One of the ever-present considerations for emerging real estate operators and developers is whether the time has come to raise an investment fund. While the process of raising capital a deal at a time is often the most practical approach, it also comes with several limitations. An operator-fundraiser must devote significant time and resources to marshaling funds for each new transaction, is highly vulnerable to the changing whims or capital limitations of their investor base, and often cannot move as quickly or aggressively as their better-capitalized competitors. The allure then, of raising a pool of discretionary capital is obvious, and for many must feel like a vital step in taking more control over their company’s destiny.

Despite this view, the road to launching a fund can be turbulent, rife with challenges and substantial costs. In that context, a panel of real estate advisors & service providers at IMN’s 2024 Winter Forum on Real Estate Opportunity & Private Investing Conference discussed some of the most salient structural considerations for emerging managers experienced and brave enough to take the leap forward. 

Anchin partner James Lockhark asked panelists the question top of mind for many attendees. “When is the right time to raise a fund?” While the timing varies based on the firm, panelists all emphasized that fund formation and fundraising processes, once undertaken, is a continuum that does not start and stop based on the ebbs and flows of deal activity. “Every time we talk to a fund manager, they’re always thinking about the next one (fund),” explained Anchin Partner Zurab Moshashvili. “So that process, that seed, is always in the manager’s heads.” This is because to establish and grow fee income, investment managers must be very focused on scaling their assets under management. “Are the asset manager fees coming our way so we can keep the lights on? Or are there other fees coming our way from acquisition fee perspective,”Moshashvili elaborated. Alex Geer, CFO of investment manager Calibogue Capital, corroborated the statement. “We’re ALWAYS capital raising, right? This is a fundamental change for a syndicator to looking to become an established manager.”

But fundraising is not the only philosophical change required. Another is approaching investment theses and execution more holistically. “The capital raising becomes less about that one deal and more about the thesis, more about the strategy, more about the markets, about the team” commented Michael Dombai, Managing Director of fund administrator Alter Domus.  “And so, it changes the business. What type of infrastructure do you have?” When I say infrastructure, I mean investment relations support. How are you using technology? What are you doing to keep track of investors? How are you managing that?”

On the surface, the point sounds obvious but should not be taken for granted. Many operators have expectations that their operations will become easier with a fund model, but Geer explained that it is often the opposite. Because fund managers get paid based on the cumulative performance of the assets in their fund, they are forced to assume long-term orientations syndicators are not. “You’re really changing your business operations. You need a fund manager, a real estate professional, who is focused on getting the best performance they can in every deal, because that’s going to affect their ability to find themselves in the promote when that last deals exit,” he commented. While a syndicator may remain committed to managing an under-performing asset to preserve the strength of his/her investor relationships (even if he or she does not stand to profit), unlike a fund manager, their performance is segregated by deal, making it potentially easier to walk away from a loss. The fact syndicator’s LP composition also tends to vary deal by deal could also make them less tethered to their individual investors, versus fund managers who are accountable to the same pool of investors for multiple deals.  

Another blind spot for many operators is the stringent reporting requirements that come with working with institutional investors. “If they are an institutional investor, they are going to be time intensive,” said David Schwartzman, Partner with law firm Cox Castle. They have their own requirements that they need to meet, their own regulations, and statutes. They’re reporting information that they need to receive from you in order to satisfy their own public reporting requirements.” Given the importance of timely and accurate reporting, prospective manager’s ability to raise funds will be often driven as much by their infrastructural strength as their investment strategy. 

The panelists also emphasized that operators should brace themselves for dealing with more intermediaries when working with large institutions. Unlike retail or high net worth investors acting on their own behalf, institutions often outsource asset management and communication functions to third parties. Speaking from experience, Geer explained. “One of the big differences is that once you’re in the funds space, particularly with the institutional investors, the person you are dealing with may no longer be the principal, who is investing the money. You’re dealing with agents, you’re dealing with consultants, and it’s very different.”

