drive to earn higher returns. Ironically, or cynically. As we should have expected, the pursuit of those high returns came with a cost. A cost that was mostly paid by the tenants in these properties who found themselves evicted as the new private-equity-managed ownership sought to maximize those returns by minimizing the number of rent-controlled units. That’s the dynamic behind the now perverse situation where public pensions have taken on the role of the cruel miserly landlord to pay for the retirements of public school teachers, firefighters and other state employees:
...
Four of the largest public pension systems in New York and California committed more than $30 billion to private real estate funds held by Brookfield Asset Management, Blackstone Group, Apollo Global Management and the Carlyle Group, according to the pension funds’ annual financial statements.Nearly all of those private equity giants have made big investments in rent-regulated multifamily properties in recent years.
Madison, a smaller fish by comparison, has also touted its appeal to public pension funds and other institutional investors with “superior risk-adjusted returns.”
Such pitches are often made by placement agents who try to persuade pension funds to invest billions of dollars in real estate and other assets, according to several insiders. And while the funds almost never oversee the management of properties, in many cases, the returns they are seeking can drive speculative bets.
...
In less than two years, Toledano’s East Village deal went bad and Madison moved to foreclose on the landlord’s firm Brookhill Properties.
But the 2017 bankruptcy proceeding came amid accusations that the lender had demanded returns that were impossible to deliver without aggressive management tactics — a move that carried both financial and reputational consequences.
Then-Attorney General Eric Schneiderman lambasted Madison’s strategy, pointing to an investor memo that stated Toledano planned to vacate, renovate and deregulate nearly half of the 279 units in the portfolio within the first two years. In some of the buildings, the required turnover rate was as high as 80 to 100 percent.
“Tenant advocates argue that landlords displace tenants,” one multifamily owner said on the condition of anonymity, “when their investors are the ones telling them to clear people out and raise the rents.”
A 2015 investor pitch to the Public Employees Retirement Association of New Mexico, obtained through a Freedom of Information Act request, shows Madison promoted returns of more than 9 percent over the benchmark S&P U.S. Leveraged Loan Index.
...
When Blackstone’s Stephen Schwarzman opened his firm’s third quarter earnings call, he had a clear message for investors: The private equity giant’s holdings — including more than $320 billion in real estate — provide returns to public pension funds that are unattainable in fixed-income investments.
“The very strong returns we generate, particularly in the current low-interest rate environment, enable teachers, police officers, firemen and other public and corporate sector employees to retire with sufficient savings and secure pensions,” Schwarzman said.
Among public pension-backed private equity firms, Blackstone leads the pack with more than $9.7 billion in commitments, investments and assets under management from seven leading public pension funds in New York and California, according to the funds’ annual financial reports.
That includes the New York State Common Retirement Fund, which has $207.4 billion in assets under management, including $3.6 billion invested with Blackstone, records show, and the California Public Employees’ Retirement System (CalPERS), which manages $396.9 billion and has $2.7 billion invested with Blackstone.
...
That risk-reward tradeoff is becoming increasingly visible to tenants, sources say.
Jim Markowich, who lived in one of Toledano’s East Village rentals, argued that the potential returns for pension fund investors like the New York State teachers do not outweigh the potential harms to those who are evicted from their apartments.
“The goal is to make double digit returns for investors,” Markowich said. “It all makes sense except it does it at the expense of people trying to live in their own homes, which is really hard to justify.”
...
Beyond the push to eliminate existing rent-controlled units, we also find that pushes to create new rent-controlled units are further restrained by the reality that the fate of state pensions now increasingly rides on rental property returns. That’s on top of the ‘pay-to-play’ dynamics — legal or not — presumably swaying public officials:
...
In New York, California and other states, public pensions are mandated to pay workers’ retirements based on an equation that was set when they were first hired — putting pressure on the funds to make lucrative investments.The message wasn’t lost on Tom Bannon, who oversees the California Apartment Association, the state’s most influential real estate trade association.
Bannon told TRD in October that the calls for rent control in California may have been tempered by the state’s public pension money invested in private equity firms who generate returns for their government investors through real estate ventures.
State politicians were aware that a stricter form of rent control would “literally shut down the California economic machine,” said Bannon, who also noted that “Blackstone is where CalPERS and CalSTRS invest their money.”
Pensive plays
During a CalPERS’ investment committee meeting last year, Ben Meng, the agency’s chief investment officer, outlined a plan to meet the fund’s obligations to pensioners.
“We need private equity, we need more of it, and we need it now,” Meng said.
At the same time, private equity firms often hire placement agents and other advisers who promote real estate assets to pension funds as a safe bet.
While placement agents have been banned in some states within the past decade, they still play a big role in pension investment strategies as a whole. In 2010 — after a series of pay-to-play scandals involving elected officials steering public pension fund investments to firms — New York, Illinois and New Mexico outlawed the use of such intermediaries.
...
And as experts were predicting at the time in March of 2020, when rates were still near historic lows, pension funds are only going to have to deepen their dives into real estate and other alternative investments as long as rates remained low. Keep in mind that the Fed only started hiking rates from their historic lows in March of 2022. That’s all part of the context of the dive into commercial real estate in recent years: A lot of the commercial real estate purchases happened at a time when pension funds were on an even greater quest for yield:
...
Overall, pension funds are investing more aggressively in real estate as they look further beyond the stock market and fixed-income investments.“Real estate still provides an outsize return over other asset classes,” said Jeffrey Scott, who runs the commercial brokerage Eastdil Secured’s New York City office.
In 2019, public pension funds in the “billion dollar club” — a list of 412 of the world’s largest investors tracked by private equity research firm Preqin — were the largest single source of funding for private equity firms.
Public pension funds provided a total of $704 billion to private equity, according to Preqin. The next largest source of capital, sovereign wealth funds, provided $272 billion.
“Pensions are what really drive the market at the end of the day. Their appetite or lack thereof determines a lot of transactions,” Scott noted.
And with interest rates close to rock bottom, pension funds are keeping their return expectations high, said Savills’ chief economist Heidi Learner, who added that many are targeting returns of 7 percent or higher. As a result, she noted, some are going to have to up their bets on real estate and other alternative investments to meet those goals.
The California State Teachers’ Retirement System (CalSTRS) has shown a particularly strong interest in real estate and now has nearly $35 billion invested in property around the country. After years of exceeding its real estate target allocation of 13 percent, in its January board meeting, the state pension fund solidified a plan to increase that figure to 15 percent, from which it expects a 6.3 percent return.
...
Yes indeed, CalSTRS has shown a particularly strong interest in real estate, as evidenced by its Blackstone Real Estate Partners X fund investment. And all CalSTRS’s prior commercial real estate investments made over the past three years that are now at risk of imploding.
And more generally, it’s clear at this point that the pandemic and resulting rate cuts effectively amplified the stampede into private equity, and in turn into real estate, as the hunt for yield only got stronger. But, importantly, it’s also rather clear that this all be driven, in part, but a relative lack of alternatives. There simply aren’t a lot of other investment options that both promise high yields and scale to the size of the pension fund industry’s demands. Keep in mind that the flood of pension fund money into private equity isn’t new. Alternative investment industries have had years to make their pitch. But we keep hearing about a greater and greater share of pension fund money flooding into private equity hands, which, again, is part of the commercial real estate story too.
Pre-Pandemic/Post-Pandemic, it’s the Same Businss Model: Heads I Win, Tails You Lose
But as is also clear from the available data is that we’re still very much looking at the same “Head We Win, Tails You Lose” business model that underpins the entire private equity industry. As we’ve seen, it’s “Head We Win, Tails You Lose” in how private equity systematically benefits from economic turmoil and things like mass layoffs and dislocation. But as Farhad Manjoo reminded us in the following New York Times opinion piece back in August, private equity firms have a “Head We Win, Tails You Lose” relations with their clients too. Because it doesn’t really matter if the investments sour, the private equity partners are still going to be paid handsomely. It’s something to keep when it comes to the things like mass evictions by private equity management in the name of its pension fund clients. That handsome “Head We Win, Tails You Lose” pay has to come from somewhere:
The New York Times
Private Equity Doesn’t Want You to Read This
By Farhad Manjoo
Aug. 4, 2022Opinion Columnist
This column has been updated.
This column is about the excesses of the private equity investment industry. It delves into the minutiae of the tax code, corporate structure and certain abstruse practices of financial engineering. There will be jargon: carried interest, leveraged buyout, joint liability. I am aware that none of this is anyone’s favorite thing to be discussing on a summer’s day.
But private equity is counting on your lack of interest; the seeming impenetrability of its practices has been called one of its “superpowers,” among the reasons the trillion-dollar industry keeps getting away with it.
With what? An accelerating, behind-the-scenes desiccation of the American economy. Democrats in the Senate were poised to pass a rule that might slightly clip the industry’s wings — a change to the tax code that would force partners in private equity firms, hedge fund managers and venture capitalists to pay a fairer share of taxes on the money they make.
But private equity has wangled out of proposed regulation before, and it’s done so again. Senate Democrats have agreed to drop the measure from their climate legislation to win the support of Senator Kyrsten Sinema, the Arizona Democrat who has often frustrated her party’s agenda and has expressed opposition to raising taxes on the wealthy.
I can’t fathom what her reluctance might be. One of private equity’s main plays is the leveraged buyout, which involves borrowing huge sums of money to gobble up companies in the hopes of restructuring them and one day selling them for a gain.
But the acquired companies — which range across just about every economic sector, from retailing to food to health care and housing — are often overloaded with debt to the point of unsustainability. They frequently slash jobs and benefits for employees, cut services and hike prices for consumers, and sometimes even endanger lives and undermine the social fabric.
It is a dismal record: Private equity firms presided over many of the largest retailer bankruptcies in the last decade — among them Toys “R” Us, Sears, RadioShack and Payless ShoeSource — resulting in nearly 600,000 lost jobs, according to a 2019 study by several left-leaning economic policy advocates.
Other investigations have shown that when private equity firms buy houses and apartments, rents and evictions soar. When they buy hospitals and doctors’ practices, the cost of care shoots up. When they buy nursing homes, patient mortality rises. When they buy newspapers, reporting on local governments dries up and participation in local elections declines.
It is unclear even if private equity pays off for the investors — like university endowments, public pension funds and wealthy individuals — who put money into the industry in the hopes of outsize returns. Since at least 2006, according to a study by the economist Ludovic Phalippou, the performance of the largest private equity funds has essentially matched returns of comparable publicly traded companies.
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With the help of lax regulation and indefensible tax loopholes, private equity’s apparent destructiveness can be enormously profitable for its partners. Private equity firms make money by extracting hefty fees from their investors and from the companies they purchase, meaning they can succeed even if their investments go kaput. Phalippou found that between 2005 and 2020, the industry produced 19 multibillionaires.
“It’s a heads-I-win, tails-you-lose model,” said Jim Baker, the executive director of a watchdog group called the Private Equity Stakeholder Project.
But it gets worse: Not only do private equity partners make money even if their companies blow up; they also get a pretty good deal from the government on what they earn. Private equity funds generally charge their investors two different fees: a management fee of 2 percent of invested assets per year (funds are held for an average of about six years), and a “carried interest” fee that is 20 percent of any investment gains realized in the fund.
In most other industries, the Internal Revenue Service would categorize a fee like carried interest as ordinary income (like how your salary is taxed) rather than a capital gain (like how your stock market winnings are taxed). After all, the partners are receiving the fee as compensation for performing a service (managing investors’ money), not collecting a gain on their own invested capital (because it’s the investors’ money, not theirs).
But that’s not how it works for partnerships like private equity, hedge funds and venture capital firms. Under I.R.S. guidelines, carried interest is taxed as a capital gain, which has a top rate of 20 percent, rather than as income, which has a top rate of nearly 40 percent. The upshot: Millionaire and billionaire partners in private equity firms pay a far lower tax rate on much of their income than many of the rest of us.
The private equity industry defends its preferential rate by citing “sweat equity” — even if partners don’t put much of their own capital at stake, they are being rewarded for investing their “ideas and energy,” as Steve Klinsky, a former chair of the American Investment Council, put it in a recent article. But it’s difficult to find many beyond the industry who will defend carried interest’s low taxation.
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Despite widespread opposition, though, the tax break has somehow endured — as Tim Murphy wrote recently in Mother Jones, it has been “the most unkillable bad idea in a town with no shortage of them, a testament to the unstoppable combination of money and inertia.” (Murphy’s piece was part of an excellent, multipart investigation of the private equity industry published by the magazine.)
The Democrats’ proposal would have merely narrowed — but would not have eliminated — the carried interest loophole. Passing it would have been a good start toward reforming the private equity industry.
Even if it passed, though, much more would need to be done. Eileen Appelbaum, an expert on the private equity industry who is a co-director of the Center for Economic and Policy Research, a liberal think tank, told me she favored many of the ideas in the Stop Wall Street Looting Act, a bill introduced last year by Senator Elizabeth Warren and several other liberal Democrats. The act would impose lots of new rules on the industry, including limiting tax deductions on excessive debt and adding worker protections for when debt binges lead to bankruptcy.
One of the most important ideas, Appelbaum said, is known as joint liability, which would hold private equity firms responsible for the debt incurred by portfolio companies if the companies go belly up.
“It doesn’t tell you how much debt you can put on it,” Appelbaum said. “It just says, ‘whatever debt you put on it, you’re going to be jointly responsible.’”
That struck me as an elegant and sensible idea. If private equity firms claim they should get credit for their “sweat equity,” why shouldn’t they be held responsible when the sweat turns to tears?
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“Private Equity Doesn’t Want You to Read This” by Farhad Manjoo; The New York Times; 08/04/2022
“It is unclear even if private equity pays off for the investors — like university endowments, public pension funds and wealthy individuals — who put money into the industry in the hopes of outsize returns. Since at least 2006, according to a study by the economist Ludovic Phalippou, the performance of the largest private equity funds has essentially matched returns of comparable publicly traded companies.”
And that’s the fundamental issue at hand. Or at least one of them: for all the hype about how pension funds are getting a great deal, that’s unclear from the data. What is clear from the data is the private equity’s track record is dismal for the debt-laden companies bought in these leveraged buy outs or the tenants living in the homes and apartments that have come under private equity’s management. Oh, and it’s also very clear from the data that private equity pays very well for the partners of the private equity firms. Whether the clients do well or not. Because there is no joint liability in these deals. It’s a “It’s a heads-I-win, tails-you-lose model”:
...
It is a dismal record: Private equity firms presided over many of the largest retailer bankruptcies in the last decade — among them Toys “R” Us, Sears, RadioShack and Payless ShoeSource — resulting in nearly 600,000 lost jobs, according to a 2019 study by several left-leaning economic policy advocates.Other investigations have shown that when private equity firms buy houses and apartments, rents and evictions soar. When they buy hospitals and doctors’ practices, the cost of care shoots up. When they buy nursing homes, patient mortality rises. When they buy newspapers, reporting on local governments dries up and participation in local elections declines.
...
With the help of lax regulation and indefensible tax loopholes, private equity’s apparent destructiveness can be enormously profitable for its partners. Private equity firms make money by extracting hefty fees from their investors and from the companies they purchase, meaning they can succeed even if their investments go kaput. Phalippou found that between 2005 and 2020, the industry produced 19 multibillionaires.
“It’s a heads-I-win, tails-you-lose model,” said Jim Baker, the executive director of a watchdog group called the Private Equity Stakeholder Project.
...
A ‘dismal-for-thee-rich-for-we’ kind of business model. At least for the workers and tenants whose workplaces and homes have come under private equity control. Ever more so as private equity takes control of more and more sectors of the economy continue to expand. In an expansion ironically turbo-charged by public pensions with a seemingly endless appetite to take on the kinds of high earning projects private equity assures them will keep these pension funds afloat. Maybe they’ll be wise fund advisers who navigate these public pension funds through the choppy investing waters ahead. Maybe not and pensions will drown beneath wave after waver of mistakes. Either way, the private equity fund partners are going to make A LOT of money in the process.
And that ‘Heads we win, tails you lose’ business model is really the big warning looming over this entire story. It would be one thing if private equity firms actually had a meaningful stake in the outcome of this grand ‘knife catching’ CRE investment strategy. But that’s not how it is. At worse, these firms will lose some pension fund clients should these investments go sour and that’s about it. And either way, it’s going to be the cut-throat ‘profits über alles’ private equity business philosophy that is ultimately managing all of these properties. On top of all the other business and enterprises that have fallen into private equity’s grip.
Even worse, it’s unclear where else pensions are even going to go in the pursuit of higher yields should their private equity-led CRE investments end going “down to the last bottom.” Sure, rising interest rates do lower the appeal of alternative higher risk investments like real estate. Inflation, on the other hand, does quite the opposite. We shouldn’t expect rising interest rates to somehow provide pension funds a real estate escape plan.
Finally, just to maintain some perspective here on a story that is primarily about the fate of public pensions in the US, it’s worth keeping in mind that the vast majority of US workers aren’t public employees and only roughly 4% of employees in private sector even have defined benefit pensions anymore, down from 60% in in early 1980s. And with 58% of US workers citing outliving their assets as their greatest retirement fear in a recent survey, it’s pretty obvious that the US is facing a much larger retirement crisis than simply keeping public pensions adequately financed. This is all part of something much larger and more dire.
That’s part of the grim context of this pension crisis: it’s just a drop in a bucket compared to the upcoming long-foreseen mass retirement crisis this is creeping closer and closer with each passing years. And while major collective challenges should be and opportunity for a coming together with major collective solutions, that’s clearly not how the US operates. At least not anymore. Major crises are indeed a major opportunity in modern American. But only for those with large pools of cash on the sidelines waiting to swoop in after everything has fallen apart. Which obviously isn’t the best system to be retiring into. Unless you happen to be a fund manager and don’t actually care whether or not your fellow citizens can retire too. In that case everything is going great and only getting better.
Turning lemons into lemonade is kind of the theme of the ongoing pension fund push into the private equity space now that so many of the commercial real estate (CRE) investments of 2022 have started to sour. That’s the whole rationale behind Blackstone’s Real Estate Partners IX fund, where pension funds are hoping to recoup their CRE losses by scooping properties as prices collapse. But what if the losses pension funds are facing in their private equity investments are actually much larger than previously disclosed? How might that affect this ‘making lemonade’ strategy? Would it cause pension funds to pull back on this double-down? Or double-down harder? That’s the ominous question raised by the following pair of articles describing a dynamic that hints at potentially much larger losses from the pension fund industry’s private equity binge than has been yet disclosed. A dynamic that perversely incentivizes even more pension fund investments in the private equity space the worse their underlying fiscal situation gets.
