SBRE Funds and Institutional Capital
The more I meet and talk with SBRE fund managers (experienced, new, or aspiring) from around the country, the more I have a firsthand opportunity to witness (and hopefully assist with) their challenges, opportunities and pursuits. And the more we at the same time raise capital for our own funds in order to invest in and alongside some of these fund managers, the deeper grows my sense of how pervasive the confusion and misperceptions are around the notion and viability of raising institutional capital. Everyone, or virtually everyone, seems to think that they are going to be able to raise institutional capital in their blind pool fund and yet only a tiny few actually accomplish it. Even if a manager does accomplish it, most often it is in a form other than as LPs in the fund pari passu to the other LPs, such as a senior-sub arrangement, a managed account, or some other specially cut deal. There are multiple reasons for this dynamic about which I have written before, but I am compelled to continue to do so to try to help SBRE fund managers better understand the realities they are dealing with when raising capital and hopefully save them unnecessary time, effort and aggravation. I realize that no matter how much I beat this drum, many or even most will continue to pursue institutional money in the hopes of growing their fund more quickly and simplifying their lives (ostensibly) by reducing the number of investors they have to deal with in order to achieve this growth. Yet, the great majority of the time this effort is in vain and even when it is not, the result is something different than what managers expect and contains its own shortcomings, challenges, and risks.
I was in New York this past week visiting with several fund managers in whose funds we’ve invested as well as some new ones we are considering. Each of these funds are at different stages of their development ranging from brand new to what I would characterize as reasonably mature. All of the managers I met with I consider to be sincere, capable and knowledgeable real estate people, each with their own strategy on how to earn solid risk-adjusted returns in one way or another. Yet despite their competence, track records, and returns, they all face similar dynamics when it comes to getting institutional capital to come in as equity into their funds, even the largest and most mature of them. The reason is that institutional investors are constrained by a number of forces that simply do not mesh well with the nature of SBRE funds. The “story” nature of the assets generally, the inability of the manager to accept gigantic amounts of money at one time, their unwillingness to be by far the largest investor in a co-mingled fund, the desire for control in asset-level decision making, the fees being charged by managers, the potential conflicts inherent in blind pool funds – one or more of these factors, as well as others, invariably comes into play and precludes the type of investment the manager seeks, leaving him back with the high net worth investor as his most likely and best suited candidate to invest in his fund.
While I was in New York, I also spoke with an investment banker actively involved in raising capital for companies and managers in the real estate and financial services sectors. Our discussion corroborated virtually every observation I have about the mismatch between the two worlds. He rattled off pretty much every issue I raise above, effectively validating the fundamental paradox between the nature of SBRE and the nature of institutional capital. The amounts of money that the latter must place in any given investment make it virtually impossible to justify the upfront time necessary to vet any given SBRE manager in the first place. The fact that most capital sources do not want to alone comprise more than some small percentage (say 10 or 20%) of any of their investments means that anyone managing less than $100,000,000 (or more realistically $200,000,000) is not even a candidate for consideration (not matter how great they are). Institutional investors are looking for something vanilla and “inside the box” and would rather take less perceived risk and earn a lower return than attempt to obtain a higher return by investing in “story” assets, especially in a co-mingled blind pool where they are not themselves involved in picking those assets. If they do decide to work with a manager, they mostly only want to invest using a “managed account” format where they are not co-mingled with others, where they have some control over the asset choices (or at least in determining the criteria for assets), and where they are able to separately negotiate (i.e. cram down) the fees paid to the manager. Most managers, in my experience, do not want to work just for a single investor, and SBRE managers even less so. It is too constrictive and goes against the entrepreneurial nature that prompted them to be independent in the first place. In the cases that they will consider a co-mingled blind pool fund, it is usually only very large funds that fall outside my definition of SBRE. In the even rarer cases they will consider an LP investment in a true SBRE fund, they will almost always want some special structure that places them ahead of the other LPs in the capital stack, thus worsening the position of the existing LPs. Managers loyal to their existing LPs, most often consisting of friends, family, themselves, and other high net worth investors, have a hard time accepting that compromise.
I have personally experienced every one of these arguments, negotiations or situations at one point or another in the 15 years or so we have been managing our own co-mingled investment funds. I also routinely see clients, prospects, and managers I work with experience and struggle with them daily. One of the most interesting aspects of our business model is the continual learning and re-learning I get to do based on real time interaction, observation and feedback with all types of SBRE market participants. Given that we are also actively and continuously raising capital for our SBRE funds, all of these observations are not just abstract theory to us, but rather important, practical, and real world intelligence we are able to consider to help make decisions about strategy, tactics and processes we implement to raise capital. We also try hard to share this intelligence with other SBRE managers to help them save time and money and to improve their ability and capacity to raise capital more efficiently and effectively. What it really comes down to, in my opinion, is that the most appropriate target audience for the SBRE fund manager is the high net worth and ultra-high net worth individual accredited investor. Acceptance of this as fact can be very hard because it has certain implications about the amount and nature of the work involved to raise enough capital to handle whatever level of qualified deal flow a manager may have. Most do not attack capital raising from this constituency methodically but rather in fits and starts while chasing institutional capital at the same time in the hopes of transcending the former for the latter. For all but a few, this is only a fantasy.
The good news is that the JOBS Act has fundamentally altered the way in which SBRE managers can reach out to this ideal target audience. General solicitation and advertising is in its infancy and will grow dramatically in the coming years. But that is a topic for another day. In the meantime, everything I experienced this past week in New York further confirmed my opinions about the dynamics I am writing about – namely that managers continue to believe they will somehow be able to get institutional capital despite the fact that institutional capital systematically avoids SBRE funds unless a custom structure can be had. At the end of the day, the two universes are parallel and do not often come within each other’s gravitational pull despite many vain attempts of SBRE fund managers to escape the pull of their own universe to enter the pull of the other. Occasionally an SBRE traveler will pull off such a metaphysical rarity, but for the most part they are alien to one another.
Matt Burk is founder and CEO of Fairway America, LLC, and SBREfunds.com, and Chief Investment Officer of Fairway’s two proprietary nationwide small balance real estate (SBRE) asset based pooled investment funds, Fairway America Fund VI, LLC, and Fairway America Fund VII LP. Fairway is the nation’s premier consulting, advisory, and investment firm in the SBRE private pooled investment fund space, providing a full spectrum of practical, real world products and services (including capital) needed for true success for SBRE entrepreneurs all over the U.S. Matt is a highly regarded adviser, consultant, and mentor to dozens of SBRE fund managers and author of a widely read blog followed by serious SBRE entrepreneurs and investors. For over 20 years, Matt has led Fairway’s deal underwriting as well as capital raising efforts in Fairway’s seven proprietary funds and individual trust deed investments, resulting in more than $250,000,000 in capital raised from accredited investors through more than 1,000 SBRE deals. He is currently working on multiple SBRE fund consulting engagements nationwide, authoring a book on how to raise capital for and effectively manage pooled investment funds, and dedicating his efforts to create greater awareness and drive more capital to the many high caliber and deserving SBRE entrepreneurs around the U.S.