Tuesday, November 14, 2006

Shoo fly pie

Guambat previously mentioned the fee pie fo Australia's Macquarie Bank. Well, they's pikers compared to those lads from Yankeeland. The good folks over at Morgan Stanley pretty much take the cake.

Morgan Stanley, Win or Lose, Gets Biggest Fees for Real Estate By Hui-yong Yu
In addition to an annual management fee equivalent to about 1.5 percent of assets, Morgan Stanley for the first time is levying 0.25 percent of the value of every acquisition the [real estate] fund makes. It's also taking a 20 percent cut of the fund's investment gains as an incentive fee, up from 17 percent previously.

Earlier this month, the Washington State Investment Board, which manages pensions for more than 435,000 public employees, got some bad news as it considered investing in Morgan Stanley's $8 billion real estate fund.

"The bottom line is they've got a higher fee structure," Michael Humphrey, a consultant advising the state, told an eight- member committee at the retirement board's red brick headquarters in Olympia, Washington. "Are people who are working for a fee simply ramping up the dollar amount of the fund to obviously enhance the level of fees?"

Across the foyer in a conference room, Morgan Stanley's Jay Mantz, Sonny Kalsi and John Kessler had reason to be confident the state was about to give them $440 million. The slumping U.S. housing market showed no signs of rebounding anytime soon, while the New York-based firm was offering access to more promising investments in Japan, China and India.

It took the Washington board less than 10 minutes to bring Morgan Stanley a step closer to raising the world's largest high-return real estate fund, a pool that Humphrey estimated may buy $30 billion of property assets in the next four years. Regardless of whether it makes money for investors, the second-biggest U.S. securities firm by market value stands to collect almost $500 million of management and acquisition fees.

When the fund produces a profit, Morgan Stanley will keep part of that too, in line with industry practice.

"Morgan Stanley in real estate is in the highest league," said Michael McCook, who was the senior real estate investment officer at the $220 billion California Public Employees' Retirement System for five years before joining San Francisco- based Kenwood Investments LLC in June.

For 15 years, Morgan Stanley's $62.3 billion of property purchases have produced annual returns averaging more than 20 percent -- better than hedge funds run by managers such as Leon Cooperman's Omega Advisors Inc. of New York and Westport, Connecticut-based Pequot Capital Management Inc.

Of the $42.7 billion that Morgan Stanley has raised from property sales since 1991, $13.7 billion, or a third, was profit, according to the fundraising presentation in Washington. Morgan Stanley's real estate revenue rose 57 percent last year, surpassing $1 billion for the first time in 2005 -- more than it made from equity underwriting.

Morgan Stanley has a big stake in the returns of its new fund. The firm and employees will contribute 20 percent of the $8 billion in capital, Mantz said at the meeting in Olympia.

Morgan Stanley typically borrows $3 to $4 for every $1 raised to increase the funds' buying power and returns.

Today, Goldman is emulating Morgan Stanley. After years of relying on wealthy individuals as clients for its Whitehall property funds, the New York-based firm is approaching institutions in an effort to raise more money and generate higher fees, said two prospective investors who declined to be identified. Goldman spokeswoman Andrea Raphael declined to comment.

Morgan Stanley in 1969 became one of the first investment banks to start a dedicated real estate practice. It expanded into property investing after the U.S. savings and loan crisis, when the collapse of more than 1,000 thrifts that speculated on real estate in the 1980s forced the federal government to sell defaulted mortgages at discounts.

Mantz, Morgan Stanley's 42-year-old co-head of real estate, told the Washington trustees on Nov. 2 that Japan presents some of the best opportunities for the firm's new vehicle, Morgan Stanley Real Estate Fund VI International. He and Kalsi, 38, the global head of real estate investing, plan to spend 40 percent of the $8 billion in capital there, betting the resurgent local economy will drive up occupancy rates and rents.

Some 25 percent of the fund's investments will go to emerging markets such as China and India, where apartment and office construction is booming as businesses grow in Asia and farmers and peasants flock to cities. Mantz and Kalsi last month held Morgan Stanley Real Estate's annual meeting for its largest clients in Shanghai, marking the first time the gathering was convened outside the U.S.

"It's not often you'll have an investment bank and principal-investing activities housed together," said Jay Long, a principal at Townsend Group in Cleveland, the largest U.S. real estate consultant to pension funds, foundations and endowments. "There are pros and cons with regard to that. The Chinese walls are a little trickier."

Today, there's even more competition, both for investors and properties. Blackstone Group LP, the New York-based investment firm that manages the world's biggest buyout fund, raised an unprecedented $5.25 billion for real estate purchases earlier this year. Warburg Pincus LLC, another private-equity firm in New York, raised $1.2 billion.

