Discretionary Funds:
Little-known Equity Capital Source
[July/August, 2000]

by Charles Lockwood

Over the next decade, top-quality public and private real estate developers and owners will be relying more and more on an expanding primary equity capital tool: discretionary funds.

Offering attractive terms, efficiency and certainty, discretionary funds have generated rapidly increasing developer/ operator and institutional investor interest. More than $3.5 billion of developer/operator discretionary funds have been executed since 1999, providing a sound equity capital alternative that offers real advantages but is also complementary to the three more traditional equity funding sources.

Public Equity Markets

In the mid-1990s, the public equity market was at its height and real estate developers and operators could sell interests in themselves at well above net asset value. On the whole, this is no longer the case.

Today, public equity is a volatile capital source, and it can be prohibitively expensive for many real estate companies. It also has very high transaction costs resulting from fees and negative arbitrage (equity being funded well before it is invested in real estate activities).

Effectively, some public firms raising public equity capital in the current environment may be doing so at below net asset value after transaction costs. What is interesting is that none of these firms would ever consider selling an individual asset for less than it is worth but they may be doing just that with their entire portfolios if they sell an interest in their company for less than net asset value.

Joint Ventures

Joint ventures have been a large source of equity capital for many top developer/operators. These ventures provide reasonably priced financing, but also involve strong investor governance provisions. Most joint ventures have a medium-term horizon of three to five years, which is suitable for some transactions but not all. Also, programmatic joint venture equity can turn out to be less certain than anticipated, because some investors may fail to meet program funding goals during hard economic times.

How Three Different Discretionary Funds Played Out for Three Industrial REITS
	REIT I	REIT II	REIT III
Size	$400 million	$200 million	$2.7 billion
Co-investment	20%	25%	20%
Life	7–9 years	4 years	7 years
Leverage	50%	60%	50%
Distributions	Pro rata to 9% IRR; 15% promote 9–12% IRR; 20% promote > 12% IRR	11% cumulative (not compounding) return; 50/50 split thereafter	Pro rata to 12% IRR; 20% promote > 12% IRR
Investors	12 Pensions, Foundations and Endowments	Pension Fund	16 Institutional Investors
Business Plan	Acquire, Develop, Redevelop	Build, Bundle, Sell	Acquire assets in Europe

Asset Recycling

Asset recycling—which involves the sale of stabilized, mature assets and the recycling of the resultant equity proceeds into higher-return situations—has been a valuable source of equity funds for many companies. But, as with other equity alternatives, this capital source has its flaws. At times, the asset sale market is highly illiquid or depressed, making asset recycling prohibitively expensive just when the greatest opportunities to deploy equity profitably are likely to become available.

In addition, some real estate companies cannot pursue recycling strategies because of the tax consequences involved. These consequences might include certain principals having low basis in assets, certain assets not being suitable for 1031 transactions and long-term/short-term capital gain issues.

The Discretionary Fund Alternative

Enter discretionary funds, which are selectively available to high-quality public and private real estate developers/operators. This equity vehicle has traditionally been accessible only to fund operators including real estate advisors and opportunity funds, but is now also available to top-flight developer/operators. While the terms and structure of discretionary funding varies from deal to deal, common elements include blind pool capital, a meaningful co-investment from the real estate developer or operator, a performance-based carried interest available to the developer or operator, a gradual funding mechanism, medium levels of leverage, investor board representation and a long-term fund life.

Discretionary funds involve an absolute commitment of capital from one or more institutional investors for real estate developments or acquisitions in accordance with a fund business plan. Funding typically occurs over time to avoid negative arbitrage and to accommodate the developer or operator timing requirements. The developer or operator exercises complete discretion over all investment decisions.

The carried interest provisions of the typical discretionary fund provides for an effective incentive mechanism from the investor’s standpoint and for a mitigation of the cost of capital from the developer or operator perspective. Discretionary fund leverage is generally relatively modest, in the 50 to 60 percent range, thereby offsetting the risks associated with development and other value-added activities typically pursued by these funds. Fund lives are long term in nature, with 7- to 10-year lives being the most common. Institutional investors benefit substantially from investing directly with developers and owners because they avoid paying a carried interest twice—once to the advisor and then once to the developer—as is the case in many advisor or opportunity fund-sponsored discretionary funds.

Benefits of Discretionary Funds

Discretionary funds offer many advantages. The real estate company gains firmly committed capital, a long investment life of seven to ten years to maximize the full value of the project investments, low transaction costs and the potential to earn promoted interests in cash flows and therefore reduce equity capital costs.

Institutional investors benefit from the high level of co-investment in the fund by the real estate company, as well as the quality of that company, low transaction costs and the absence of the “double promote,” which means that the investor is not paying an incentive fee to two groups when one group is principally generating the value-added profits.

Best of the Best

In today’s real estate markets, discretionary funds represent an excellent complementary equity source for high-quality real estate developers and operators. The carried interest, low transaction costs and absence of negative arbitrage make discretionary funds very compelling compared to public equity except when public share prices are very high relative to underlying values. Relative to joint ventures, funds are very compelling given the firm commitment of capital, the discretionary nature of the equity and the long time horizon associated with this equity source. And unlike asset recycling, discretionary funds don’t require the liquidation of assets, which could have adverse tax and value implications.

The addition of discretionary funds successfully rounds out today’s equity capital market, providing the missing link that—in combination with public equity, joint ventures and asset recycling—gives real estate companies the financing they need to capture market opportunities and grow profitably.