So what is this perverse dynamic? Well, as progressive columnist David Sirota warned back in February, it’s not just the promises of high returns that has caused US pension funds have fall in love with private equity in recent decades. There’s also the accounting gimmick that synergizes with those promises of high returns and allows pensions to effectively make up their own returns and make their finances appear stronger than they actually are. That accounting gimmick is rooted in the fact that it is both extreme difficulty to a value on a lot of private equity investments but also required by law. As a result, private equity firms are allowed to simply make up the alleged market values for the investments they are holding on behalf of their pension fund clients.
And as studies have shown, those made up values tend to be inflated values that fraudulently puff up the balance sheets of pension funds and at least temporarily make everything seem better than they actually are. It’s a convenient fiction for both parties...until the bill comes due. Because at some point these investments have to be sold and reality intervenes. That’s the basis for David Sirota’s warnings that, as bad as things were looking for the private equity-led pension fund investments as CRE write-downs pick up the pace, it’s probably actually worse.
Interestingly, as we’re going to see in a Bloomberg opinion piece from last month by Allison Schrager of conservative Manhattan Institute, this issue of fraudulent private equity bookkeeping just might be one of those issues that can resonate across the ideological spectrum. Because not only does Schrager acknowledge the real abuses inflicted by private equity management on workers and communities, but she has a solution: given that pension funds now account for roughly two-thirds of the capitol under private equity control, one way of reducing the amount of private equity-induced social harms is to simply starve private equity of the billions of dollars its using to inflict these harms by fixing these accounting loopholes that make private equity such an enticing temporarily solution to pension funds looking to chase higher returns.
Will such a fix ever actually get implemented? It’s hard to see that happening in the US, but it’s worth keeping in mind that the longer it takes to fix these accounting gimmicks, the more painful it’s eventually going to be to fix:
“But while pensioners may be imperiled, Wall Street executives are protected thanks to their heads-we-win-tails-you-lose business model. While reporting asset losses for investors, some of the firms managing pensioners’ money are raking in even more fees from investors and continuing to raise executives’ pay.”
It’s a crisis for pension funds. A crisis of underperforming private equity investments that simply aren’t living up to Wall Street’s promises. But it’s a crisis for the underperforming fund managers. It’s the heads-we-win-tails-you-lose business model in action. The kind of business model that raises the basic question of why pension funds agree to these terms in the first place. And that brings us to the brewing scandal in this sector. The kind of scandal that’s only going to grow as pension funds pour more and more money into private equity following promises of high returns. Because as a growing number of voices are pointing out, these promised returns aren’t meeting the hype. Quite the opposite, the 2022 returns were actually getting written down, with more asset revaluations on the way. And that brings us to the disturbing underlying factor incentivizing the systematic inflation of pension fund’s private equity returns: private equity investments are difficult to price, with returns often not being realized for years. And yet they must be priced for basic accounting needs. Existing rules handle that accounting paradox by effectively allowing private equity firms to just make up an assumed valuation. And the higher that assumed valuation, the less underfunded pension funds will appear. It’s a recipe for creating fiscal time bombs in the balance sheets of pension funds:
But it’s not just accounting trickery at work here. There’s also the fact that the terms of these contracts between pension funds and private-equity firms are typically hidden. And as studies have found, a rather grim conclusion is reached when you factor all those hidden fees: private equity returns have been more or less in line with public equity returns:
And despite all of these warning signs, all indications are that the flood of pension fund money into the private-equity space is only going to grow, with New York lawmakers recently raising the cap on the amounts of pension fund money that can flow into private-equity investments:
That was the assessment from progressive David Sirota from earlier this year. An assessment that are partly echoed last month in the following Bloomberg piece by Allison Schrager of the conservative Manhattan Institute. As Schrager acknowledges, private equity earned its ruthless reputation for a reason. It’s been genuinely ruthless in the pursuit of profits and it’s not hard to see why the public would want that ruthlessness reigned in. But Schrager argues against creating new rules that would directly restrain private equity from engaging in these kinds of ruthless management tactics and instead proposes an indirect approach: fix the accounting rule chicanery that has made private equity such an appetizing investment to pension funds. That’s it. Fix that, and there’s going to be A LOT less pension fund money flowing into the private equity space. Less private equity money = less private equity-caused social damage.
That’s the fix Schrager is proposing. And while it remains very unclear if any such fix is politically feasible given the immense lobbying power of this industry, it’s pretty notable that reigning in the abuses of private equity is a potential point of agreement between people as ideologically diverse as David Sirota and Allison Schrager:
“There are some terrible abuses that private equity firms should be held accountable for, and the market does need to change. But mitigating the damage doesn’t require a bunch of new rules on private equity itself. A better and less obvious solution would be fixing a distortion in the market that’s provided private equity funds with so much money in the first place. It starts with looking at the investors in these funds, and in particular public sector pensions that have provided some of the bags of cash that have empowered the reckless behavior.”
If you are worried about private equity’s brutal track record of abuses, there’s a pretty powerful remedy just sitting right there waiting to be used: end the perverse accounting incentives that have encourage pension funds to flood the private-equity industry with billions of dollars based on a lie. The kind of lie of fake high returns that have enticed so many pension funds to engage in a kind of mutually convenient fiction with private equity firms that will keep all parties satisfied until the music stops. A fiction so convenient that pension fund money now accounts for roughly two-thirds of the capital under private-equity management. In other words, this convenient accounting fiction has doubled as a amplifier for damage inflicted upon society at large by private-equity’s heads-we-win-tails-you-lose business model:
And then Schrager points to another fact that is only going to grow as more and more pension fund money flows into private equity’s hands: not all private equity firms are of the same caliber and with pension funds now functioning and private-equity’s the primary customer it’s inevitable that at least some of those billions of dollars are being thrown at subpar private-equity funds. It’s not just investment opportunities getting systematically crowded out. It’s investment talent too:
Do the subpar private equity fund managers charge subpar fees too? It’s a nice thought but it’s hard to imagine that’s actually the case for this heads-we-win-tails-you-lose industry. Instead, we can expect more of the same, but presumably worse. Especially should a wave of previously undisclosed losses belatedly get revealed as David Sirota warned. Don’t forget the underlying logic of the CRE double down: good deals have to be snagged in order to make up for all the losses piling up from last year’s CRE binge. So the worse the surprise writedowns get, the more compelling the logic to double down even more. Yes, the worse it turns out all these private equity investments ultimately turn out to be, the more pensions funds are going to be compelled to dive into private equity because they don’t have no where else to go. Private equity has become the pension fund industry’s last resort, for good or ill. That’s the demented death spiral dynamic at work here. Well, a death spiral at least for the pensioners’ retirements. The fund managers of course be getting paid either way.
The best investments are often the ones made when everyone is looking elsewhere. When the market zigs, the best investors zag. Of course, investing in something that almost everyone else is trying to get out of is all so a great way to lose your shirt. So what kind of investment did the University of California’s pension fund make earlier this year with its $4.5 billion investment in one of Blackstone’s real estate investment trusts (REITs)? It’s a question that isn’t just potentially weighing on the minds of UC pensioners. It’s also a question for a growing number of renters. Especially student renters. Yes, this large investment was made just months after this same REIT purchased 69 percent of American Campus Communities (ACC), the US’s largest student housing company, in a $12.8 billion deal in August of 2022. Student rents from the nation’s largest student housing company are now helping to pay the pension of the largest public college system. With Blackstone raking in the hefty private equity fees the whole time. Was this a good investment?
But there’s another wrinkle to this investing decision: that $4.5 billion investment didn’t happen at time when other investors were scrambling to capitalize on the available REIT opportunities. It happened as the other investors in that same Blackstone REIT were making redemption requests. So many redemption requests that Blackstone was blocking them. And it’s not like those redemption requests ended after this $4.5 billion UC infusion. In fact, In March, the Blackstone REIT received $4.5 billion in redemption requests, while only fulfilling $666 million of those requests. Does that sound like a safe private equity fund to be dumping billions of dollars into? Is the UC pension system’s Blackstone REIT play ‘crazy like a fox’? Or just crazy?:
“Just months after Blackstone’s real estate investment trust purchased America’s largest owner of private student housing, the same trust received a $4.5 billion infusion from the University of California’s Board of Regents, two of whom have close ties to the company. The investment rewards the financial firm only a few years after the company and its executives spent $5.6 million to kill California ballot initiatives that would have expanded rent control in the state.”
The University of California just pumped $4.5 billion into a Blackstone’s REITs that purchased 69 percent of American Campus Communities (ACC), the largest student housing company in the US, in August of 2022. Now, if the ACC was dedicated to providing students with affordable housing, that might be seen as a somewhat noble area of investment for the UC pension plan. But this isn’t that kind of an investment. It’s a profit-maximizing investment. Which means it’s a student-housing-minimizing investment too. Hence the fourteen thousands homeless UC students:
But the controversy over this investment isn’t simply the capitalist morality of paying for pension by paupering students. It’s the fact that this $4.5 billion investment happened at the same time Blackstone was facing massive redemption requests from the other investors in the fund. So many redemption requests that Blackstone began blocking redemption requests in December, the same month Nadeem Meghji, Blackstone’s head of real estate for the Americas, announced on CNBC that the $4.5 billion UC investment “changed the narrative”. And throughout this all, Blackstone distributed $200 million to itself in management fees. You almost couldn’t come up with a better example of the ‘heads we win, tails you lose’ private equity business model:
So why did the UC board of Regents decide to make a $4.5 billion investment in a fund that was suspending redemptions at the time? Well, perhaps the incestuous relationship between Blackstone and the UC Investment Committee has something to do with it:
And then there’s the fact that Blackstone didn’t just spend $5.6 million opposing a California rent control ballot initiative. Its management practices as landlord have been so harmful towards renters that the UN accused it of “wreaking havoc” on housing market. It’s so bad the UN felt the need to make a statement:
So is Blackstone at least making the outsized market-beating returns that theoretically justify squeezing renters to pay pensioners? Does this brutal ‘zero-sum game of capitalism’ at least help pay for grandma’s retirement? Nope. Low risk index funds would have performed better over the last decade:
The renters got squeezed for nothing. Well, not nothing. Blackstone got a big payday. Behold the glories of capitalism!
But who knows. Maybe this really will end up being a great investment for the UC pension system in the long run. Time will tell. Time and the ability of Blackstone to ‘squeeze blood from a stone’ in extracting every last penny it can from all those renters. Including all those UC student renters. Every last penny is going to be needed to pay those hefty private equity fees. Fees that will be paid whether or not the UC pension system is crazy like a fox or just crazy. Which makes this a reminder that there’s no conflict between ‘zero-sum capitalism’ and ‘head we win, tails you lose’ business models. Quite the opposite.
Financial markets are no stranger to diverging opinions. But they aren’t exactly ‘divergent opinion’-friendly either. Especially when actually buying and selling and happening in the midst of those divergent opinions. Someone is getting a deal and someone else is ending up with the short end of the stick.
So when we see the following story about public and private real estate funds arriving at sharply divergent commercial real estate (CRE) valuations, we have to ask: who is getting the short end of the CRE stick? Are the publicly traded Real Estate Investment Trusts (REITs) overly bearish in their CRE valuations? Or are the private real estate funds — the same private-equity-managed funds public pensions have been doubling down on — overly optimistic? That’s one of the big questions raised by a report issued a couple of weeks ago that compared the implied “cap rates” between publicly traded REITs and their private real estate fund counterparts and found significant differences in how these different market players are estimating the future values of various CRE investments. Specifically, it turns out public REITs are consistently issuing higher cap rate estimates than their private-equity counter-parts, including 27 percent higher cap rates for office buildings.
What are the implications of a public-private cap-rate gap? Well, since higher cap rates are associated with higher-risk (and lower valued) CRE projects, this report is indicating that public REITs are systematically using lower valuation estimates for CRE projects than their private-equity counter-parts. So private-equity is operating off of higher overall CRE value estimates, and this public-private valuation gab is happening at the same time public pension-funds are allowing private equity funds to lead them on a grand CRE double-down gamble. Is this a red flag? Because that seems like maybe it’s a red flag:
““In the ideal world, where markets are completely rational, the public market valuations would reflect what we are seeing in that forward-marked private market cap rate,” Uma Moriarity, senior investment strategist at CenterSquare, told Commercial Observer. “But there’s a really meaningful disconnect between where transactions are happening and where valuations are happening in the private market … compared to where we think private market valuations should be.” ”
A meaningful disconnect between public and private market CRE valuations. How meaningful? Well, for office buildings, public REITS have average cap rates of 8.75 percent compared to the 6.39 percent average cap rate they found private REITS were estimating, a public-private valuation gap of 27 percent. That’s a pretty meaningful disconnect considering that these same public and private entities are make deals in the same space. Presumably making deals with each other:
And as the article describes, that higher cap rate for public REITs translates to lower valuations. In other words, private real estate funds are systematically putting higher assumed valuations on CRE investments than their public REIT counterparts. And as we’ve seen, it’s the private real estate fund that so many public pensions are increasingly invested in. That’s why we have to ask: are the public REITs overly bearish or are the private equity funds not bearish enough? That’s the big question posed by this public-private valuation gap that is as high as 27 percent for office buildings:
Keep in mind that one effect of overly-optimistic private valuations is the overly optimistic valuation of the many CRE investments already held by by these private equity funds. Which, in turn, means the many pension funds invested in these private equity real estate funds are also going to be systematically over-estimating the value of their private equity investments. So when we see signs of overly inflated CRE valuations by private equity funds, it’s worth keeping in mind that fixing those overly inflated estimates will simultaneously make their clients financial positions that much worse. And that much more desperate. Perhaps desperate enough for a CRE triple down, which can no doubt be arranged if needed.
The US economy is no stranger to moral injury. One could argue that moral injury is one of the core fuels driving the economy. And while the US healthcare sector is very obviously no stranger to moral injury, it’s worth noting the growing pandemic of moral injury that was highlighted in a New York Times Magazine piece last month about the moral injury increasingly felt by US doctors. Job dissatisfaction is for doctors and other medical professionals apparently at such levels that, as of March of last year, 1 in 5 health care workers had quit their job and another 31 percent were considering it.
And while the stresses of the COVID are clearly a big part of this job dissatisfaction crisis across the health care sector, the moral injury we’re talking about didn’t start with COVID and isn’t abating. On the contrary, it’s only growing as the private equity business model takes over more and more of the health care sector. A profits-over-people business model that has resulted in medical professionals increasingly feeling like they experienced a moral injury in carrying out their jobs.
Specifically, the kind of moral injury analogous to what military psychiatrists describe as an emotional wound sustained when, in the course of fulfilling their duties, soldiers witnessed or committed acts — raiding a home, killing a noncombatant — that transgressed their core values. Doctors are increasingly feeling like they are forced to transgress their core values. And increasingly for the profits of their employers. In particular their private-equity hospital owning employers. That’s the relatively new form of moral injury increasingly being reported by workers in the US health care sector. And increasingly reported anonymously as more and more doctors are fired for speaking out about sub-standard practices mandates by their profit-hungry employers.
And, surprise, it turns out private equity firms backed by US public pension funds are the major players in this space. Blackstone, which purchased $6.1 billion TeamHealth in 2016, and KKR, which acquired Envision Healthcare for $9.9 billion in 2018, are now two of the biggest players in the US health care space. And therefore two of the biggest bosses, determining doctors’ patient vs profits priorities. Morally injurious patient vs profits priorities that health care workers have to work under or get fired. Moral injury done in the name of not just profits but the profits needed to fund the pension fund investors behind those Blackstone and KKR acquisitions. And profits needed pay for the fund managers, of course.
So to get an idea of private-equity approach to running hospitals, here’s an article from November of 2019, right before the COVID pandemic broke out, describing how US pension plans were dodging questions over the growing congressional ire raised by a pandemic of surprise medical bills facing patients. Surprise medical bills that private-equity-owned hospitals in particular were notorious for issuing, with Envision and TeamHealth leading the way in surprise medical bills and the focus of the congressional investigation:
“Millions of Americans with medical insurance policies have been hit with “surprise” bills for thousands of dollars after receiving hospital treatment from a healthcare company owned by a private equity manager.”
The surprise medical bill pandemic of of 2019 was a product of private equity-owned hospitals. In particular, two of the largest health care providers in the US, TeamHealth and Envision, which happen to be owned by private equity giants Blackstone and KKR. Surprise:
And as Oxford finance professor Ludovic Phalippou grimly points out, while private-equity firms may insist that the cut-throat tactics are needed to earn the high returns retirees need to fund their pensions, it’s not like the profit generated by these surprise fees are necessarily going to private equity investors. But we can be very confident the private equity fund managers are getting a cut. It’s how the ‘heads we win, tails you lose your retirement’ business model operates. Opaquely:
And in case it’s not clear that surprise medical billing is very much part of the private-equity preferred health care business model, here’s an article from September of 2019 about the discovery of the identities of the entities behind a massive ad campaign opposing any government action to address the surprise billing pandemic. A dark money campaign that had, at that point, anonymously spent $28 million on the “Doctor Patient Unity” dark money group: TeamHealth and Envision were behind the ad spending binge dedicated to protecting the ability to surprise bill. In other words, private-equity was behind the ad campaign dedicated to protecting the ability to surprise bill patients. Surprise:
“Now, the mystery is solved. The two largest financial backers of Doctor Patient Unity are TeamHealth and Envision Healthcare, private-equity-backed companies that own physician practices and staff emergency rooms around the country, according to Greg Blair, a spokesman for the group.”
What a shocking revelation: the two largest private equity-owned health care providers that happen to be notorious for surprise billing are behind dark money ad campaign opposed to ending the practice.
