Where has Private Equity Gone?
Firms focus on buying and originating debt

With Wall Street shaken and stirred over the failures of Lehman Bros. and Bear Stearns & Company Inc., not to mention AIG's bailout and Merrill Lynch's takeover by Bank of America, many private equity investors are looking for a place for their money and they've identified opportunities within the real estate debt arena.

Not only have a number of real estate debt funds been raised to buy existing debt (both senior and subordinate), but several funds have decided to originate debt as well – essentially morphing into lenders.

From traditional private equity heavyweights such as Kohlberg Kravis Roberts and Investcorp to real estate-specific private equity players like Colony Capital and Ascent Real Estate Advisors, debt has emerged as the new, safer alternative to equity investment.

"We still see opportunities in equity, although at moment the more compelling opportunities are in debt," explains Todd Sammann, principal of Colony Capital LLC. Earlier this year, the Los Angeles-based private equity firm finished an equity raise of $900 million dedicated to investing in distressed real estate debt. Since the fund closed in May, the firm has invested or committed more than $300 million, primarily in mezzanine debt and CMBS securities, just two of several debt strategies being pursued. 


"The rationale firms are choosing the debt route," says Josh Kamin, a partner with global law firm King & Spaulding's Atlanta office. "Today, the risk/reward is better for debt."

Rethinking investment strategies

For most investors, the credit crisis that flared up in mid-2007 has forced them to modify their investment strategies and private equity firms are no exception. In fact, the lack of liquidity in the global credit markets has made life a lot more difficult for private equity firms – especially those that relied on leverage (credit and debt) as the backbone of their investment strategy.

Most private equity players are searching for "distressed" debt – although the cause of distress in the present dislocation is perhaps caused primarily by the lack of investors with appetite or access to capital, rather than the underlying performance of the collateral.  Lenders are desperate to move real estate debt off their books, which can only be accomplished with significant discounts.

The investment environment is even more difficult in the commercial property sector, as many private equity firms are still licking their wounds from previous investments. Over the past few years, private equity players have been busy investing equity in properties that were under managed. Today, that strategy has been pushed to the back burner.

Colony Capital, along with other private equity firms, is reacting to the credit crisis that has forced banks to sell real estate-backed loans at discounted rates and made it difficult for borrowers to obtain the mortgage proceeds they need to close deals. Most private equity firms that are moving toward the debt side are most interested in mezzanine debt.

They're hesitant to sink equity into joint venture deals with developers and owners given the uncertainty in the market regarding property valuations and future property performance. Golden Tree InSite Partners, for example, hasn't done a new equity deal in the U.S. in more than 12 months, Shapiro says, adding that the firm put out $300 million worth of equity in 2006 and $100 million in 2007.

But, instead of languishing on the sidelines and trying to wait out the current environment, private equity investors have finagled another way to invest in real estate by buying subordinate debt from Wall Street investment banks, commercial banks smaller regional banks. Case in point: Golden Tree InSite Partners has plans to invest $200 million to $300 million in mezzanine debt this year.

And, recent reports indicate that the U.S. real estate division of Bahrain-based investment firm Investcorp purchased two junior and senior mezzanine loans from a Wall Street investment bank and four similar loans from major commercial banks totaling $210 million for its Investcorp Real Estate Credit Fund, which has $1 billion worth of funds to deploy into real estate debt.

Most private equity players are searching for "distressed" debt – but the meaning of the word "distressed" refers specifically to the loan itself or the lender rather than the underlying performance of the asset. For example, many lenders are desperate to get real estate debt off their books and are selling off pieces at discounts.

Additionally, many borrowers need to refinance their loans to recapitalize or their loans are coming due, yet they've had trouble getting new loans. In both these cases, the underlying assets have not shown signs of distress – they're still cash flowing and covering their debt service – therefore, they don't fall under the traditional "distressed" asset description.