Lone Star Funds of Dallas raised $5 billion last year for a fund run by John Grayken, a former real estate executive at Morgan Stanley. Los Angeles-based Colony Capital LLC plans to run a $4 billion real estate fund that, like Morgan Stanley, will invest worldwide. New York-based Citigroup Inc., the biggest U.S. bank, is seeking almost $3 billion combined for two similar pools for Europe and Asia.

"There's a lot of capital in the market and markets are fully priced, so it's more challenging to get returns," said Long of the Townsend Group. "The fees are very expensive."

It's a fees frenzy as private equity firms clean up
THE funniest thing about private equity is the term. They used to be called leveraged buy-out funds (LBOs), but about the time Kentucky Fried Chicken became KFC because we don't like fried food any more, the collective noun was quietly changed to private equity, which sounds nice and Swiss.

But what these things do is your common or garden LBO. This is the only funny thing about private equity: apart from that, it's very serious — brutal even. The current boom in private equity, I mean LBOs, is re-leveraging the corporate world 25 years after it last happened and 19 years this month after the then highly leveraged corporate world, sailing with spinnakers full, hit the rocks.

There is one big difference between now and then, which is the eye-widening fees charged by the modern LBO funds. The new boom in debt-driven takeovers is a consequence of five things, some old, some new:

■ Low interest rates and economic and market stability increasing risk appetite.

■ Super fund portfolios growing more quickly than traditional avenues for investing.

■ Arbitrage between the value of assets and their market prices.

■ Overregulation of public corporations, so that going private itself creates value.

■ A boom in the financial ambitions of the executive classes — greed.

As a result, boards are routinely recommending LBO bids knowing that the funds expect to make an internal rate of return (IRR) of at least 20 per cent over three years, which means the board is selling too low and/or giving up on their own responsibility to get the best out of the company.

We are also now seeing the appearance in Australia of management buy-outs (MBOs), where the managers drive the process. The Flight Centre deal is one of those.

MBOs, in principle, are a fundamental conflict of interest and probably should be banned or at least made more transparent. Can the Australian Securities and Investments Commission or the Australian Stock Exchange think of a good reason why Flight Centre chief executive Graham Turner should not release to the market the management strategy and IRR forecasts with which he persuaded Pacific Equity Partners to join him in buying the company from the investors for whom he is supposed to be a fiduciary? If Turner's strategy and forecast memorandum to PEP is not material to the company's value under the ASX continuous disclosure regime, I don't know what is.

Coles Myer is a rare example of a board refusing to play the private equity game, although even there the board got itself into a pickle by trying to win over investors with forecast returns that are higher than the management's bonus hurdles.

Private equity gets better returns from a given set of assets than a public company board for three reasons: drastic transformation and cost cutting in private with no disclosure; giving the management the chance to get very rich; high gearing — up to 80 per debt.

But you can't understand private equity if you don't understand the fees. It's all about the fees — more specifically performance fees.

What distinguishes all the investments that super funds collectively call "alternatives" — infrastructure funds, hedge funds and private equity funds, and which now attract between 10 and 20 per cent of their assets — is the existence of performance fees. The normal fund managers just get a flat fee — their bonus, if they do really well, is to keep their jobs.

The standard deal for all three alternatives categories is 2+20 — that is 2 per cent base management plus 20 per cent of the profit. Some charge more.

This year LBO funds are all being oversubscribed two times over as the money available expands geometrically: both the size of the superannuation pool and the percentage going into alternatives are growing quickly.

So whereas the management fee, which is meant simply to cover overheads and salaries, was 1.5 to 1.75 per cent three years ago, now it is 2 per cent and a source of profit, especially as most private equity firms raise new funds. Each new one increases costs, while bringing in a full 2 per cent fee.

Ovidio Iglesias, of Wilshire Australia, the specialist private equity investment consultant and fund of funds operator, says that during the first five years the management fee applies to committed capital, whether it's invested or not. This is known as the "investment period". During the second five years, known as the "harvest period", it applies only to invested capital, which means there is a huge incentive on the fund to invest all the money within five years.

The performance fees kick in after an 8 per cent preferred IRR to investors. New operators usually have to offer a 10 per cent hurdle, while some of the more established funds are driving it down to 6 or 7 per cent.

If it's a $1 billion fund that ends up being worth $3 billion after 10 years, the investors get their $1 billion back plus 80 per cent of the $2 billion profit. The fund operators get 2 per cent a year of the $1 billion invested plus 20 per cent of the profit. If the IRR is less than 8 per cent, the whole profit goes to the investors and the fund operator has to scrape by on 2 per cent.

This is all producing a fundamental shift in the way the capital market operates, but is it dangerous?

Well yes, of course it is, in my view: it's a boom based on debt, greed and excess isn't it?


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