And while the identity of the groups behind Doctor Patient Unity was technically anonymous for months after the dark money group suddenly popped out of nowhere in July of 2019, note how FEC filings indicate that the group treasurer worked for a firm that often played similar rolls for Republican affiliated groups. Which makes it rather likely that the secret identities of the groups behind Doctor Patient Unity was really more of a DC open secret:
Also note how both TeamHealth and Envision Healthcare were taken over recently, with Blackstone acquiring TeamHealth for $6.1 billion in 2016 and KKR paying $9.9 billion for Envision Healthcare in 2018. As such, we also shouldn’t be surprised to learn that Fitch Ratings had the debt loads of both companies at the top of its list of “loans of concern”. Yes, the talk of the proposed anti-surprise billing government action had to be a fact in Fitch’s loan concerns, but also keep in mind the underlying private-equity business model: buy a company and load it up with debt to pay out to investors and fund managers. It’s a reminder that when private-equity-own firms engage in surprise billing in the pursuit of profit maximization, that extra proceeds aren’t going directly to pay investors and fund managers. The extra proceeds are used to pay off the debt that was already issued to pay off the investors and fund managers. In keep with the ‘heads we win, tails you lose’ business model:
And in case it’s unclear just how dependent the private-equity-owned firms are on surprise billing, not the then-recent study that found that TeamHealth and Envision both routinely operated “out of network”, which more or less guarantees that patients will often face a surprise bill:
And when we see how most doctor and hospital groups would rather have both sides (insurers and providers) present their preferred price to an independent arbitrator, it’s important to keep in mind that these ‘doctor and hospital groups’ are also going to be heavily influenced by the private-equity industry. So when we see the American College of Emergency Physicians (ACEP) distinguish its own opposition to the proposed legislation to end surprise billing from the dark money campaign of TeamHealth and Envision, and then see that the group’s current president worked for TeamHealth and its then-president elect worked for Envision, it’s a reminder that private-equity’s views on these matters are increasingly going to be the industry’s views as private-equity’s stake in the sector grows:
And that role private-equity is increasingly playing in speaking for doctors and other people working in the health care sector brings us to the following NY Times report from last month about another form of injury being inflicted upon this sector in the pursuit of profits. The moral injury a growing number of health care professionals are expression as they are dealing with new hospital owners who are increasingly asking them to prioritize profits over patient health. With private-equity hospital owners being the primary perpetrators of this moral injury. It’s another surprise:
“Because doctors are highly skilled professionals who are not so easy to replace, I assumed that they would not be as reluctant to discuss the distressing conditions at their jobs as the low-wage workers I’d interviewed. But the physicians I contacted were afraid to talk openly. “I have since reconsidered this and do not feel this is something I can do right now,” one doctor wrote to me. Another texted, “Will need to be anon.” Some sources I tried to reach had signed nondisclosure agreements that prohibited them from speaking to the media without permission. Others worried they could be disciplined or fired if they angered their employers, a concern that seems particularly well founded in the growing swath of the health care system that has been taken over by private-equity firms. In March 2020, an emergency-room doctor named Ming Lin was removed from the rotation at his hospital after airing concerns about its Covid-19 safety protocols. Lin worked at St. Joseph Medical Center, in Bellingham, Wash. — but his actual employer was TeamHealth, a company owned by the Blackstone Group.”
It’s a pretty damning statement on the power relationship between the ‘investor class’ in the US and everyone else: even doctors are so powerless in modern America that they have successfully been terrified into silence under the threat of getting fired. Silence over systemic patient abuses all done in the name of ‘productivity’ and higher investor returns. And it’s the doctors working under private-equity firm — which oversee the staffing in roughly 30 percent of Emergency Rooms already — who are the most terrified to share their sense of moral injury with the rest of society. It’s hard to come up with a more apt metaophor for private equity’s capture of American society than this truly sick state of affairs:
What does the future hold for this field? Well, less trained doctors, if the stunning levels of personal distress reflected in the survey results of medical professionals are any indication of what to expect: one recent survey found that 1 in 5 health care workers had already quit their job since the start of the pandemic, with another 31 percent considering that option. So a majority of medical professionals have either quit or are considering quitting in just the last few years. And while the unique stresses of the pandemic obviously played a role in those survey results, the ‘moral injury’ reported by these professionals wasn’t created by the pandemic. It was created by the stresses of provided care to people while adhering to the profit-maximizing mandates of their employers. The pandemic has receded. Private equity’s ruthlessness in the pursuit of those profits will never end:
So are there any viable cures available for the growing numbers of doctors who feel like they are violating their own consciences in the pursuit of investor profits? Well, there are solutions. Unfortunately, they’re the kinds of solutions that are increasingly unthinkable for the captured American economy: unionization. This is a good time to recall how threatening employees if they vote to unionize remains rampant among large US employers:
Finally, we get to this interesting legal approach to weakening private equity’s growing grip on medicine in the US: state laws that prohibits nonmedical corporations from controlling the delivery of health services. California has such a law. And as we can see, it’s a law the private equity industry has already wormed its way around. But that doesn’t mean the law can’t be changed and fixed. And then actually enforced. Legally reigning in these kinds of business models really is an option, even if it doesn’t feel like one in a society captured by special interests. But it is an option:
Can the private-equity industry actually get reigned in? Well, in December of 2020 Congress did pass the “No Surprises Act” that was signed into law and has been in force in January of 2022, removing patients from payment disputes between hospitals and insurance companies. Yes, to some extent, the private-equity industry really has been reigned in on this particular front.
Of course, private-equity will still be allowed to own a seemingly ever-growing stake in the health care sector and inflict general moral injury on its staff. And as the Biden administration’s recent updates to the No Surprises Act implementation — updates designed to thwart various cheats and workarounds the industry has already come up with to get around the new regulations — we can’t really expect the surprise billing to truly end. Nor can we expect the dark money lobbying campaigns to end. Or the growing numbers of doctors quitting or thinking of quitting. We can’t really realistically that to end. But at least the private-equity industry’s surprise billing spree has sort of put of hold for now. Seemingly to the detriment of the pensioners indirectly relying on those surprise bills to pay for their retirements. Yes, America’s broken retirement system and broken health system are increasingly the same broken system. Owned and operated by private-equity, for whom the system is very much not broken and working just fine.
Is another Fed rate hike on the way? Or might we be looking at the beginning of the end of the current cycle? We’ll presumably have better answers to those questions following this week’s scheduled Federal Reserve meeting, when the Fed is expected to hike rates once again, but possible for the last time for a while.
And while many factors — in particular rising wages — play a role in the Fed’s rate hike decision-making, you have to wonder how big a factor the following private-equity financial time-bomb is in the Fed’s decision-making process. Because as the following articles describe, the private-equity industry’s rate-sensitivity goes well beyond just the impact rising rates have on the sector’s bloated commercial real estate (CRE) holdings.
For example, there’s all the corporate debt that’s become increasingly popular with private-equity investors in recent year. Corporate debt that obviously hasn’t performed well in response to all the rate hikes.
But then there’s the rate-sensitivity associated with the private-equity assets that have been fueling the corporate bond buying binge: insurance company asset pools. Yes, insurance companies are one of the other sectors private-equity has been increasingly investing in over the last decade. Why insurance companies? Well, thanks to regulations, they tend to have large pools of assets that well exceed their long-term liabilities. Assets that can be taken and invested by a private-equity parent company. Insurance companies also have a lot of ‘float’, which is the money coming into the firm before it has to later be paid out. Gambling with the ‘float’ is the apparently one of the new hot things in private-equity.
And here’s where it gets extra demented. There’s one particular type of insurance product private-equity firms are especially interested in: Annuities, which are effectively like personal pension insurance products. It turns out annuities have a feature that private equity finds particularly attractive in the form of ‘surrender charges’, which impose a potentially stiff fee for the early withdrawal of funds. So what we are ultimately seeing is private-equity firms using pension fund money to purchase insurance companies so they can gamble with the assets backing the annuity policies. And the gamble of choice has been corporate bonds, a particularly distressed asset class in a rising rate environment. It’s not great.
Ok, first, here’s an Institutional Investor article from February 2022 describing private-equity’s big dive into insurance. A big dive that comes with enormous opportunities. In particular, a big opportunity to take those giant insurance asset pools and invest them in higher-risk/higher-yielding opportunities. But also risks. Like the obvious risk that the underlying assets placed in higher-risk investments will be mismanaged and lose money:
“According to McKinsey, one major factor that has attracted private equity firms to the insurance space is the spread between the cost of liabilities and the potential investment returns. Insurance companies are “well stocked with assets,” which usually exceed the future payouts by a large amount. Until the companies approve insurance claims, they need to find return-generating investment vehicles in which to park the assets, and that falls into private equity’s area of expertise. Of course, insurance firms are highly regulated and only a small portion of these firms’ assets, which back policies, can be moved into higher risk investments.”
Yes, there was one major factor driving the recent private equity insurance company binge: insurance companies tend to have far more assets on hand than their future liabilities, as required by regulations. Assets that’s that need to be invested in the mean time. It’s those giant pools of regulated assets fueling private equity’s growing insurance appetite.
Of course, giant pools of assets don’t generate outsized returns without taking on additional risks. And that’s why the push towards private equity-owned insurance companies should really be seen as an elevation in the overall risk of the insurance industry. That’s how private-equity operates, after all.
But the article also hints at another risk: many of the insurance industry’s regulations happen at the state level. As such, it’s state regulators that private-equity firms navigating the insurance industry’s regulations have to work with. In other words, every state represents opportunities to find an extremely compliant regulator:
That was the situation in February 2022. Flash forward a year and we find the following American Prospect piece by David Dayen describing how the pension fund clients ultimately financing these private-equity insurance acquisitions aren’t the only retirement funds put at risk by this strategy. Private equity has a particular appetite for insurance companies that issue large volumes of annuities. The kinds of annuities that operate as personal retirement supplements.
Why annuities? Well, the funds put into annuities have a number of obstacles to the early withdrawal of funds, making the pools of annuity premiums particularly useful in creating what is known as ‘float’, or revenue streams coming into insurers before it goes out to pay claims and benefits. But while large pools of ‘floating’ cash represent an obviously useful source for generating income, that’s not necessarily risk free income. There’s no guarantee the ‘floated’ funds aren’t going to be lost. Losses that could ultimately translate to retirees not receiving their promised annuity payments. Annuities aren’t protected against an insurance company’s default, after all. And as the article also notes, while the insurance industry is indeed regulated at the state level, the track record for state regulators over the last decade has been rather underwhelming. Which is why we probably shouldn’t assume regulators will prevent the next meltdown:
“The problem is that PE always manages to find a new victim. Even as it reports losses to pension funds and other investors, managers are feeling little pain thanks to astronomical fees. And another juicy meal for the industry has recently emerged: insurance companies.”
As David Dayen warned just five months ago, private-equity has been on an insurance binge of late, and the consequences of putting those massive insurance reserves under private equity management are still unfolding. Downstream consequences like the eventual fallout from all of the gambling done using the insurance ‘float’. In particular, the ‘float’ coming in from annuity policies, which are themselves basically personal pension insurance products. So private-equity is purchasing insurance companies and taking the ‘floated’ money allocated for annuities to make big bets and earn the high returns their mostly-pension fund clients desire. Yes, pension funds are being financed by making bets with annuity money. Sure, all that ‘floated’ money will have to be paid out to the insurance clients someday. But not today. And if the money isn’t actually there when its eventually needed, it’s the annuity holders and pensioners who will feel the pain. The private equity fund managers will be just fine:
And note the company that appears to have pioneered the approach of using the large volumes of ‘floated’ annuity premiums to earn higher returns: Apollo, which created Athene in 2012 to focus on annuities. Annuities that now account for half of Apollo’s total assets under management:
So if private-equity’s new model is to buy insurance companies to control those giant pools of as sets, what kinds of investments are private-equity firms making with all that money? Well, as the following Financial Times article from last month describes, the private-equity industry has found a new ‘target’ for its large pools of cash to invest in: corporate debt.
Keep in mind that, the insurance industry in general has been on a corporate debt binge over the past decade, so it’s probably not entirely a coincidence that the private-equity corporate debt spree followed its insurance industry spree. And the fact that Apollo in particular is seen as leading the way in this trend only underscores that it’s likely Athene annuity premiums ultimately financing a lot of those debt purchases.
But as the following article also describes, it’s not as simple as just buying more corporate debt. Private-equity is increasingly using ‘financial wizardly’ to issue that debt in a manner that partially obscures the debt from corporate balance sheets. Techniques like transferring a manufacturing facility or real estate portfolio into a subsidiary or “special purpose vehicle” and then borrowing against that, allowing the parent company to avoid reporting that debt on its balance sheet.
Don’t forget the caveat we got in the above piece: self-dealing is an inherent danger when we’re talking about private-equity. Self-dealing like using private-equity funds to purchase the debt of other companies owned by the same fund. And here we are finding that private-equity is increasingly involved in setting ‘special purpose vehicles’ that can obscure corporate debt levels. It’s not hard to see how this ends poorly:
“Executives said the shift was a natural outgrowth of private credit’s fundraising spree, giving managers cash to lend. As well, most major private equity groups have bought or invested in an insurance company in the past five years, drawing in hundreds of billions of premiums to invest.”
A giant pool of insurance company assets. That’s apparently what’s fueling the current private-equity binge on corporate debt. It started with a binge on insurance companies over the past decade, leaving private equity firms with large pools of assets available for investment. And in the case of Apollo, roughly half its assets under management are thanks to a single insurer, Athene:
But unlike traditional insurance companies, private equity-owned insurance companies don’t face the same kinds of regulations that require they invest their holdings in relatively safe investments. This allows the private equity firms to engage in ‘financial wizardry’ potentially involving the creation of “special purpose vehicles” that have the benefit of hiding the newly issued corporate debt. So it sounds like we have private equity firms buying up insurance companies and then using those massive new asset war chests to make the kinds of risky investments the insurance companies themselves wouldn’t be legally allowed to engage in. Risky investments that, in turn, allow companies to obscure their debt loads. What could possibly go wrong?
And if this already doesn’t sound like a dicey enough situation, deals resembling traditional asset-backed securities are also increasingly popular in the private equity space. This is a good time to recall how the systematic mispricing of mortgage-backed securities played a key role in the lead up to the 2008 financial crisis. Let’s hope the private equity industry is doing a better job this time around!
Will private-equity’s big insurance play pan out for all of its pension fund clients? Time will tell. And as the following Reuters piece from the end of March, this insurance-fueled investment strategy has a rather large potential vulnerability: rising interest rates. Yes, rising rates pose an acute threat to this annuity-centric insurance-fueled phase of private-equity expansion. A threat in the form of annuity holders asking for an early withdrawal as higher rates create more and more temping alternative opportunities. Hence, Apollo having to assure the markets that it wasn’t going to face its own version of a ‘bank run’ due on Athene’s large annuity holdings. As Apollo pointed out, the bulk of its annuities have ‘surrender charges’ that impose a fine for early withdrawals. It’s a financial “fortress” as the company put it. But as the article also notes, that only covers 82% of Apollo’s annuity holdings, meaning 18%, or $33 billion, in annuities are indeed eligible for an early withdrawal. Apollo’s fortress has a pretty wide open back door.
Apollo also touted its then-$73 billion in available liquidity (as of March 10) including $56.9 billion in investment-grade corporate bonds. Also keep in mind that bond portfolio presumably dropped in value with each Fed rate hike since then. It’s all a reminder that the private-equity industry’s strategy in recent years of of plowing annuity premiums into corporate bond purchases could be particularly vulnerable to a rising rate environment:
““Now that we are seeing runs on select U.S. regional banks, we’re also starting to see some investors voice those same concerns about insurance firms. What’s going on in regional banks is like a wakeup call,” said BMO Capital Markets analyst Rufus Hone. Following a meeting with Apollo executives, Hone wrote in a note last week that he does not anticipate a spike in withdrawals from Athene’s annuity holders and that Athene’s funding base was stable.”
So with banks starting to teeter, what’s the status of all those annuity investments? That was one of the big questions facing Apollo back in March as the regional bank run was playing out.
But Apollo had an answer ready: Don’t worry about us! Our annuities are fine because of all the surrender charges that penalize annuity holders for early withdrawals! That was the message to the markets Apollo had to issue back in March as the bank run was playing out. A message of assurance: there simply couldn’t be a ‘run on annuities’ the same way there was a run on the banks. Except, of course, it’s not that simple. Yes, surrender charges do impose an obstacle to annuity withdrawals, but not a complete obstacle. If interest rates rise enough, it’s going to be worth paying those surrender charge fees and withdrawing anyway:
And then there’s the fact that 18% of Athene’s annuity liabilities don’t have surrender charges. Yes, it turns out the whole ‘no problem, we have surrender charges to save us from early withdrawals’ narrative ignores about $33 billion in liabilities:
Finally, note the type of assets Apollo was touting as part of its assurances that it has enough assets on hand to weather any upcoming storms: $56.9 billion in corporate bonds. It’s a financial war chest for sure. A war chest that shrinks with each rate hike:
Of course, rates and fall and this ever-growing bond portfolio could end up being a great investment. Again, time will tell. But it’s hard to avoid noticing how a lot of the underlying motivation for these investment strategies seem to have less to do with the underlying quality of the investments and more to do with the fact that these private-equity firms have more and more money under management with fewer and fewer remaining investment opportunities to work with. More and more money under management thanks to the insatiable appetite of pension funds that, themselves, having been plowing more and more money into private-equity for the same lack of alternatives.
We’ll see if this ultimately blows up. But it’s also worth keeping in mind that when you have a situation where private-equity firms can self-deal — like you sing the assets of insurance companies they own to purchase the corporate debt from other companies in their own portfolios that might be running into difficulties — and obscure, for a time, the real financial status of that portfolio of companies, it might take a while for things to all apart. But when it does, let’s just say America’s growing retirement crisis might finally be too big to realistically ignore. Not that we won’t still find an unrealistic way to ignore it.
Up we go. Ever higher. They did it. The Fed pulled the trigger and raised interest rates to the highest level in 22 years on Thursday and hinted at more rate hikes to come later this year.
On one level, it points to a robust economy seemingly intent on a ‘soft landing’ in the face of historic rate hikes. But as we’re going to see in the following pair of articles, the higher these rates go the more we’re seeing businesses forced scramble to adjust to a credit market environment that also hasn’t been seen in years. A credit market environment that is particularly poorly suited for the private equity model of leveraged buyouts in anticipation of an IPO.
