The inspiration for this article, and much of the data and analysis, comes from a 2023 academic research piece entitled, “Persistently Poor Performance in Private Equity Real Estate”. Using Preqin data, the researchers assessed the longitudinal performance of 2,738 liquidated private equity funds, managed by 1,205 different GPs. Funds that aren’t liquidated (i.e., still own properties) were excluded from the sample by only including vintage years up to 2011. The GPs were American, as were the investment targets.
The researchers assessed three categories of private equity funds: Buyout (BO), Venture Capital (VC) and Private Equity Real Estate (PERE). Buyout is what most imagine when they hear or read the words private equity. BO funds purchase large companies, often with maximum debt secured by the company being acquired, with the aim of selling the company once sufficient equity value has been created. Venture Capital investments are smaller and typically into tech or other types of fast growing companies. These funds expect some ventures to fail, others to shoot the lights out, and still others to just putter along. Real Estate Funds purchase real estate and generally take development or re-development risks when the private equity structure is involved in order to beef up the returns.
Overall Performance
Of the three, real estate funds performed the worst:
The Real Estate funds performed consistently across strategies. The riskier strategies of Value-Add and Opportunistic funds had IRRs of 7.9% and 7.1%, respectively. The less risky strategies of Core and Core-Plus represented 30% of the Real Estate funds in the sample, and they each had IRRs of 5.4%.
Performance Over Time
The researchers also looked at fund manager performance over time, as well as by the number of funds each manager raised during the period. Some observations:
Across all private equity categories, first fund performance was quite good. This is attributed to first funds being smaller, and other factors such as heightened scrutiny of the new manager, resulting in a more developed and narrow investment thesis.
Buyout IRRs stay consistent across time even though their fund sizes increase from five to eight times from the first fund.
Venture Capital managers tend to perform better as they raise more funds. VC fund sizes grew slower than Buyouts, and keeping fund sizes smaller could be a primary success factor.
Real Estate funds performed worse with each subsequent fund raised by the manager, achieving a dismal 5% IRR for fund 7 and beyond. Unlike Venture Capital, Real Estate funds continued to raise larger and larger funds, but at a lesser rate than Buyout funds.
Possible Causes of Low Performance by Real Estate Private Equity Fund Managers
The paper speculates, based on anecdotal evidence and other gleanings from the research process, that there are several potential contributing factors for the lackluster performance of real estate private equity fund managers.
Real estate is difficult to generate alpha (i.e., returns). The business of real estate is fairly straightforward without as many moving parts as the others fund types assessed. You create value for the equity holders of real estate in a few ways including utilizing debt, stabilizing incomes and then selling, and the risker strategies of developing, redeveloping or rehabbing.
REITs do a better job with Core and Core-Plus Strategies. Buying and operating mostly stabilized buildings are more suitably done by REITs. They have aligned company cultures, transparency mechanisms, and other advantages including favorable taxation. REITs will generally outperform the more conservative PERE funds by 1% to 5% annually. REITs are also liquid, more transparent, regulated, and have significantly lower fees.
Public pension funds are funders. 11% of all public pensions funds in America are invested in Real Estate funds. Another 11% is invested in all other private equity categories including Buyout, Venture Capital, Fund of Funds, Co-Investment, and Secondaries. Pensions are comfortable with real estate as it is a good way to offset their long-term future pension liabilities. The issue, the researchers point out, is that pension funds are more subject to political influences, regulations which encourage herd investing (i.e., ERISA’s “Prudent Investor” rule), and other organizational frictions that influence the investment process. Some of these are discussed in a previous Emerging Real Estate Digest, and in the video below of Professor Hooke speaking on the matter.
Local “sharpshooter” partner. Often the large PERE fund will partner with a local developer who has the deep local knowledge and political connections to facilitate the development. These additional layer of fees for the local developer can often eat up 10% or more of the total project costs, which obviously diminishes returns for the investors and their beneficiaries.
Professor Hooke Provides Further Light on Organizational Friction at Public Pensions