One of the main concerns for any emerging manager is their ability to cover the considerable overhead expenses required to operate a successful fund, even a small one. The panel re-assured attendees, arguing that institutional investors traditionally view such fees as an unavoidable cost of doing business.  “If you’re raising a small fund and you’ve got a headcount, you know, the fee may need to be higher. And I think in our experience, people have been receptive to that. Having said that, the better way to fix that is to just raise a bigger fund. Geer elaborated. “In our business, for instance, our founder was doing this himself out of his garage. And it was like pulling teeth to get a salary draw approved for himself and the fund. And once he had had headcount, that conversation just went away.  They were like, okay, you’re telling me it’s a 2% management fee.  It wasn’t 0.5% (like for a larger fund). Whatever it was, it’s just like, well, you know, he’s not just paying himself, like he’s got to pay people. I think people understand that this is an ongoing business model that you’re going to be working on forever, you’re going to be stuck. Unlike syndications, you can’t just wash your hands of a deal.”

Moshashvili went one step further. You have to make sure that (costs) are obviously built into the legal documents correctly, right, so that fund administration costs are to be absorbed by the fund. But it’s also extremely important to make sure you set a cap where you allow yourself to bill back organizational costs to the fund as well. Those costs can be significant for larger fund investors, especially with investors who are more sophisticated, that read the documents, may have more comments.”

That does not mean that large investors won’t leverage such requests or others to drive better terms for themselves. Moshashvili went on. “From an asset management perspective, what we have seen is that if you’re going from friends and family and going to a little bit more institutional or larger funds, at that point they (an anchor fund) may be asking for a piece of the general partner or the investment manager from a revenue share perspective or other types of fees. So, they’ll write a $30, $40, $50 million-dollar check and that check can help you go get other investors, so you get to a $100 or $200 million dollar fund. But that $30 million or $40 or $50 million-dollar check doesn’t come for free.”

One of the more nebulous considerations raised was whether to register with the SEC an Investment Advisor, a process that is not only time-consuming and costly leading up to the registration, but afterwards in order to stay in compliance. Because of nuances around what constitutes a security, depending on their strategy and need for flexibility, real estate fund managers may have to factor this into their headcount needs and cost structures as well. Schwartzman commented, “In real estate it can be grey. It’s not necessarily grey if you’re buying the dirt. There’s not going to be a security issue. If you’re buying something like a green bond or a very passive interest in another real estate related investment vehicle, then they are going to be a security. “You may want to stay in one lane if you don’t have to think about these problems, rather than necessarily going for a super broad strategy because you might do something else. Because once you do so, you are subject to significant compliance and oversight and practices that you’ve launched when you’re not registered or positive.”

Schwartzman commented that while macro headwinds and the meaningful reduction in transaction volume had slowed the pace of CRE fund fundraising generically, opportunities still exist for emerging managers with compelling strategies. “My hopeful expectation is that things that we were (originally) hoping to do first quarter closes will leak (only) into the second quarter. And I think the real ramp up will happen, hopefully, in the second quarter with third quarter being somewhat back to normal. Hopefully, what is going to drive that is not so much the fundraising business, as it relates to raising funds, but just the opportunity that people are seeing with the assets as maybe some of that repricing is finally down and debt’s available in order to do good deals.”

Alternatively, Geer felt that the popular narrative that dry powder was overly abundant was an exaggeration from the fund investor side, because institutional LPs would need more of their legacy investments to return capital before feeling comfortable deploying into new strategies. “I think that slows down fundraising for the fund perspective just because people aren’t in a position to commit to keep deployment at the level they want it, because they may be stuck in assets for two extra years, a year, whatever the case may be. You see some of these industry reports about how much dry powder there is in the industry. I don’t know, I think I’m starting to think about heavily discounting that number because I think that as assets spill past their expected sale date, I think that dry powder number probably should be coming down considerably, even if it is, being drawn off of commitments available.”

Regardless of the viability a manager’s strategy, it was clear, ironically, that one of the biggest drivers of fundraising success will be institutional portfolio re-allocations due to fluctuations in the stock market, something outside of real estate professional’s control. “Particularly the US governmental plans, they have obligations as it relates to having diversity in their allocations,” said Schwartzman. “Their real estate bucket will be sensitive to the stock market, and so when the stock market is up, that real estate bucket is up, and when that stock market’s down, that real estate bucket gets smaller. They don’t have to act quickly, but it impacts their behavior. Last year we saw them press pause because of where the market was. Given where the market ended and what I’ve heard from some of my clients, they’re ready to deploy capital again.”