And that brings us to a new trend in private-equity investing. Two trends, in fact: first, private-equity firms are increasingly purchasing the debt issued by their own ‘portfolio companies’ (i.e. the companies held by a private-equity firm’s investment portfolio managed on behalf of its clients). Second, it turns out that private-equity firms are increasingly selling shares of companies in their portfolios despite market conditions being distinctly unappetizing for such sales. Oh, and it also turns out that the investors on the other side of these share sales are the portfolio companies themselves buying back their own shares. So we have private-equity firms purchasing the debt of their own companies at the same time they are selling shares in their companies back to the companies themselves. Is this a problem? Because that seems like a potential problem.
Now, we should probably had some additional details. For starters, the reports on the new trend in private-equity buying the debt of their own companies came back in April, right in the middle of the regional banking crisis. A crisis that created some rather appetizing opportunities for investors with cash to spend as banks scrambling for capital were willing to sell off their corporate bond holdings at fire sale prices. In that sense, the story was an example of the enormous economic advantage private-equity for opportunistic market plays like taking advantage of crises that have other market players scrambling for the exits.
But as with all of these stories, there’s another side to the story. Like the fact that banks were willing to sell those bonds at reduced prices in part because of the expectation of further Fed rate hikes to come. Rate hikes that threaten to depress the profits, and therefore the share prices, of the same companies held in these portfolios. Which, of course, is directly related to the second trend, which Bloomberg reported on earlier this month, about the growing volume of “follow-on share sales” (share sales by insiders following an IPO) that are also increasingly be sold back to the portfolio companies themselves. Share sales taking place in a notably week market environment that has extended the 12–18 month period traditionally needed to complete all the follow-on share sales into a much longer timeframe. And as the report notes, part of the motive for these questionable share sales is the fact that rising interest rates are not only putting a crimp on corporate profits but also potentially making the upcoming refinancing of corporate debt all the more expensive. In other words, the shares are being rushed to market over fears of an even worse market to come. And that’s all why we have to ask: it’s this a looming private-equity problem of self-dealing, conflicts of interest, and ‘kicking the can down the road’ strategies? Or private-equity earning its outsized service fees by being extra savvy? As always, time will tell.
Ok, first, here’s that Bloomberg article from back in April, right in the middle of the regional banking crisis, describing private-equity’s big play: buying portfolio company debt. And as the article notes, while there were indeed bargains to be had, it was still a gamble. The kind of gamble that may not pan out well should interest rates keep rising:
“The trades come as banks have stepped up efforts to offload billions of dollars of debt stuck on their balance sheets — the product of a sharp repricing of risk assets last year that upended underwriting pledges. With Wall Street willing to realize significant losses in some cases to shed the risk, buyout firms coming off the weakest quarter for M&A since 2020 are finding the often double-digit yields on debt of companies they’re already well acquainted with too good to pass up.”
It was a private-equity bond buying bonanza back in April, thanks in large part to banking crisis that left regional banks scrambling for cash and willing to take a loss. In that sense, stepping in to buy those cheap bonds might be a shrewd business decision. The banking crisis created a fire sale too good to pass up.
And yet, as the article notes, it’s important to keep in mind that the same factor that triggered the banking crisis — rapidly rising interest rates — is the same factor that was depressing those bond prices and creating the opportunity too good to pass up. And as we were just reminded of on Wednesday’s Fed rate hike, there was never a guarantee rates wouldn’t keep rising and keep depressing those bond prices:
Also note how purchasing portfolio company debt — the debt of companies held in a private-equity firm’s portfolio — can be spun as a sign a strength and confidence in the company. And while that could indeed be the motivation, there’s obviously a range of other motives when we’re talking about companies that are intended to be sold off for a big profit someday, especially if we’re in an environment where there simply aren’t a lot privately-held companies going to market of late. In other words, are private-equity firms purchasing their own portfolio debt because they have a lot of confidence in those companies? Or because they don’t have a lot of other investment options and want to lower debt loads to sell those companies as soon as they can?
That was the news back in April, as the banking crisis that prompted that bond sale was still shaking out. Jump to earlier this month, and we find a very interesting new trend in self-dealing: private-equity firms are increasingly engaged in “follow-on share sales” (share sales by insiders following an IPO), despite the unfavorable market conditions. And guess who is increasingly buying those shares: the portfolio companies themselves.
What’s driving this trend? Well, it sounds like the IPO market in general has been awful, with the normal 12 to 18 month expected timeframe for a company fully unloading its shares after an IPO disrupted and taking longer. As a result, private-equity firms have yet to realize and lock in the gains much of the for their clients. Largely pension fund clients that are increasingly overexposed to private-equity and eager to see results.
But there’s another ominous reason for the rushed sales that only grew more ominous following the latest rate hike: rising interest rates are depressing the profits of these portfolio companies. In other words, they don’t expect these shares to actually do well going forward. Better to sell them now.
So we have private-equity rushing the remaining shares in portfolio companies into a lousy market in a race against higher interest rates and, in turn, increasingly selling them back to the portfolio companies themselves. Is this a penny-wise but pound-foolish investment strategy? Or something savvier? *fingers crossed*:
“With a lack of realized gains on their investments as proof of their capabilities, PE firms have a tough time convincing institutional investors like pension funds and endowments to fork over fresh capital for their latest funds. That’s exacerbated by the fact that institutional investors have an overexposure to private equity after last years’ inflation-fueled market swoon.”
Yikes. It appears that private-equity firms are feeling pressured to bring shares to market under very non-ideal market conditions. What are the sources of these pressures? Well, a lack of realized gains for their clients — which are largely pension funds at this point — is ironically one of the primary reason these shares are being sold as presumably sub-optimal prices. But there’s also the fact that pension funds are simply over-exposed to private equity at this point making them all the more sensitive to a lack of realized results:
But then we get to the really scary potential scenario down the road pension funds who are ultimately dependent on the sale of these shares to see the necessary yield on their investments: with interest rates poised to go higher, the future sale of the remaining shares might have to take place in a higher interest rate environment that has not just eroded the profits of these portfolio companies but made their debt-service more expensive. And because these are private-equity-owned companies, they are loaded with debt. So this is like a ‘hot potato’ kind of scenario: they need to sell those shares before rising interest rates tank their value. Fear of what’s to come is part of what’s behind this rush to market:
Notably, it’s the portfolio companies themselves who are purchasing a growing number of these newly shares. And while such moves have the benefit of allowing the companies to retire those shares, the shares aren’t free. Are the companies paying the lowest price they can get away with when repurchasing these shares or are they padding the portfolio’s immediate returns by paying an inflated price? We don’t know, but conflicts of interest abound:
And with the private-equity firms purchasing the bonds of their own portfolio companies, we have to ask the question: so is it the portfolio companies that had their debt purchased and canceled back in April who are now purchasing these new shares? And are they issuing new debt to purchase these shares? If so, who is ultimately purchasing that debt? The private-equity firms benefiting from those share purchases, perhaps? Again, time will tell.
But let’s not forget that the completion of the follow-on share sales might allow private-equity firms to exit their exposure to the companies in their portfolios, damn the downstream consequences. But the people working for those companies are presumably going to care about those downstream consequences. And we’re talking about the private-equity industry here, an industry notorious for larding up the companies they buy with debt and then screwing over the employees and stripping the assets. So when we read about portfolio companies buying the follow-on shares themselves, we should probably be asking whether or not we’re looking at another round of that same pattern. Those shares aren’t free and aren’t necessarily being purchased at the best price.
And while some sort of upcoming private-equity self-dealing disaster sounds possible should interest rates just keep ticking higher and higher, let’s not forget the downsides to this panning out and actually being a great investment strategy. Sure, it would be great for the private-equity fund managers and their pension fund clients if all of these trends ends up being savvy moves. But when the biggest players sitting on large piles of cash are able to capitalize on financial crises through self-dealing in their large portfolios of companies, what kind of systemic risks does this pose to the broader economy? Don’t forget that one of the classic criticisms of the rise of private-equity industry has been how it operates with an unfair market advantage that other players lack, meaning a lot of that savviness is really just exploiting those unfair advantages. Advantages that, again, are perversely amplified with largely pension fund money these days. Pensioners increasingly rely on a business model that damages society and probably shouldn’t exist.
And that’s all why we already kind of know how this ‘Heads we win, tails you lose your pension fund, and society is damaged either way’ gamble is going to pan out. The details have yet to be worked out, but it’s sure to work out great for a few insiders, especially the fund managers, and not to great for pretty much everyone else, especially pensioners and the employees of these companies. Which is sort of the meta-business model for the world in 2023, and another reason the private-equity business model, and many, many other business models, probably shouldn’t exist.
Pension funds increasingly investing in the annuity industry is one of those features of the US’s retirement industry that should raise all sorts of questions about what the future holds for America’s growing retirement crisis. Limiting annuity payouts to retirees to help pay pension plans is a rather questionable business model, after all.
But how about pension fund investments in other areas of insurance? Like auto insurance? What kinds of business model conundrums can we expect from these types of investments? Well, we got a hint of those conundrums thanks to a recent $90 million settlement arrived at in a lawsuit that pitted the investors of Allstate auto insurance industry against Allstate’s executives. Investors who were largely pension funds and annuity funds who faced a sudden 10% drop in the value of their investments back in 2015 after Allstate’s executives decided to update investors on the reasons for the then-38% drop in quarterly profits.
It wasn’t the weather, as the executives had previously suggested. No, it turns out that the precipitous decline in quarterly profits was due to a loosening of underwriting standards the company engaged in starting in 2013, the year Geico overtook Allstate in the auto insurance market. Loosened underwriting standards that, for a period of time, did indeed increase Allstate’s customer base. But by the last quarter of 2014, that business strategy came with a predictable cost in the form of higher payouts. It was that loosening of standards, and the initially deception about the impact of those loosened standards, that formed the basis for the now-successful lawsuit.
And while it’s not clear that the pension fund investments in Allstate were done through a private-equity fund — Allstate accepts a range of institutional investors including pension funds and hedge funds — this remains a story with potentially significant future implications for the pension fund industry’s ongoing and deepening love affair with private-equity. Because it’s hard not to notice the parallels between the short-term enrichment strategy pursued by the Allstate executives and the overall private-equity ‘heads we win, tails you lose’ business model.
And that brings us to one of the very interesting details of this lawsuit: when it was first file in 2017, the pension fund plaintiffs were seeking to have at least part of the settlement paid via disgorgements from the top executives’ salaries from 2014 and 2015. Which makes sense if you think about the fact that many of these plaintiff were possible still Allstate investors. Having the company itself pay a fine over the malfeasance of top executives out to shareholders might directly compensate the shareholders, but potentially also impact the existing share prices, a problem that presumably wouldn’t come if the fine is paid via the disgorgements from the top executives past salaries.
Sadly, it doesn’t appear that such disgorgements were part of the ultimate $90 million settlement. At least the reporting doesn’t mention it. But still, it’s nice to see pension funds at least pursuing the option. You never know when disgorgements might come in handy for dealing with the pension funds’ partners in this ‘heads we win, tails you lose your retirement’ industry.
Ok, first, here’s a report on the $90 million settlement. A settlement pursued by two classes of investor: pension funds and annuity funds:
“The lawsuit came after Allstate on Aug. 3, 2015, reported unexpectedly high claims payouts from auto accidents, causing a larger-than-expected 38% decline in quarterly operating profit.”
Allstate’s pension fund and annuity fund investors didn’t like being lied to by the executives. Especially when the executives were lying about the cause of the 38% drop in quarterly operating profits. Hence the settlement. $90 million paid out to the shareholders at that time who actually took a hit from the 10% drop in Allstate’s stock following the belated mea culpa be Allstate’s top executives that, yes, it was a loosening of the underwriting standards two years earlier that was the cause. Not the weather as previously claimed
Again, keep in mind the growing trend of pension funds investing in annuity companies via private-equity. So when we see both pension fund and annuity funds suing over this, don’t forget that the pension funds may be behind those annuity fund too:
So given that the lawsuit succeeded in arriving at a settlement, it’s worth noting what the plaintiffs originally asked for when the suit was filed back in 2017: a disgorgement of the top executives’ salaries from 2014–2015, on top of damages. And while it doesn’t appear that such disgorgements were part of the settlement, it’s a rather remarkable request from screwed over investors. Especially should such insurance-related lawsuits end up hitting the private-equity industry. An industry with a ‘heads we win, tails you lose’ business model where the private-equity fund managers make a fortune regardless of how the investments perform. That’s part of the significance of this lawsuit: It was almost tailor-mode for addressing the inherent gross injustices with the industry’s ‘heads we win, tails you lose’ business model:
“Shareholders seek disgorgement of top executives’ salaries for 2014 and 2015, plus damages for breach of fiduciary duty and unjust enrichment. The complaint also demands shareholders be allowed to vote on proposals to strengthen controls over financial reporting and to strengthen the board’s oversight of underwriting standards.”
It sure would have been nice to see some top executives have their past salaries disgorged. If only as a tiny first step in the right direction. That didn’t happen, but it was nice to see some investors actually calling for those kinds of solutions.
And note how, for a while, the strategy of loosening those underwriting standards did indeed improve Allstate’s sales. It’s a reminder of why this strategy was so tempting: it was guaranteed to get results in the short-term. It obviously came with the implicit gamble that those policies were going to have to be paid out one day, but it worked for a while:
Also note part of the motive behind the loosening underwriting standards: Allstate was losing market share in 2013. Loosening underwriting standards was a clear way of reversing that trend. It came at a price. But, again, it’s not like the loosening of the underwriting standards didn’t accomplish the desired results in the short-run:
Also keep in mind that what we are seeing play out in this auto insurance sector will potentially apply to all sort of areas of insurance. Health insurance, home insurance, life insurance. All of these sectors could ‘benefit’ in the short-run from loosening of underwriting standards. That’s, again, why the disgorgement lawsuit strategy to end up being much more popular in future years.
Also keep in mind that, with climate change worsening, it’s entirely possible that ‘the weather’ really will be the culprit. In other words, for weather-vulnerable forms of insurance like home and auto insurance, a refusal to tighten underwriting standards could effectively operating as a ‘loosening’ over time. The insurance industry, like the pension industry, is based on a making sane long-term bets. Which is also a reminder that the whole economy-wide paradigm of paying top executives gobs of money to ensure short-term share price appreciation isn’t actually compatible with pensions. Or insurance. Or a viable future. The kind of future we won’t be able to disgorge our way out of.
How dangerous would an AI-driven private equity firm be to the world? It’s one of those fun thoughts that’s no longer idle speculation. At least it won’t be someday. It’s really just a matter of time before the CEOs of large investment firms — some of the most expensive employees on the planet — get replaced by AIs, so we might as well start thinking about the potential consequences. And perhaps a good way to ask that question is to try and answer a closely related question: how much more, or less, dangerous would an AI private equity CEO be to humanity than, for example, Tim Gurner, the latest financier to ‘say the quiet part out loud’ before quickly apologizing? Those would be the comments, now heard loudly around the world, that Gurner — founder of the Gurner Group real estate development firm — made at a recent Australian Financial Review panel. Comments that decried how uppity employees were getting with respect to employers, with all sorts of employees getting the notion that their employers are actually fortunate to have someone capable of providing their labor and contributions. Gurner went on to cheer the policy currently being pursued by central banks — notably the Fed — of raising interest rates for the expressed purpose of raising unemployment and tamping down wage gain demands. Gurner pines for “pain in the economy”, in particular a rise in unemployment by 50%, so people would relearn that they work for their employers who aren’t actually fortunate to get their labor. Yep, he said that. In public.
And then, predictably, Gurner apologized a few days later and retracted the insensitive comments. Presumably after all his private-equity friends called him up and hounded him out for saying the quiet part out loud. The ultra-rich aren’t supposed to publicly share their contempt for the rabble. It’s not just classless. It’s like an invitation for a class war. Or rather, an invitation for the rabble to recognize that the major reason average people have been struggling so much in recent decades is precisely because the ultra-rich have been quietly waging a class war the whole time. Waging and winning that class war, one tax cut, deregulation, and gutted social program at a time. It’s like Fight Club in that you don’t talk about. Although it’s the opposite of Fight Club in that it’s just a few rich guys beating the snot out of the masses ruthlessly for decades on end. Either way, you’re not supposed to talk like that.
Tim Gurner obviously isn’t the first ultra-rich guy to express such sentiments. But he might be the first one to do so in such a big way in the era of truly impressive AI. The kind of AI that portends future AIs that could plausibly replace a CEO like Gurner for much of the decision-making of the firm. So given this opportunity Gurner gave us to once again examine the ongoing stealth class war that’s been wage and won with brutal efficiency by Gurner and his fellow global ultra-rich, it’s worth asking the question: how much more dangerous would an AI CEO be to humanity than Tim Gurner? Which one would exhibit more humanity and possess a higher degree of empathy?
And forget hypothetical future intelligence AIs. How about ChatGPT? Which one would you rather see at the helm of the Gurner Group, from the perspective of a non-investor who is just trying to survive in this world? Tim Gurner? Or ChatGPT? These are the sad questions we get to ask in our sad world run by figures like Tim Gurner. Of course, for the Gurner Group’s investors, the answer is clear, for now, that Gurner as CEO would be preferable to ChatGPT. But you really do have to wonder how long it will be before an AI really could perform Gurner’s role with just as much proficiency. Because odds are the AI will be able to do the job at a fraction of Gurner’s cost too. And without his public image.
But there’s another reason that just took place last month that made Gurner’s comments particularly untimely for the financial industry: private-equity just dodged a bullet. Again. As always.
Or as Axios put it in the article below, Gary Gensler, head of the Securities and Exchange Commission (SEC), ‘blinked’ in the face of industry demands to defang the new regulation congressional Democrats were demanding. Not that there aren’t new rules and regulations for the sector. But it was by all accounts dramatically watered down from what was being talked about just weeks earlier.
Gensler ‘blinked’, and almost no one noticed (who knows why). And then, a few weeks after Gensler ‘blinked’ without anyone noticing, Gurner ‘blabbed’. The timing almost couldn’t have been worse.