Colony Capital is one such private equity firm that is focusing on "distressed" debt, Sammann says. "A lot of the collateral underlying the mezz paper is performing quite well, and it's the lack of liquidity that is causing the distress," he explains. "That lack of liquidity pushes the pricing down where the economics are accretive for us."

Similarly, Shorenstein Properties' interest in mezzanine debt ramped up in mid-2007, although it made its first mezz investment in 2003. In fact, the San Francisco-based company increased its Shorenstein Realty Investors Nine fund to $2.06 billion from $1.3 billion earlier this year after in light of "ongoing dislocation" in the credit markets, according to Chairman and CEO Douglas Shorenstein.

So far this year, Shorenstein's ninth fund has invested in a $250 million mezzanine package backed by 450 Lexington Avenue in New York City and a $51.5 million mezzanine loan backed by the McCandless Towers in Santa Clara, Calif. In total, the firm’s total debt holdings are about $685 million.

By investing in the mezz piece, private equity players have put themselves in the position to achieve return in the mid-teens to low 20 percent range. Plus, if the borrower gets into trouble and defaults on the loan, the private equity firm might have an opportunity to take possession of a property, says Dan Gorczycki, a managing director of Savills Granite, a New York City-based investment firm.

Morphing into lenders

In addition to investing in existing real estate debt, many private equity firms have raised funds or dedicated capital to originate senior mortgages and/or mezzanine debt.

Prior to the credit crisis, borrowers could get senior debt to cover 80 to 85 percent of the loan-to-value. Today, lenders are requiring far more equity, and borrowers are lucky to get a mortgage worth 60 percent loan-to-value. As first mortgage loan proceeds decline, borrowers must come up with more equity or turn to mezzanine financing to complete their transactions.

New York City-based Ascent Real Estate Advisors, which has invested in mezzanine debt for several years, is now considering providing first mortgage loans because it isn't satisfied with the amount of mezz money it has been able to deploy. "It's all well and good that private equity players now want to provide mezzanine debt, but the problem is that there's a void for first mortgage debt too," says Dean Benjamin, partner of Ascent Real Estate Advisors, adding that he expects his firm to invest $100 million to $150 million in mezz debt this year – on par with previous years.  

While private firms obviously have the ability to invest more equity into deals, today they can take a safer position within the capital stack, yet still receive equity-like yields by investing in mezzanine debt, says Steve Collins, managing director of international capital of Jones Lang LaSalle. "Private equity firms are taking advantage of the fact that borrowers need to fill in a larger piece of the capital stack between the senior debt and equity," he points out.

Apollo Real Estate Advisors, for example, raised $930 million for its debt investment fund, Apollo Real Estate Finance Corp. Earlier this year, the fund and M&T Bank provided a $163.5 million floating-rate debt package to Taconic Partners and Square Mile Capital for the $172 million purchase of 375 Pearl Street, a 1.2 million-square-foot office building known as the Verizon Building in Manhattan. Apollo arranged for M&T Bank to provide $110 million in senior debt financing.

Bradford Wildauer, Apollo partner who oversees the firm’s U.S. debt investments, says the continuing credit crisis has created increased opportunity for the firm as both a buyer and originator of debt.

LEM Mezzanine, which is a series of private equity funds with over $450 million of equity, is actively originating new mezzanine and subordinate debt financings and has  been doing so for several years, says partner Herbert Miller. However, LEM Mezzanine is not interested in providing loans to distressed borrowers or assets. And, the firm is deploying capital very cautiously because its feels "fundamentals are not on solid ground," Miller says.  

Fundamentals aside, Miller believes that private equity players that are just now entering the debt side of the business to take advantage of the credit crisis will lose interest as soon as the credit crunch eases because the upside on real estate debt is limited and it's not on equity investments.

But that's okay with plenty of private equity investors. "There are many times when we are more than happy to collect that mezzanine return with the limited upside because we didn't suffer the downside," says Batkin of Terra Capital Partners.

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