And while the Gurner Group might be primarily focused on real estate development, it also takes institutional client money like sovereign wealth fund money. In other words, the Gurner Group is effectively a real estate focused private-equity fund. As we’re going to see, the Gurner Group been expanding heavily in Australia’s residential rental markets, setting up funds that recent got $400 million in investment from Singapore’s national ‘rainy day’ sovereign wealth fund of foreign reserve investments and even raised $2 billion back in February from an investor its choosing not to name to build build-to-rent (BTR) luxury apartments in Australia. Because it turns out the Australian-based Gurner Group, much like the rest of the private-equity industry in US, isn’t required to publicly disclose their investors. And that still appears to be the case in the US following the new SEC ruling.
Of course, none of this will actually result in the private-equity industry’s bullet-dodging last month garnering a large amount of public attention or outrage. As is the case with most outrageous abuses of power. The public doesn’t really care, in large part because the private equity take-over of the economic has been quietly steadily building for decades. It’s slow motion. Not headline grabbing. Plus, the industry known for gobbling up entire sectors of the economy is on its way to owning the media landscape too. Because of course that’s what happening. What else did we expect? Odds are all the private-equity-owned media isn’t going to be super keen on reporting about how private-equity just won its showdown with the SEC two weeks before Gurner made these remarks. Which is why, odds are, the industry is going to dodge another bullet. A very bad PR bullet, loudly fired by Tim Gurner’s big careless mouth that got accidentally honest and gave use a glimpse at how the world looks from on high when you’re at the top of rigged pyramid:
““We need to see unemployment rise,” Gurner declared. “Unemployment has to jump 40, 50 per cent in the economy. We need to see pain in the economy. We need to remind people that they work for the employer, not the other way around. There’s been a systematic change where employees feel the employer is extremely lucky to have them, as opposed to the other way around. It’s a dynamic that has to change, we’ve got to kill that attitude, and that has to come through hurting the economy, which is what the whole global – the world – is trying to do… to increase unemployment to get back to some sort of normality.””
Surging unemployment is a social good, according to Gurner Group founder Tim Gurner, because it will put workers back in their place. The proles are getting too uppity, it seems. Sure, Gurner has now recanted those words following the global outcry. But the article points out, there’s no real way to deny what he said. Gurner was just regurgitating the unspoken rules of neoliberalism. Along with the unspoken goal. A goal of reversing the class gains of the last century and returning to a more feudal era. A time when the serfs know their place. Which happens be be beneath the boot of the ultra-wealthy. Wealth is for the wealthy. Work is for the poor:
And as Gurner reminded us with his comments about how, “we’ve got to kill that attitude, and that has to come through hurting the economy, which is what the whole global – the world – is trying to do… to increase unemployment to get back to some sort of normality,” that class warfare sentiment and a desire to keep the poors in their place really is being pursued around the globe, especially be central banks that have long view wage inflation as the most pernicious form of inflation possible and an excuse to hike rates in the pursuit of higher unemployment and lower wages. It’s presumably part of why Gurner felt the need to issue a public apology: he wasn’t just saying his own ‘quiet part out loud’. He was sharing the financial world’s general sentiment. Fed Chair Jerome Powell hasn’t been shy about expressing exactly that opinion. The really is a global elite desire to reign in the rabble with the threat of unemployment. Or as Gurner might put it, a “return to normalcy”. The kind of normalcy an aristocrat might find familiar:
So with Tim Gurner accidentally exposing himself, and his industry peers, to the world, it’s worth asking: so who are the Gurner Group’s investor clients? Pension funds possibly? Other ‘little people’ who need to be put in their place? It sure would be interesting to know how those types of investors feel about partnering with the Gurner Group.
And that brings us to the following article in the Australian Financial Review from February of this year about the $2 billion raised by the Gurner Group for its ‘build-to-rent’ (BTR) investment fund. A fund set up to build rental properties in Australia. Specifically, luxury rental properties. This isn’t about addressing Australia’s affordable housing crisis. It’s about making money for Gurner and his investors.
So who gave the Gurner Group $2 billion months ago to build luxury rental properties in Australia? We have no idea because the Gurner Group isn’t saying and they don’t have to say. Which is a reminder that Gurner’s ‘starve the poors’ attitude is operating in an industry that enjoy with extraordinary privileges globally:
“Mr Gurner, who last year secured $400 million from Singaporean sovereign wealth fund GIC, to grow his east coast build-to-sell apartment business, would not disclose the identity of the new $2 billion BTR investor, but confirmed there was no Australian money involved.”
Who is that mysterious $2 billion investor? It sure is an interesting question now that Gurner has turned himself into an enemy of the common man. What kind of investors are these? Investors ostensibly working for the common man, perhaps? Pension funds? Sovereign Wealth funds? Gurner isn’t saying, other than that it’s offshore money. But thanks to the extreme secrecy enjoyed by his industry we have no idea who it is, which also presumably means this international investor hails from a country with its own secrecy rules in place that allow this investor to keep their own investments secret too.
Intriguingly, this $2 billion mystery investment came weeks after reports that Blackstone was also planning further BTR investments of its own in Australia’s market. Which raises the question: could the mystery investor be Blackstone’s own Australian BTR fund? We have no idea, but it’s hard to avoid suspicions given the secrecy:
And just note the kind of impact the Gurner Group’s real estate investments are going to have on Australia’s housing market: it’s exclusively luxury housing. In other words, these are the kinds of investments that are only going to exacerbate existing housing affordability crises:
And in case it’s not clear that the kind of secrecy enjoyed by the Gurner Group in Australia is also routine for the private-equity industry in the US, here’s a look at a potentially massive change in how private-equity was forced to operate in the US. At least that’s how it looked last month when the following Fortune Magazine article was written and the SEC had yet to rule on the new slate of regulations backed by congressional Democrats like Elizabeth Warren. New rules like a requirement to issue quarterly performance reports or conduct annual audits. Along with new rules on the public disclose of investors. Yep, private-equity can legally keep its investors secret under the current regulations. And this is still the case despite private-equity eclipsing commercial banking in 2020. It’s a giant, and rapidly growing, largely unregulated shadow banking sector of the global economy.
Now, as we’ll see, this slate of new rules that promised to gut the industry’s ability to operate in the shadows were, themselves, gutted at the last minute when the SEC made its ruling a few weeks ago. The industry dodge the bullet again. But it’s worth noting that it was just last month when it looked like private equity might finally be facing a kind of moment of truth...before dodging the bullet as usual:
“Last year, the Securities and Exchange Commission proposed new rules for the industry that it may adopt as soon as this month, the Wall Street Journal reported, citing people familiar with the matter. It would be a major change for private funds, which have, until now, enjoyed loose regulation. The private market has burgeoned and drawn investors because of its lack of regulation compared to the public market, which has become increasingly regulated over time, Steven Kaplan, a private equity researcher at the University of Chicago, said.”
New rules for private-equity are on the way! At least that’s how it looked last year when the Private Funds Proposal was I’ll getting formulated. Not only would private-equity firms and hedge funds be forced to issue quarterly performance reports to clients and conduct annual audits, and actually disclose to clients the fees they are charging, but they could be forced to disclose information about clients too. Information like client identities:
And note the industry’s rather laughable defense against these rules: the SEC had no standing to regulate the industry because congress has exempted the industry from these rules for such a long time. There’s a precedent for loose regulations that should be adhered to. It’s a remarkable way to express that profound sense of entitlement. Especially since it was congressional Democrats pushing for these new rules:
Also note the timing of these potential new rules: they were coming right when private-equity funds are reporting their first negative-return year since 2009. Which raises the question: just how much more negative might those returns be under these proposed disclosure rules? And how many other FTX-like financial time bombs are there waiting to go off the moment they are exposed to sunlight? Because it doesn’t sound like clients were necessarily obligated to receive accurate information under the existing rules. Everything is allowed to remain opaque until the assets are sold. In other words, the opaqueness at risk of being lost under these rules are probably exceptionally convenient for the industry during a down year when losses have to be hidden:
Finally, note that this sector now eclipses the commercial banking sector. With almost none of the commercial banking sector’s regulations. Because we apparently can’t learn lessons:
Yes, it was a moment of hope, not too long ago. The private equity industry’s amazing multi-decade run in the US as a regulatorily-preferred sector of finance was facing a very real threat. But that was then, and this is now:
“The bottom line: Gensler blinked.”
Yep, the new rules basically got tossed. Not all of the new rules. But most of them it seems. Gary Gensler, the SEC Chair, ‘blinked’ in the face of all the industry lobbying. Because of course he did. That’s what happens. Virtually always. Power wins.
So that almost concludes our look at how Tim Gurner’s surprisingly honest comments about the need to teach the little people to stay in their place was almost eclipsed by an ending of an era of the private-equity industry. Almost. But then the same thing that always happened happened again. Tim Gurner’s era continues.
But, again, Tim Gurner wasn’t just expressing his own personal views. He really was revealing a widely held class sentiment. A sentiment that in many ways echoed now-notorious comments made by Blackstone’s CEO Stephen Schwarzman back in 2011. As Schwarzman lamented at the time, not enough poor people pay income taxes and he wishes all of them had to pay at least a little....so they would have ‘skin in the game’ as he put it.
And then Schwarzman went on to elaborate by suggesting that the 45% of Americans who are too poor to pay income taxes aren’t really “part of the system” and can’t have an “we’re all in this together, solving problems together” attitude. He really said that. This was just months into the Occupy Wall Street movement. That’s how firmly Schwarzman held those views. He expressed them as people were camping out in the streets to protest people like him. The guy who is still leading the world’s largest private-equity firm, a firm with almost $10 billion in public pension money under management as of March 2020 as the pandemic was unfolding, views average people as a bunch of leeches who aren’t really ‘part of the system’ or willing to ‘solve problems together’. And in the years that followed, public pension funds showered his firm with billions.
Keep in mind that Schwarzman topped the list of US CEO pay in 2008, the year Blackstone went public. Which was also, of course, right before the financial crisis created by Wall Street’s grotesque greed blew up the stock market, devastating Blackstone’s share price. But at least the insiders got to get out before things went south.
And that’s all why we have to assume Tim Gurner’s ultra-wealthy peers probably weren’t very pleased with his comments. Because, again, Tim Gurner wasn’t just expressing his personal opinion. He was echoing a sentiment we’ve been hearing from his ultra-wealthy brethren for years as they got wealthier and wealthier, whether Stephen Schwarzman prefers we remember or not:
“The issue isn’t the amount, it’s the concept that we are all in this together, solving problems together.”
Why can’t the poors just work with us to solve problems together. So said the billionaire two months into Occupy Wall Street. It was so stupid on so many levels it raises the question: who got yelled at more by their ultra-wealthy peers after their lapses in accidental honest? Schwarzman in 2011 or Gurner in 2023? Either, it’s the same old story, just with a lot more wealth and power for the industry in 2023 compared to 2011. Don’t forget what Schwarzman said in December 2020: the pandemic presented the kind of ‘acceleration moment’ for the industry that the 2008 financial crisis presented for the industry, where it came out of it bigger than ever. In 2011, Blackstone was already riding that ‘acceleration moment’, and it sure looks like the last few years of been another one of those ‘moments’. A moment heavily fueled by pensions, sovereign wealth funds, and other large pools of institutional money lured in by the promises of higher returns. Steve Schwarzman, Tim Gurner, and a whole lot of other extremely wealthy people are a lot wealthier than they were in 2011 thanks in large part to access to the pools of funds of the savings of average working people. Average people who aren’t earning their keep apparently, in the eyes of these titans of industry.
Which, again, begs the question: who would be worse for average working people to be managing these investment firms? Figure like Tim Gurner and Steve Schwarzman? Or some sort of next-gen AI that will maybe be available in a decade or so? The AI obviously poses risks. But are they worse risks? We’ll find out. But if it turns out that humanity ultimately seals its doom after handing too much control over to AIs put in charge of investment funds and other institutions that keep society humming along, let it be known that the guys in charge before made it very difficult to not give Skynet a try.
Are private-equity giants behaving like financial predators in today’s markets? Or are they operating more like pension-fund-bloated useful-idiot prey for for sophisticated investors? It’s long been a question looming over this sector of finance and as we’re going to see, there’s a new twist to this question: the growing trend of commercial real estate (CRE) investors turning to ‘dequity’ in the search for financing to fill in existing financial gaps. ‘Dequity’ being a term to describe the range of lending tools that combine a mix of debt and equity. Higher risk lending like mezzanine loans that tends to charge higher interest rates and come with conditions that allow the lender to trade in the debt for equity in the property. In other words, the kinds of loans that borrowers to typically engage in unless they have no better options. That’s the new big trend in the CRE sector.
And while private-equity giants are obviously in a position to exploit this kind of market distress and seek out opportunities for distressed borrowers who they can shake down with a stingy ‘dequity’ offer, we’re also implicitly talking about a number of distressed private-equity-backed CRE projects if when we’re learning about new levels of distress in the CRE markets. And that’s why we have to ask: is this story about the growing CRE reliance on ‘dequity’ a net good-new or net bad-news story for private-equity? And in particular, private-equity’s extensive list of pension fund clients already deeply invested in the CRE sector. How is this trend going for that group CRE players?
The answer isn’t obvious, at least not based on examples we’re going to read about. In one case, Masterworks Development bought a discounted note on a $61M mezzanine loan belonging to a portfolio of distressed Blackstone-owned hotels just last month. The $61 mezzanine loan was first issued in 2017, shortly after Blackstone’s 2016 purchase of the hotels from Masterworks for $283 million, along with an additional $274 million loan in more traditional mortage-backed securities. So as we can see, the current precarity of Blackstone’s investment is exacerbated by the underlying private-equity model of purchasing businesses and then loading them up with debt. And in this case, it appears the businesses are in such poor shape that the original holder of that $61 million mezzanine loan decided to sell it at a discount instead of using the option to convert it to an equity stake in the properties. It points towards the underlying trend driving this new ‘dequity’ trend: a lot of CRE business models are still broken.
It’s that broken CRE business model that has turned traditional borrowing that has handed lenders the kind of leverage where ‘dequity’ is really the only option for increasingly desperate CRE borrowers. It’s a sentiment rather frankly expressed by Geri Borger Urgo of Newpoint Real Estate Capital — a new CRE lending platform created by private-equity giant Meridian Capital Group a couple of years ago — who put it as follows: “What I think is interesting about pref right now — and I love the term ‘rescue capital’ — but there is a shift, or maybe a buyer-beware aspect to it...I don’t want to use the term predatory financing, but it’s what comes to mind. So we’re seeing a lot more power being given over to that pref holder.”:
““What I think is interesting about pref right now — and I love the term ‘rescue capital’ — but there is a shift, or maybe a buyer-beware aspect to it,” said Geri Borger Urgo, Newpoint Real Estate Capital’s head of production. “I don’t want to use the term predatory financing, but it’s what comes to mind. So we’re seeing a lot more power being given over to that pref holder.””
Yes, the borrowing landscape for CRE developers has become so unfavorable for borrowers that ‘dequity’ — describing a form of borrowing that can result in lenders gaining equity stakes in investments — has become the new buzzword. It’s now the de facto ‘solution’ for a sector facing increasing borrowing costs and who have no other option. But don’t call it predatory financing:
And while we should expect deep-pocketed players like the private-equity sector to be salivating on the sidelines waiting for an opportunity to play the role of a preferred lender, there’s also no avoid the reality that private-equity remains one of the biggest existing CRE investors. In other words, if ‘dequity’ is the new hot trend in CRE, that almost certainly means a large number of private-equity investors are on the ‘wrong’ side of this trend too:
A mezzanine loan bought at a discount. It’s like a distilled example of ‘dequity’ in action. Keep in mind that this wasn’t a newly issued mezzanine loan but instead, as we’re going to see in the following article, an existing loan issued in 2017. And that means someone else was already holding the loan held the loan and decided to sell it at a discount to Masterworks instead of triggering the conversion to equity. It’s a potentially significant clue as to the business prospects for these properties.
And don’t forget, when we see discounted mezzanine loans issued on property held by a Blackstone real estate fund, it’s Blackstone’s clients who are ultimately on the short-end of this deal should those loans get converted into equity. Clients that almost certainly include Blackstone’s many pension fund clients.
Also don’t forget that these ‘dequity’ deals may save borrowers from more drastic measures in the short-run, but at a cost to the long-term yield on the investment. Mezzanine loans tend to be much higher interest than more traditional forms of borrowing. So we should probably expect the long-term side-effects on investment yields from this growing ‘dequity’ trend to only show up years from now. Likely in the form of reduced future yields for private-equity’s pension fund clients in many case.
And as we can see when we take a closer took at that ‘dequity’ deal Blackstone secured last month for its ailing hotels, the private-equity group operating as the predator in this case, Masterworks Development, is actually the same private-equity company that sold Blackstone the now-ailing hotels back in 2016 in a deal Blackstone financed, in part, with the $61 million mezzanine loan at the time.
It’s all a reminder that the debt-intensive private-equity strategy of using large amounts of debt to make highly leveraged acquisitions is an increasingly dangerous strategy as interest rates rise and tradition means of borrowing dry up. It’s also an example of why one of the big questions looming over this ‘dequity’ trend in CRE market is whether or not private-equity — with its deep pockets but also deep existing exposure to the real estate sector — is going to end up being more predator or prey:
“The Blackstone fund bought the four hotels from Masterworks in 2016 for $283 million.”
That’s quite an investment performance: Blackstone buys these four hotels from Masterworks in 2016 for $283 million. Then immediately issues the $61 million in mezzanine debt on top of a $274 million loan against the property. It was the classic private-equity debt-intensive approach to investing. And then the pandemic happens and the properties end up basically going into default. And here we are in 2023 with the properties still in default and Masterworks Development in a position where it could purchase that mezzanine debt at a discount and able to immediately decide whether it wants to convert that mezzanine into equity and take over the properties itself, or somehow refinance the debt and keep Blackstone as a borrower. Either way, this was obviously a great deal for Masterworks. Not so much for Blackstone’s clients, with the value of the portfolio down 15 percent from what what it was appraised at in early 2017 when Blackstone took out that $274 million loan on its newly acquired property:
So what’s Masterworks going to do? Convert the debt to equity? The last holder of the mezzanine debt obviously didn’t find that to be a tempting option. We’ll see, but the fact that the portfolio of hotels is expected to continue to struggle “in the near to medium term” suggests Masterworks might have the option to execute an equity conversion move for the medium term too, not that it necessarily has any medium term appetite to do so:
Let’s hope the particular Blackstone fund behind this now-troubled CRE investment wasn’t a bunch of pension funds. And if so, let’s hope the mezzannine financing ends up actually helping the investment stabilize itself and doesn’t end up just diluting an already ailing investment. Either way, this is just one of a growing number of number of ‘dequity’-financed investments in the CRE space. Investments that will have reduced long-term yields on these investments at best, and possibly much worse results when this all shakes out in the long run.
It all raises another grim question for this sector: So are any pension-fund backed private-equity funds playing the role of predatory lending in this environment? It will be interesting to see if that ends up happening too, or if the pension funds are mostly just prey here. On the one hand, it will be kind of awful to learn about pension funds benefiting for predatory lending practices. But on the other hand, it’s arguably more awful to learn that everyone in this space is engaging in predatory lending except for pension funds who are all on the receiving end. It’s a kind of moral hazard that shouldn’t have been allowed to develop in the first place, but here we are, forced to hope pension funds are operating more as predator than prey, while recognizing it’s probably the opposite.
The pain is piling up. Along with the assurances that it’s all manageable and there’s nothing to worry about. And yet the worry is only growing as the private-equity continues to grapple with what is arguably the biggest challenge in the industry’s history: the assumptions the industry’s entire business model has been predicated on has gone into reverse and looks likely to stay in reverse for the foreseeable future. Assumptions like historically low interest rates, readily available refinancing options, and a seemingly endless source of new investor funds. In particular new pension investor funds. All of those trends are over, and it’s not clear that the industry has a response beyond even more desperate financial engineering options. The kind of financial engineering options that all seem to be centered around buying a financial cushion now at the cost of future returns. Options that could become particularly costs down the line should the current interest rate environment — a historic normalization — not go into reverse with a return to the historically low borrowing costs that fueled the last decade and a half of the sector’s growth.
Now, of course, the private-equity industry’s defenders will point to the other major asset that the industry brings to these investments: superior management skills. At least that’s the sale pitch the sector has long used to lure in more and more investor money. But what if those superior investment skill were just ‘vaporware’ the entire and it really was just a sector based on financial engineering gimmicks that simply aren’t possible without historically low borrowing costs? What if, as one market player puts it, “Many of the reasons these guys outperformed had nothing to do with skill...Borrowing costs were cheap and the liquidity was there. Now, it’s not there...Private equity is going to have a really hard time for a while ... The wind is blowing in your face today, not at your back.” What if that’s the reality of the situation? It’s the big question facing the industry and most especially all of those pension fund investors now trying to determine if they need to pull back or double down. We’ll seeing how much additional pension fund money ends up flowing into private-equity funds as this plays out, but as the following Financial Times article makes clear, a lot of that money is going to spent just trying to prevent the existing broken business model from bursting at the seams:
““Many of the reasons these guys outperformed had nothing to do with skill,” says Patrick Dwyer, a managing director at NewEdge Wealth, an advisory firm whose clients invest in private equity funds. “Borrowing costs were cheap and the liquidity was there. Now, it’s not there,” he adds. “Private equity is going to have a really hard time for a while . . . The wind is blowing in your face today, not at your back.””
Yikes. What if the outsized historic returns of the private-equity industry in recent decades was primarily all down to low interest rates and financial engineering? What if these returns had little to do with the industry’s alleged superior management skills? That would suggest the industry is rather screwed in today’s normalized interest-rate environment, wouldn’t it? That’s the big meta question looming over this story: is the private-equity industry a sham that could only function as long as interest rates were held at near-record lows? And if so, what does that bode for the industry going forward? After all, of private-equity giants like the Carlyle Group can manage to raise capital, what does that say about Carlyle’s smaller competitors? The entire sector appears to be in a state of distress that has no signs of lifting soon:
And note the response from the industry itself assuring investors that everything will be fine: Blackstone’s president points out how much “dry powder” there is in uncalled investor cash that the industry still has that’s available when the right deals come along. But as other point out, that optimistic outlook is predicated on a business model that — using massive leverage to take companies private — is no longer viable as long as interest rates remain higher for longer. Plus, those predicted great deals on distressed assets are presumably going to be include deals offered by other private-equity firms trying to offload assets they can no longer finance. In other words, the ‘good news’ of great deals that should be available doubles as perilous news for the sector. It’s two sides of the same coin:
And when we see reports about how lenders are getting increasing wary about refinancing heavily indebted companies with borrowings nearing maturity, note the names of those big lenders: private-equity giants Apollo, Blackstone. So when we hear assurances that private-equity be able to finance its way out of this situation, it’s worth keeping in mind that the creditors who are currently holding back on lending include other private-equity firms:
So what will the industry ultimately end up doing to stay afloat? Well, there’s short-term solutions like payment-in-kind debt, that simply push off interest payments into the future. Or as one executive describe it, a “Hail Mary”:
And then there’s the “net asset value” (NAV) financing, that involves borrowing money using things like cash flow as part of the collateral. Borrowing to pay out to the investors. It’s an example of the kind of financial engineering options that can keep the fund paying out to investors as expected in the short-run, but poses obvious long-term risks that includes eventually forcing the sale of the healthiest assets in a portfolio to eventually repay these loans:
There’s also the growing interesting in self-dealing, where a private-equity firm basically sells the assets of one fund to another fund. Great in the short-run...not so much in the long-run:
As another example of the argument that the industry was really just a one-trick-pony based on low interest rates and leverage, we see the warnings about how many private-equity firms have exploded in size over the last decade, which in turn implies that much of the assets owned by these firms were purchased near the market highs. And that includes firms like Thoma Bravo, which grew from around $2 billion in assets in 2010 to $131 billion in 2023. This is a good time to recall how Thoma Bravo had to deny insider trading accusations related to its investment in SolarWinds, where the company appeared to sell off a stake in its SolarWinds investment to a Canadian pension fund literally one day before the SolarWinds mega-hack was publicly announced. Which is a reminder that the self-dealing sale of overvalued assets from one private-equity fund to another is probably going to involve the sales that end up leaving private-equity’s pensioner investors holding the bag:
And that brings us to ominous warning at the end: pensions and endowments are already pulling out of the sector and accepting large losses to do so. Keep in mind that pensions have been the dominant private-equity investors for the past decade. So if the dominant private-equity investor sector ends up pulling back significantly, that’s only going to make the sector more and more reliant on these ‘alternative’ forms of financing:
Again, the industry’s historic track record is predicated on historically low interest rates, financial leverage, and a seemingly endless flood of new investor cash. What happens when all of those trends go into reverse? And what if it’s in reverse for years to come? We’ll see, but pension cuts seem like a pretty foreseeable outcome. Along with more yachts for the fund managers and partners. It’s that kind of broken business model.
One man’s crisis is another’s opportunity. It’s a phrase often heard in the context of investing. But there’s probably a more complete way of putting it since another’s financial crisis is really only your opportunity if you have the cash on hand to exploit it. One man’s crisis is a rich man’s opportunity. It’s kind of how our system works.
And that brings us to the following set of stories about an unfolding dynamic in the private-equity markets. The kind of dynamic we should expect at this point: family offices — the investment firms for the ultra-wealthy — have for the first time allocated more of their assets in the private markets vs public equities. According a survey of 330 family offices by Campden Wealth and RBC, the portfolio allocations to public equity and private capital markets were respectively 28.5 per cent and 29.2 per cent last year in 2023. This is the first time family office allocations to private capital markets have has exceeded the publicly traded stocks. It also sounds like these family offices are stocking up on cash, and laying in wait for the right opportunities.
At the same time, another record was just set in the markets: the top 10 percent of US households now hold 92.5% of publicly traded US stocks, a greater share than at any point in history. Two decades ago, that figure was around 77 percent, an absurd figure but not as absurd as today.
So at the same time almost all the wealth in the publicly traded stocks are held by the wealthy, we learning about how the ultra-wealthy are now increasingly pivoting their investments towards the private-equity space. Why the pivot? Well, it sounds like family offices smell blood in the water in terms of the assets currently held by private-equity investors. And it’s not just the family offices detecting these deals. Global regulators have been increasingly sounding the alarm in recent months on the overinflated valuations private-equity firms are placing on their assets. UK regulators are even reportedly investigating this issue.
How do we know these valuations are overinflated? Well, one example is the fact that UK pension funds are being forced to sell assets at steep discounts would be an example, up to 40% below the valuations on their books. In addition, stakes in private-equity buy out funds have been selling at 85 cents on the dollar in recent years as central banks started raising their rates.
Overall, it appears that the problems facing pension funds in the private-equity space are bigger than previously acknowledged. And the ulta-wealthy are ready to take advantage of the opportunities these problems are inevitably going to create, especially if regulators start getting more directly involved. One pensioner’s crisis is a ultra-rich man’s opportunity. Or, rather, many pensioners’ crises.
Ok, first, here’s a look at how US stock markets aren’t just distorted by the extreme valuations of a handful of tech giants:
“Today, however, the wealthiest 10 per cent own 92.5 per cent of the market — a “record high concentration”, Alden notes. And while the richest 1 per cent owned just 40 per cent two decades ago, their share stood at 54 per cent in the most recent data from 2022.”
A record high concentration of stock market ownership in the wealthiest 10 percent of Americans. It would be nice if this wasn’t exactly the kind of record that we should expect in today’s economy.
But that record concentration of wealth in the public stock markets isn’t the only wealth-concentration record that’s recently been set. For the first time on record, family offices, the asset management option exclusive for the ultra-wealthy, now hold more of their assets in private equity holdings over public stock holdings. So this record concentration of public stocks by the wealthy is happening at the same time the ultra-wealthy have been increasing their share of private market assets. In other words, the ultra-wealthy are increasingly interested in the private-equity space:
And that brings us to the following CNBC article from a little less than two months ago about this shift by family offices out of stocks and into the private markets. As the article describes, family offices have been particularly keen on direct-deals in the private equity space post-pandemic, presumably on the hunt for distressed assets and sellers with no better options. Along those lines, it sounds like they are sitting on lots of cash. Waiting for the right opportunity. Which will, of course, be the wrong opportunity for the entities forced to sell those distressed assets:
“And they plan to concentrate even more heavily on private markets in the coming months, according to the survey, which found 41% of family offices plan to boost their allocations to private equity funds, and a third plan to put more money into direct private equity deals.”
Family offices aren’t a position where they are forced to make deals. Quite the opposite, they detect opportunities on the horizon. At least that was the sentiment as of a couple of months ago as more and more money were getting dumped into the private-equity space:
And note how this increasing interest in the private-equity space by family offices isn’t new. It’s been going on for the last decade, with increasingly interest post-pandemic. Which raises the question of whether or not those earlier investments will pan out in this higher interest rate environment. But, of course, those same concerns apply to all of the players in the space, including pension funds, and are precisely the reason family offices detect the upcoming potential for great deals. The family offices are set to come out ahead in the long run as long as the family offices have the cash on hand to secure those deals. And it sounds like family offices have that cash ready to go:
And in case it’s not clear what has these family offices salivating over all the potential private-market deals on horizon, here’s an article from back in October, published about a month and a half before the above article, describing how UK pension funds have been forced to sell off assets as steep discounts. But that’s not the only story in this article. It also sounds like there could end up being a lot more steep discounts than the current market reflects. Why? Because the on-the-books valuations of many of the assets held by these pension funds appear to be wildly over-inflated and not reflective of real market conditions. This is particularly true for commercial real estate assets that are notoriously difficult to price. It’s apparently such a big problem that UK regulators are investigating. In other words, there’s an account hole sitting on the books of pension funds that has yet to be acknowledged in many cases. And should regulators forced these funds to acknowledge the much lower valuations for many of these assets the funds are going to be forced to sell them...presumably at a steep discount:
“Global watchdogs are raising the alarm about the value of so-called private market assets, including big infrastructure projects, the paper worth of which has yet to be adjusted downwards while listed markets, such as bonds, have suffered an historic rout due to higher borrowing costs.”
This isn’t just a UK issue. Global watchdogs are raising the alarm. Or as Global securities regulator IOSCO reported back in September, the valuations on the books for privately held assets have become “inevitably stale,” due, in part, to the lack of timely reporting requirements in this space. So when we read about UK pension funds selling office blocks at hefty discounts, keep in mind that this is a global issue:
And these aren’t trivial discounts. Pension funds have been selling assets at discounts as much as 40% to the values held on the books, according to EY’s UK head of pensions consulting. A 40% discount that will be painful for pensioners but a steal for those family offices with the cash on hand to swoop in and score a deal:
Finally, note how it’s not even just privately held real estate assets that are selling at a discount these days. Stakes in private-equity buyout funds have been selling at around 85 cents on the dollar since “early 2022”, with UK-listed investment trusts trading at a 27% discount on average compared to the net as set values reported in their portfolios. It’s a sign that ‘the market’ has been operating since early 2022 — when rates started rising — as if the asset valuations on the books are bogus:
As the report warns, there are a number of surprises sitting on the books of investors in the private-equity space. A space that has been increasingly dominated by pension funds over the last decade. A crisis for pensioners becomes an opportunity for the wealthiest families on the planet. Because of course. That’s the only way this realistically could have played out. The system is broken. And also working as intended.
It’s time for another round of disturbingly predictable updates. It appears, with interest rates more or less capped out for the time being and the expectation of rate cuts later this year, the credit markets are engaging in a bit of what we might consider irrational exuberance. At least the private credit markets in the private-equity space. Yes, borrowing by private-equity-owned firms has exploded over the last month in response to those change rate expectations and in increasing appetite for corporate bonds by lenders looking to lock in higher rates before they fall.
Now, on the surface, this should be good news for private-equity-owned corporations in general that there’s so a robust demand for their debt. Unless, of course, they take the money raised by that debt and just burn it. Which is kind of what they’re doing: private-equity owned firms are increasingly borrowing in order to pay out dividends to private-equity investors. In other words, the “dividend recapitalization” play is back on.
Recall how, back in pandemic-afflicted months of 2020, these dividend recapitalizations were all the rage in the private-equity space as investors desperate for higher-yielding corporate bonds were willing to accept exceptionally risky bonds like payment-in-kine (PIK) bonds that allow borrowers to pay interest with additional borrowing. Also recall how this demand for higher yielding corporate bonds eventually led to a surge in the issuance of corporate junk bonds in order to finance these dividend recapitalizations in 2021. That debt-for-dividends trend started to fizzle in 2022 and 2023 as rates rose. But it appears that right now, after rates have risen to an apparent medium-term peak with expectations they’ll fall later this year, has rekindled the dividend recapitalization play. Quite simply, lenders are more than happy to make loans they know will be primarily used to pay dividends — and therefore will weaken the underlying health of the company and increase the risk of default — because that’s just the kind of risk these investors are willing to make as it appears rates make be peaking for now.
But the borrowing binge by private-equity to pay dividends is just one half of this story. There’s, of course, the other side of this trend. Someone is willing to make these risky loans. And, increasingly, that someone is other private-equity firms. Yep, “private credit” is the other big hot new trend in the private-equity space, as traditional banks have tended to pull back from the lending markets. And all expectations are this private credit lending by private-equity clients — and pension funds in particular — is expected to continue rising in coming years.
Finally, keep in mind the other big story in the background here: all these dividend recapitalizations wouldn’t be necessary if firms were able to offload their assets like commercial real estate. But they can’t in many cases. The market simply isn’t there. In other words, this dividend recapitalization trend is, in part, covering up the fact that a lot of private-equity firms’ big bets in the CRE space haven’t panned out so well. The private-equity industry is effectively financing its own cover up. For now:
“With weak deal volumes and sluggish demand for initial public offerings making it harder to offload existing investments, private equity firms are turning to such so-called dividend recapitalisations to pacify investors eager for a return on their capital.”
Can’t sell your private-equity investments but still need to pay out dividends? No problem, just borrow the money. That “dividend recapitalization” strategy is increasingly popular in the private-equity space. A strategy that, as we saw, was increasingly popular in the earlier months of the pandemic, before falling out of favor in 2022 as rates rose. And here we are, with borrowing rates substantially higher than they were in 2020 and 2021, but seemingly poised to fall later this year, and a new dynamic has emerged where investors looking to lock in higher rates appear to be more than happy to finance a dramatic growth in this kind of a borrowing:
And note one of the details in this new dynamic: part of the incentive to investors in these deals is the use of senior debt which, if these companies run in trouble, make it more much likely the bond investors will get their money back, as opposed to junior debt which has a higher default risk:
So with dividend recapitalization borrowing the new hot trend for private-equity firms unable to offload their investments in a timely manner, how much longer can we expect investors to keep financing it all? Well, that brings us to the other side of this disturbing story: private-equity’s explosion in private lending. Yep, buying corporate bonds is another hot new area for private-equity investors. In fact, since 2010, the private credit markets on Wall Street have grown from $250 billion to $2.7 trillion. And as the following piece notes, the money financing this explosion of private credit comes from the kinds of investors we should at this point expect to be financing this: pension funds, endowments and foundations, insurance companies, retail investors, and sovereign wealth investors:
““It comes from pension funds, endowments and foundations, insurance companies, retail investors, sovereign wealth investors,” Dwin said. “So it is loans from a source other than deposits, usually to privately held businesses.””
Yes, at the same time we’re seeing an explosion of new private-equity borrowings to help finance dividend recapitalizations, we’re also learning about an explosion of new private-equity corporate lending, including firms like Apollo Global, one of the same firms we saw above that was engaging in dividend recapitalizations. In other words, the private-equity space appears to financing its own dividend recapitalizations. What could possibly go wrong?
And as the following Reuters piece notes, expectations are that this kind of private credit lending by private-equity — and in particular pension funds — is expected to continue growing in coming years at the same time regulators are growing increasingly concerned with the stability of this “shadow banking” sector in general:
“Private credit has become popular among pension schemes and insurers because it offers higher returns than traditional fixed-income products and typically better downside protection than equities.”
It’s not surprising to see private lending grow in popularity as a way of chasing yield in what had been a historically low-interest environment, especially if it offers higher yields than traditional fixed-income investments. But, of course, that higher yield is tied with the higher default risk, which is presumably part of what has global regulators increasingly concerned about this growing “shadow banking” trend. But for now, it appears that pension funds have found a new favorite investment:
You have to wonder how many of those pension funds are effectively engaged in some sort of mutual back-scratching at this point. A kind of “I’ll buy your debt (to finance your dividends) if you buy my debt( to finance my dividends)” kind of arrangement, perhaps? It’s not quite a pyramid scheme, but the parallels are hard to ignore. Time will tell how this ends. Perhaps in the form of pension funds simultaneously falling into crisis. Or, who knows, maybe in another round of dividend recapitalizations. The shenanigans only have to end when the new money runs out, after all.
Uh oh. It appears private-equity has a new investment strategy of choice. Look out world.
It’s not an entirely new investment strategy. As we’re going to see, it’s really just an extension of what has long been the sector’s go-to real estate-based investment strategy it’s had for years. But with a few twists. Including a potential nuclear twist. Yes, private-equity appears to have identify an area of supply and demand imbalance ripe for exploitation. And all signs point to it becoming more and more imbalanced going forward: Data centres. The large complexes housing racks and racks of servers that have becoming increasingly in demand as the cloud computing industry continues to explode. As we might imagine, data centres hold A LOT of real estate. But not enough real estate to keep up with the growing demand.
That imbalance in data center real estate is part of the allure the sector poses to private-equity sector. But only part. There’s another massive supply and demand imbalance forming in this sector: electricity. Data centres don’t just take up lots of space. They are massive power consumers, ever more so thanks to the explosion of generative AI technology. In fact, it’s that explosion of interest in AI that appears to be driving the current explosion in demand for data centres in general, with more and more tech giants turning to data centres to give them the AI computing capacity they need. On top of all that, AI computing consumes about four times as much electricity as traditional cloud computing. So at this point it’s becoming a race to secure both the land and power for data centres, with the winners in a position to charge increasingly profitable rents.
But electricity isn’t the only resource getting pushed to the limit with the explosion of AI computing. The water required to cool off the systems operating in these kinds of centers is enormous. And that’s not including water that might be involved in the underlying electricity generation. Which brings us to what is possibly the most ominous part of this new trend: private-equity firms are apparently increasingly interested in building micro-nuclear reactors that could make these data centres no longer reliant on the local grid. Now, on the one hand, not putting these kinds of strains on the local grid is generally a good thing. But at the cost of a new micro-nuclear plant in the area. It’s not necessarily the best tradeoff.
Also keep in mind that story about investments in the development of micro-nuclear plants by someone who might have a keen interest in data centres and AI: Bill Gates. Recall the investments by Gates and Warren Buffet in the development of cheaper, small nuclear power plants that rely on molten salt instead of water. Part of the advantage is the much smaller buildings that would need to be built to house the reactors. But the technology comes with a catch: it relies on Uranium enriched enough to potentially build a nuclear weapon. So this explosion of electricity demands from AI could be creating the kind of economic incentives that could lead to a proliferation of Bill Gates’s micro-nuclear plants. Oh goody.
And don’t forget another recent story that ties into all this: the US intelligence community’s increasing interest in using AI to parse those the vast volume of open source data. It’s a reminder that the military industrial complex could be a major driver for these trends. Mine-nuke-powered AI data centres for the MIC. What could possibly go wrong? We’ll find out, presumably with enormous profits for the private-equity sector regardless of how it goes, meltdowns or not:
“It’s part of the classic Blackstone playbook for real estate, the largest piece of its $US1 trillion ($1.52 trillion) empire. The firm identifies where there’s a rising need for properties but too few to meet demand. It then directs billions of investor dollars to build giant landlords poised to capture big rents and market share, a move it has deployed in everything from warehouses to suburban homes.”
Yes, on one level, the aggressive moves into the data centre space is just an extension what is at this point a classic investment strategy for Blackstone. A strategy focused on identify supply and demand imbalances in real estate and using the vast resources of the private-equity giant to exploit those imbalances to maximal effect. And all indications are that Blackstone is just getting started, with AI making the supply and demand imbalances around data centre stronger than ever. And Blackstone is just one of private-equity players rushing into this market:
But it’s not just the supply limits on the real estate needed to house these data centres. There’s also the supply and demand imbalance on the electricity needed to power these centres, with AI being a particularly power-intensive form of computing:
And notice how the price these data centres can charge is based on the energy costs, not the square footage of real estate space. In other words, the more expensive it is to power these centers, the more the data centre operators can charge. And since data centres tend to be clustered in the same regions, we should expect even greater energy supply and demand imbalances as this sector continues to grow. It’s a recipe for not just price gouging but also ruining the grid reliability for the everyone else living in these areas:
And that potential for power crises created by the enormous data centre electricity demand brings us to another constraint: water demand. Data centres have massive water needs for their cooling systems. It’s a very serious potential limit on the ability of this sector to expand at the rate it appears to want to expand. New cooling technology that isn’t so water dependent is going to have to be developed:
And then we get to these potentially ominous plans for dealing with the power supply challenges that are only going to get worse: micro-nuclear reactors. Just what the world needs. This is a good time to recall the investments by none other Bill Gates in the development of exactly this kind of technology. It’s the promise of cheap, small nuclear power plants that rely on molten salt instead of water. But with the catch that the technology relied on Uranium enriched enough to potentially build a nuclear weapon. Are we going to see Bill Gates’s mini-nuclear plant technology deployed to power the AI-data centres of tomorrow? That appears to be where the sector is heading:
Time will tell how this plays out, but it sounds like the private-equity sector is viewing this as one of the most potentially profitable types of investments its ever engaged in, hence all the enthusiasm and massive new investments. At the same time, it’s hard to think of a bigger potential investment disaster than a literal nuclear disaster. So it’s going to be interesting to see how the industry ends up structuring these deal in a way that minimizes the power downside of mismanagement of these entities. After all, one of the biggest long-standing complaints about the private-equity equity is the incentives for gross mismanagement and a flouting of all precautions in the search of profit. An industry sort of predicated around making as much money as quickly as possible and leaving a giant mess for the suckers and rubes to clean up. How is that kind of business model going to mesh with the real-world consequences of micro-nuclear reactors? Again, we’ll find out. Possibly in the form of some very difficult to clean up real-world consequences.
It’s official: Taylor Swift is the hottest thing in the NFL. Silly right-wing paranoia aside, not only has Swift’s relationship with Kansas City Chiefs tight end Travis Kelce earned the team over $300 million in additional revenues in 2023, but the NFL as a whole had its highest viewership among women since it started tracking in 2000. In other words, she’s made the billionaires who own all those NFL franchises a lot of money. Everyone is a winner.
Of course, fully cashing in on the Taylor Swift/NFL honeymoon would entail not just increased viewership and ticket sales but actually selling the team. Striking while the iron is hot. Which isn’t so easy to do for the NFL, with its notoriously strict ownership rules that require a single wealthy individual to be the primary entity behind a team’s ownership. It’s a problem that grows as the already stratospheric valuations of NFL franchises continue to show no ceiling. The NFL franchise market has almost become like the high-end art market: it’s obvious these things are worth a fortune but it’s not clear who has the kind of fortune, and interest, to buy them.
So with that Swifty-update in mind, here’s a fun Super Bowl Sunday private-equity story: Guess which industry is currently pondering opening its doors to the private-equity industry? Yep, the NFL is seriously considering it. And as none other than Kansas City Chiefs owner Clark Hunt recently put it, “I don’t want to predict one way or another whether we will ultimately adopt it...But I do think it is avenue that can be helpful from a capital standpoint.” And opening up NFL ownership to institutional investors isn’t just just on Hunt’s personal wish list. The league set up a committee to assess the potential impact of such a move.
Nor is it an unthinkable move on the NFL’s part. If anything, the league is behind the times. As Hunt describes, “It’s a subject that we’ve been discussing for a couple years...Private equity ownership is allowed in the other four big US sports so we’ve had a chance to observe that unfold and it’s a topic we’re going to continue to discuss.” In a world where the NBA allows sovereign wealth funds to buy stakes in teams, how long can the NFL’s relatively strict ownership rules hold out when so much potential investor capital is there for the taking and already shaping other professional sports? It seems like a matter of when, not if.
And, yes, Clark Hunt is the grandson of H.L. Hunt, a rather notorious historical figure with ties to the assassinations of both JFK and MLK. And let’s not forget the rather interesting history around the ownership of the San Francisco 49ers. As we described in FTR#304, the De Bartolo family has long been suspected of having organized crime connections, including a 1982 Customs Department report that alleged the De Bartolo organization had succeed Meyer Lansky as the financial wizard for organized crime. And that’s just the family history of owners of two teams in this year’s Super Bowl. Which is a reminder that institutional investors aren’t the only kinds of owners with difficult backgrounds.
But let’s not forget another part of what makes something like private-equity a difficult owner for any sort of professional sport: the asset-stripping short-term nature of the business model. Great in the short-term, not so much in the long-run. That’s kind of industry’s track record at this point and it’s unclear why the NFL would want to invite that into its ownership ranks. But with franchise valuations already sky-high, there’s only so many billionaires out there who can possible buy one of these teams.
And that brings us to a fitting fun fact about the NFL’s ownership: the recent sale of the Washington Commanders for a record high price of $6 billion was to Josh Harris, the co-founder of private-equity giant Apollo Global Management. He’s like a walking pinnacle of the industry’s ‘heads I win, tails you lose your retirement’ business model. Also recall how it’s Apollo that has been pioneering the questionable strategy of using that pension fund money to purchase insurance companies so they can gamble with the assets backing the annuity policies, with the gamble of choice being corporate bonds.
So the Washington Commanders are now facing the question of what happens when a literal private-equity giant buys the team. Will asset-stripping ensue? Harris happens to also own the Philadelphia 76ers and the New Jersey Devils, so he’s not actually an unknown entity as a professional franchise owner. But after the NFL opens its doors to the entire industry that’s no longer going to just be a question for the Commanders.
And, again, if the current owners want to find new owners willing to pay the exorbitant valuations of today, let alone the more exorbitant valuations of tomorrow, they are going to have to find markets with very deep pockets. There’s limit to the number of individual billionaires interested in owning a team, and therefore only so much competition to bid up those valuations and payouts.
So in terms of real-world Swifty impacts, by increasing the overall popularity and valuations of the NFL, Taylor Swift has made the NFL even more likely to be forced to open its doors to the private-equity industry’s vast pools of cash. That’s the only way to truly unlock that Swifty-created value is with private-equity money. And there we have a it. A underpinnings for the real Taylor Swift/NFL conspiracy. Taylor Swift is softening the owners up with swollen valuations so private-equity can go in for the kill. We should have seen it coming.
So while Clark Hunt is only indicating that the NFL’s ownership is only thinking about the whole possibility of opening the doors of ownership to institutional investors like pension fund-fueled private-equity firms, keep in mind that they’re probably also thinking about how to fully tap the NFL’s new Swifty-super-sized franchise valuations:
“Private equity firms have been making a bigger push into sports, led by firms including Arctos Partners, Ares Management, and Blue Owl Capital. The National Basketball Association has been steadily opening up to institutional investors, and in late 2022 allowed sovereign wealth funds, pensions and endowments acquire passive stakes in its teams.”
Is the NFL going to follow in NBA’s lead and open its doors to the really big money? Institutional money? Pension-fueled private-equity and sovereign wealth funds? Kansas City Chief’s owner Clark Hunt, grandson of H.L. Hunt, sure sounds interested. Because of course he’s interested. A team as valuable as the Chiefs might run into a challenge when it comes to finding a buyer under the NFL’s current ownership rules. There’s only so many billionaires with that kind of money laying around available to buy a team. Institutional investors with that kind of money, on the other hand, aren’t so rare. By opening up the NFL ownership to institutional investors, not only does the market suddenly become far more liquid but the valuations potentially jump too as the number of potential buyers suddenly explodes. From a return on investment standpoint, opening up to institutional investors is the next logical choice for the NFL. It’s how ultra-expensive franchises can be sold off to new investors in the hopes they’ll be super-ultra-expensive enterprise that can be re-sold in the future:
It’s also rather notable that Josh Harris, the co-founder of Apollo Global Management, was the person who purchased the Washington Commanders for $6 billion, the largest sale ever of an NFL team. Apollo is, of course, one of the private-equity equity giants that’s grown enormously through pension fund clients over the last decade. So when we look at Harris’s $8 billion valuation, it’s kind of hard to ignore that his firm achieved that valuation by developing a massive inflow of fees and bonuses from clients like pension funds. The ‘Heads I win, tails you lose your retirement’ business model. Also recall how it’s Apollo that has been pioneering the questionable strategy of using that pension fund money to purchase insurance companies so they can gamble with the assets backing the annuity policies, with the gamble of choice being corporate bonds. You have to wonder if Harris is going to be bringing the classic private-equity asset-stripping mentality to his new team.
But concerns about the vulture-like nature of private-equity obviously shouldn’t be limited to the Commanders once the doors are opened to the entire industry. You could have the sovereign wealth funds of monarchies owning large stakes in a number of teams. All the kinds of investors looking for a return on their investments. These aren’t trophy purchases. How is the opening of the owners club to the massive pools of institutionally managed wealth going to change the league, both institutionally and from a fan experience perspective? Could this be a recipe for one ownership-related headache after another? Clark Hunt may be open to the idea but we have yet to see how the rest of the owners feel. Although we should find out soon:
““There aren’t that many people that can write a giant $3, $4 billion check and then raise a whole bunch of money to make up the difference,” said Salvatore Galatioto, whose company has advised investors on buying and selling professional sports franchises. “That’s the reality of the world.””
There simply are not that many individuals on the planet who can afford an NFL team. Valuations that, have risen to stratospheric heights in recent years. That’s how much of a luxury good NFL teams have become. The marketplace for NFL teams lacks the pool of ultra-rich individuals needed to create marketplace liquidity. The increase in valuations for NFL teams has, incredibly, outpaced the historic re-concentration of wealth that’s transpired post-Reagan Revolution. Even with wealth more concentrated than ever in the modern era, there’s still not enough billionaires wealthy enough to afford all these teams.
And that’s the state of affairs at today’s valuations. What about decades from now, when these teams will theoretically be worth billions dollars, perhaps tens of billions, more in value? Hence the conversations now taking place. Quite simply, if the NFL’s owners want potential buyers they’re going to have to relax the rules, much like the NBA has done. But that also means an era of new, potentially controversial, ownership. Like Middle Eastern sovereign wealth funds. Or private-equity, perhaps backed by pension fund money. Or publicly traded entities with shares anyone can buy that, in turn, own shares of different teams. Does the NFL want to invite sovereign wealth funds, private-equity, pension funds, and the general public into the club? That’s where things seem to be headed. Because that’s where the really big money is:
But the questions about this path forward don’t just loom large for NFL owners. These potential new investors who are going to be paying these exorbitant prices presumably want a return on their investments too, right? Does something as illiquid as an NFL team make sense as an investment? Sure, sports leagues aren’t necessarily correlated with the broader market so they might seem to fit in well as a kind of investment hedge. But Isn’t the same “who do we sell to?” problem going to follow? Is it going to be mass NFL IPOs next? It’s a weird conflict of priorities. After all, it’s not hard to imagine an individual billionaire viewing their personally owned team as more of a showy hobby than a money-making enterprise. Profit may not be the top priority. But we can’t expect pension funds and sovereign wealth funds to prioritize anything other than profits. Nor can we necessarily expect them to care about the long-term health of the team or impacts on local communities. Especially when private-equity is involved. What will private-equity’s asset-stripping mentality do to an NFL franchise? What kind of new corporate sleaze factor is the NFL introducing into its management circles? These are the kinds of questions that have to be complicating the NFL’s upcoming decision on the matter. But what choice do they have if they want to retain the ability to sell these ultra-expensive enterprises? Ultra-billionaire club conundrums:
And who knows, maybe having a bunch of teachers unions owning large stakes in the NFL will actually be good from a public relations standpoint. Kind of like the Taylor Swift effect, but instead of tuning in a new audience of young teens it’ll be all their teachers. Heck, since so many public pension funds are for a single state, you could even imagine the state public pension funds investing in their own state’s professional sports teams. There are some strange, and not necessarily bad, paths forward for the NFL with this Pandora’s Box they’re planning on opening. It doesn’t have to be bad.
Well, except with private-equity, it does have to be kind of have to be bad. For someone. That’s the business model. Someone has to pay the piper. Or, more specifically, someone has to pay Josh Harris. So he can buy another professional sports team. And now, thanks to the real Taylor Swift/NFL conspiracy — the conspiracy to make the franchises worth so much they can’t help but open up to private-equity investments — Josh Harris and all the other private-equity principals can make even more money as their firms charge whatever management fees they make up for running an NFL team. It’s really quite diabolical when you think about it.
And the worst part is, Taylor probably doesn’t even realize it. For her, it’s just another zany public romance. Because that’s how private-equity rolls. Behind the scenes, pulling strings. Or at least that’s how private-equity gets to roll until Taylor finds out she’s been used. The ballad of the real NFL/Swift conspiracy is far from over.
You could call it a warning sign. A warning sign about you can’t really do anything about but good luck anyway. Try not to flinch too much. It’s going to sting.
That’s kind of the gist of the between-the-lines message we get from the following pair of Bloomberg pieces for the past couple of weeks about developments in the private-equity space. The kind of developments that should have pension fund private-equity investors bracing themselves for bad news. But not yet. The bad news comes later. It’s still good news. Just ominous good news now.
The good news is that private-equity firms have found an ‘innovative’ means of paying out dividends to their investors. This is in the face of shortfalls in the ‘traditional’ means of raising capital like selling portfolio companies and leveraged borrowing. Yep, the private-equity giants hard having a hard time engaging in more leveraged borrowing at the same time they can’t really find buyers for the companies they are managing on behalf of their clients. It’s not the best sign for the viability of the private-equity model. Not the best sign for their clients especially. But despite those difficulties, the industry has found a way to raise new funds: private-equity firms are increasing burrowing against their funds’ assets. That might sound innocuous for the private-equity equity industry but it’s a big deal.
These net-asset-value loans (NAV loans) are described by Bloomberg as a “once-unorthodox form of private credit that has grown in popularity as a way for private equity firms to raise cash during prolonged lulls in fundraising and dealmaking”. And investors (“limited partners”) aren’t happy about it, especially because it sounds like a lot these NAV loans are being used to pay out distributions/dividends to the firm’s investors. Dividends are still be paid out to investors. It’s just now, those dividends are being financed by borrowing against the value of the investors’ private-equity portfolios. Again, it’s not the best sign for the industry. But it hasn’t fallen apart yet, thanks to the alarming NAV loans.
And as we’re also going to see, those investors can get as pissed as they want, but it doesn’t appear there’s a lot they can about it. Private-equity firms generally don’t have to ask for investor permission to borrow against the assets of the funds under their management. They’re doing it despite the protests of their clients because they legally can issue these NAV loans against their clients’ assets under management without their clients’ permission. Or at least the laws are vague enough that the private-equity giants feel emboldened enough to do it.
And then the Bloomberg article slips in this remarkable observation: the vague laws around the legality of this kind of borrowing is only one of the reasons the “limited partners” have limited options with their protestations. The other reason is simply that there aren’t a lot of other fund managers that are prepared to take investments on the scale that private-equity giants can handle for the kinds of clients private-equity takes. In particular pension funds can’t find alternatives to private-equity equity. And therefore public pension funds kind of have to do what their private-equity fund manager demands because it’s not like there’s anywhere else for them to park their billions of investments and get the necessary returns. Don’t forget that pension funds now comprise around of third of all private-equity investors and are behind over two-thirds of the capital under management by the private-equity industry. It’s a major factor to keep in mind in this larger story: pension funds are effectively captured audiences.
That’s the ominous good news. Good in the sense that the industry has found a way to still pay dividends despite not being able to sell their portfolios. It’s not yet an immediate emergency. Dividends are still being paid. They’re just ominous dividends now.
The bad news is more overtly bad: Moody’s updated its forecast for the credit ratings of several private-equity giants: BlackRock Inc., KKR & Co. and Oaktree Capital Management — with a combined $20 billion under management — now have a negative outlook for their Baaa3 ratings. Baaa3 happens to be Moody’s lowest investment grade ratting, meaning a downgrade puts these giants in junk territory.
So why did Moody’s issue this negative outlook on these three private-equity giants? Or, more accurately, the credit on their “business development corporation” (BDC) parent companies that all possess large private-equity wings? It’s not the performance of private-equity portfolio companies. At least not directly. Instead, it’s a problem with the performance of private loans these firms have issued out as part of the explosion in private “direct lending” in the private-equity space. Specifically, the average rate of “non-accrual loans” (loans that haven’t paid interest in 90 days) for the company’s Moody’s monitors in the BDC (private-equity) space is 0.4%. But for BlackRock, it jumped from 1.2% to 2.2% in the last quarter and for KKR and Oaktree it more than doubled to 6.4% and 4.5%, respectively.
We don’t know the borrowers who aren’t paying interest and if they are part of a private-equity-managed portfolio. But it’s worth recalling how, back in February, we learned that private-equity firms were piling debt onto their portfolio companies to pay out dividends to themselves and their investors, raising further alarm about the health of the portfolios. Part of that alarm was over how the debt was weakening the underlying portfolio, burdening them with more debts that might become unserviceable some day. Are we seeing a spike in loans to other private-equity-owned companies going sour? Were they companies that took out debt to pay dividends? These are some of the questions looming over these troubling trends in the private-equity space. Troubling, again, for the private-equity investors, especially pensions. The fund managers and partners are fine:
” The ratings company on Monday reduced its outlook for direct lending funds managed respectively by BlackRock Inc., KKR & Co. alongside FS Investments and Oaktree Capital Management, lowering them to negative from stable. The three publicly traded business development companies, with a combined total of more than $20 billion in assets, each increased the number of loans on non-accrual status, meaning they’re in danger of losing money on those investments.”
Three of the largest “business development companies” (BDCs) in the private-equity space — BlackRock, KKR, and Oaktree Capital — are on the verge of hitting junk status, according to Moody’s. They’re all already at Baaa3, the lowest investment grade rating. Downgrades into junk tend to trigger consequences. But it’s not specifically their private-equity investments that are reportedly souring. It’s private direct lending loans — one of the hot areas of interest in the private-equity space over the last year — that are are going to sour, with the dollar amount for “non-accrual loans” (loans that the borrower is no longer paying interest on) more than doubling over the last quarter, well above the median of 0.4%
But, of course, as we also saw, a lot of the private-equity in recent months has been debt put on the portfolio companies to pay dividends out to the private-equity investors. So when we see Moody’s go on to cite highly leveraged private-equity firms as the borrowers of this increasingly “non-accruing” debt, it’s worth keeping in mind that the private-equity industry has been in the process of creating ‘non-accruing’ conditions for their own portfolio as part of a borrow-now-something-later strategy:
And that ominous article brings us to the following Bloomberg article published a week later about another new troubling trend in the private-equity space: private-equity firms are increasing burrowing against their funds’ assets. These NAV loans are described as a “once-unorthodox form of private credit that has grown in popularity as a way for private equity firms to raise cash during prolonged lulls in fundraising and dealmaking”. Part of the reason of the increasing turn to NAV loans by private-equity is that traditional forms of raising capital have become increasingly hard to come by. Traditional forms like raising capital is selling portfolio companies, which is the ostensible point of private-equity. And tradition forms of raising capital like the private-equity giants themselves getting leveraged loans. Which is another way of saying these private-equity giants (their BDC parents, really) have already leveraged themselves to the hilt. But those dividends have to get paid, one way or another. Hence the need to start leveraging the capital under management. Capital they are investing and managing on behalf of increasingly upset clients who are presumably partly upset about the fact that they can’t do anything about it and don’t have many other options anyway:
“Private equity’s reliance on NAV loans has exploded in recent years as traditional sources of financing — such as selling portfolio firms or leveraged loans — have become harder to access. Private credit firms are raising funds to offer the loans as banks rein in lending amid a regulatory crackdown in response to last year’s regional bank crisis.”
Traditional sources of finance such as selling portfolio firms or leveraged loans are drying up. Private-equity giants can’t sell the companies they manage and have already maxed out their credit lines. Even worse they’re taking out these NAV loans to pay out distributions (dividends). NAV loans could make sense as a cost-effective way of raising capital to invest in the “portfolio companies” under management. But that’s not what we’re hearing. Instead, the NAV loans are being used to pay returns to investors, meaning the underlying investments aren’t actually generating the promised returns. That’s kind of a blaring alarm in this sector, getting papered over with an investment that exacerbates the underlying risk to the investors. But hey, at least the private-equity managers will technically pay out the promised returns and get their bonuses:
And as long as the dividends get paid, who cares, right? Well, the “limited partner” investors watching this fiasco play out with their investments care. Not that they have a real say in the matter:
Not only are the rules vague regarding whether or not private-equity firms have to get permission at all to take out these loans, but it’s not like private-equity investors have alternative investment classes to go with. Especially pension funds. Almost no one else can take the volumes of investment money — with the market-beating returns that private-equity has long promised — that pension funds have. Private-equity giants are the only game in town:
Some might call this all a questionable investment for pension. Others might call it a trap. But as we can see, part of that trap has been the lack of any alternatives. Who else offers the kinds of returns private-equity firms have promised and, often, returned?
Which is all the more reason pensioners should hope we don’t see see too many private-equity credit ratings junk downgrades. That’s presumably only going to lead to more NAV loans against pension-backed portfolios under worse loan conditions.
And don’t forget, the more the pension fund loses on its soured private-equity investments, the higher the returns it needs to get on its future investments. Which is all the more reason to plow it back into private-equity and hope for the best. Because where else are they going to go? Pension funds really are thoroughly trapped.
It’s quite a story. A story that’s been playing out for a while now and only getting worse. Hopefully all this borrowing for dividends will end up being examples of private-equity financial wizardly saving the day. But so far signs seem to point towards things getting worse and the industry getting more desperate. It’s quite a story with too many quite signs for quite an unhappy ending. Unhappy for the pensioners. The best paid parties in this story will continue doing great. It’s that kind of story.
It’s been clear for a while now that private-equity’s big play on real estate has become a giant gamble gone awry. With client money, of course. But what hasn’t been clear so far is how the industry plans on navigating this this giant gamble as things continue to fall apart.
Although we’ve been getting some clues on that front, like the disturbing new trend in net asset value (NAV) loans that companies are using to borrow against the assets of the fund to pay out dividends. And as we’re going to see in the following Business Insider piece, there’s another disturbing angle to that trend: since these are private, no public, investments, it’s up to Blackstone to set the price per share but it’s also basically up to these private-equity firms to make up their own NAVs. Or at least the NAVs that are reported to investors and the public. So Blackstone can effectively fabricate how the funds have performed by inflating the NAVs and use that fabricated performance to justify the price it sets per share.
At least that’s apparently been the practice for the Blackstone Real Estate Income Trust (BREIT) in recent years. A practice that is leading to a growing number of financial experts warning investors to stay far away from BREIT and assume the fund is at risk of plummeting in value if the commercial real estate market doesn’t end up rebounding.
There is one scenario that can force Blackstone to be much more honest about the valuations of these investments: selling them. Which, of course, is something Blackstone will be very hesitant to do given the ongoing weakness in the commercial real estate space. Yep, the fact that the underlying real estate investments have performed so poorly that they could only be sold for a loss that Blackstone doesn’t want to see realized operates as an excuse to keep the real NAVs hidden from prospective investors. It’s a demented downward cycle.
Now, what is it that has experts convinced that Blackstone is fraudulently overvaluing its fund? Well, there’s the fact that Blackstone had performance claims for BREIT that vastly exceeds the performances of its peers over the last year. And there’s also the fact that, while BREIT pays out a 4% dividend annually, it failed to generate enough cash from the underlying real estate investments in the fund to cover those dividends.
So has Blackstone ended up taking out NAV loans to make those dividend payments? That doesn’t appear to be the case. At least not yet. Instead, Blackstone found a different solution: finding new investors for the fund, with the idea being that the new investments can be used to pay out the dividend. And as we’ve seen, Blackstone found those new investors, with the University of California pension fund handing over $4.5 billion to buy up and manage college student housing units.
On the surface, it’s not a great sign new investment money is used to pay out dividends. It’s effectively the sign of a pyramid scheme. But as we’re also going to see in the following article, that $4.5 billion UC investment has some features that make it an even more dangerous means of paying out dividends. Because it turns out Blackstone had to sweeten the deal for UC in order to secure that money: If BREIT failed to meet an 11.25% annualized return, UC would receive up to $1 billion in new BREIT shares. It was such a great deal for UC that, after initially making a $4 billion investment, UC put in an additional $500 million.
The issuing of new BREIT shares, of course, dilutes the value of BREIT for all of the other investors. Which brings us to another disturbing BREIT trend: another part of the reason BREIT has been able to cover its dividends so far is that roughly half of the BREIT investors opted to be payed in shares instead of cash for their dividends. In other words, Blackstone’s ability to cover its BREIT dividends is even more compromised than the desperate terms of the UC deal indicated. It is currently expected that UC will receive $564 million in new BREIT shares this year.
There’s another ominous aspect to this BREIT story that should be kept in mind: BREIT is unusual in that, while being a privately held fund, it accepts investments from individual investors, with a minimum investment of just $2,500. It’s not only pension funds piling their cash into BREIT, the first of its kind for Blackstone. As one expert puts it below, “BREIT was a test case for the whole industry.” Which makes this story a reminder that the influence of the private-equity business model is only growing. Private funds that effectively make up the values of their underlying investments could be increasingly common, barring regulations. BREIT is a template for the future of the private-equity industry. A template that Blackstone is insisting has been an outstanding success but appears to be failing upon closer scrutiny.
It also sounds like the fate of the underlying BREIT investments are, at this point, heavily dependent on falling interest rates, a scenario that has been looking less and less likely in recent weeks. So if rates don’t end up falling sooner rather than later, we should probably expect the Ponzi scheming to only deepen. Also keep in mind that the valuation of the underlying real estate assets isn’t just tied to interest rates. It’s also tied to the health of the economy. In other words, it’s not just lower rates that BREIT investors need to see. It’s lower rates and an ongoing healthy economy. An economic Goldilocks scenario is necessary. And if that doesn’t happen, there’s always the option of finding new investors with more fresh cash to buy more time...or maybe just some NAV loans:
“But the rosy picture that Blackstone paints may not tell the whole story. In recent months I’ve spoken with veteran analysts, accountants, and investors who have come to believe that BREIT is essentially a house of cards. That’s because the returns the fund claims it has delivered depend almost entirely on BREIT’s own estimates, which skeptics believe are wildly inflated. What’s more, when BREIT faced a flood of redemption requests from investors, it only fulfilled all those requests after raising cash from new investors — including one that received a sweetheart deal from Blackstone to invest in BREIT. “It is the absolute definition of a Ponzi scheme,” said Nate Koppikar, who runs a hedge fund called Orso Partners that has shorted Blackstone’s stock because of concerns over BREIT. Unless the real-estate market comes roaring back, analysts warn, BREIT could end up shrinking to a fraction of its current size, leaving the fund’s investors holding the bag.”
Is Blackstone’s privately traded BREIT real estate fund just a giant scam based on made up valuations? Yes, according to an alarming number of experts increasingly puzzled over its seemingly impossible performance. An impossible performance that starts looking much more possible thanks to fraud when we delve into the details, including the glaring detail that the BREIT failed to generate enough cash to cover its dividends last year. How could a fund that didn’t make enough to pay out its dividend apparently outperform the rest of its peers? Something isn’t adding up here:
Adding to the alarm over the BREIT fund’s inability to generate enough case to pay out last year’s dividends is the fact that roughly half of the investors opted to receive their dividends in the form of more shares. In effect, those investors are doubling down on a failing fund. And as one observer notes, those who opt to take cash instead of dividends aren’t seeing a return on capital but rather a return of capital. In other words, the BREIT is cannibalizing itself to cover dividends:
At the core of this scammy situation appears to be the absurd state of affairs where Blackstone gets to more or less fabricate the net asset value (NAV) of the fund while also setting the price per share. Beyond that, updates to this made up NAV only happen once a month, which is a recipe for fund performance estimates untethered from real world events. A month can be a very long time for an investment gone awry. According to one observer, BREIT’s NAV was overstated by more than 55% in April of 2023. That’s not “creative accounting” at work. That’s a scam. A legal scam, apparently. And it’s only when BREIT sells assets that it’s forced to update its NAV to something closer to reality. Sales that would also ultimately be a disaster given the current real estate market conditions. BREIT can’t earned enough on its real estate portfolio to cover its obligations, but it can’t sell the overvalued assets either:
But also recall how NAV loans have been increasingly used by private-equity to raise the funds needed to pay out dividends. So when we see how BREIT is systematically overvaluing its NAV at the same time its unable to raise the cash from the underlying investments needed to cover the dividends, keep in mind that NAV loans could be part of this equation. NAV loans based on presumably wildly overvalued NAVs. But then there’s another motive for the systematic overvaluation of NAVs: elevated management fees. Which, by definition in this case, are wildly overpaid management and performance fees:
And then there’s the apparently scammy valuations of BREIT’s large data center investments which are seemingly generating value despite not even being up and running yet. Recall how data centers have been one of hot areas of private-equity investment. Blackstone isn’t the only one diving into that sector but hopefully it’s just Blackstone engaging in systematic fraudulent valuations:
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But NAV loans aren’t the only potential source of emergency cash for paying out dividends. New investments can serve that purpose too, like the $4 billion BREIT received from the University of California pension fund. Which, of course, is kind of like a pyramid scheme. And yet it doesn’t appear Blackstone was easily able to find the necessary frech investment cash without dangling special incentives in the form of $1 billion in additional BREIT shares if the performance doesn’t meet the 11.25% return. Already, over $564 million in new stock is expected to be paid out, diluting the value of the fund for all of the other investors. What kind of special incentives will BREIT introduce should the situation get worse and more cash is required? Time will tell:
So what can we expect for BREIT’s investors going forward? Well, it sounds like that’s going to be heavily dependent on whether or not interest rates fall sooner rather than later, which is the kind of bet that’s been looking worse and worse in recent months. Also keep in mind that if rates are cut in coming months, that could be in response to an unexpected economic downturn, which may not do great things for real estate prices. BREIT is basically hoping for a sustained strong economy but with subsided inflationary pressure. Sure, it could happen, but you may not want to bet on it:
Finally, given how private funds like BREIT were among “the biggest losers” from the Great Recession, note how the volume of cash from ordinary investors that’s been flowing into private-equity managed real estate funds in the lead up to pandemic — when real estate seemed like a much safer investment — has actually been far higher than the analogous volumes that flowed into similar funds pre-Great Recession and that wasn’t money from ordinary investors. The opportunity for ordinary investors to invest in these kinds of funds is new. In other words, we appear to be set up for a repeat of the private-equity industry’s Great Recession real estate investment debacle, but this time it’s going to be bigger and with many more small investors taking the hit:
“BREIT was a test case for the whole industry.” Uh oh. Sure, if BREIT fails spectacularly we might see fewer ordinary investors take the plunge should the industry as a whole start offering more of these ‘private-equity for the masses’ opportunities. But that’s assuming ordinary investors are meaningfully aware of this history. Ordinary investors aren’t the most sophisticated investor class.
But let’s also not forget that, thus far, there’s no indication Blackstone hasn’t been collecting its BREIT fees. And it hasn’t fallen apart yet. Financial trickery- trickery that might doom BREIT’s long term prospects — have kept the thing afloat. Based on that metric, BREIT has been pretty successful, at last for Blackstone. And sure, BREIT’s troubles don’t help Blackstone’s share price. But as we just saw, the kinds of troubles facing BREIT aren’t insurmountable. At least not in the short run. Tricks are available to keep in ship afloat even if the underlying assets are sinking. Long run concerns might be more insurmountable, but that’s the long run. And as we’ve seen over and over, ignoring the long run in the favor or short-term gains is kind of at the core of the private-equity business model. Which is why we should expect a lot more BREIT-like fund offerings for ordinary investors regardless of how the BREIT test case performs. “Heads we win, tails you lose” is more or less already how the US economy and social contract in general operates for average Americans anyway at this point. Formalizing that relationship into private equity offerings for the masses is kind of the next logical step. And here we are.