Growth of  REAL ESTATE Secondaries

While real estate is largely illiquid and intended to serve as a long-term investment, private funds typically have lives of 7-10 years. This timing mismatch can create opportunities in the secondary market. 

Transaction volume in real estate secondaries has experienced tremendous growth as both limited partners (LPs) and GPs look for flexibility and liquidity in managing their private market investments (see Figure 1).

Assets under management for real estate secondary funds almost tripled between December 2016 and June 2020, from $9.3 billion to $27 billion.3 Today, real estate represents approximately 5% of the overall secondary market, which continues to be dominated by private equity assets (see Figure 2). 

The Rise of GP-Led Recapitalizations

LP-led deals are the more traditional type of secondary transaction. They involve the sale of a fund interest from an LP that wants to liquidate prior to the fund’s termination. Traditional secondaries provide those LPs with liquidity (for example, to meet capital constraints), allow them to lock in gains early and/or give them a way to reduce their over-allocation to an asset class.

Investors that purchase those secondary interests, on the other hand, can potentially gain access to high-quality assets at attractive valuations, J-curve mitigation, higher current income, shorter payback periods and greater diversification. Exposure to secondaries can also broadly augment a defensive, risk-adjusted approach to investing in real estate.

GP-led transactions are a more recent phenomenon. GP-led is a broad category that encompasses a number of ways in which a GP can generate liquidity for itself or its investor base, including recapitalizations, tender offers and spinouts. 

For GPs, engaging in a secondary transaction can confer several benefits: 

• Accelerate liquidity and lock-in gains for their LPs 
• Add strategic and/or long-term investors to their investor base 
• Retain many of their best assets while realizing additional upside 
• Obtain fresh capital for new or follow-on investments
• Deliver more customized solutions to their LPs

GP-led transactions can also provide several benefits to both primary and secondary LPs, such as opportunities to:

• Reset the fund’s economics to better align the GP’s interests with those of the LPs
• Realize returns earlier in their investment or lock-in gains
• Generate liquidity
• Manage or re-balance their portfolios
• Target high-quality assets that are difficult to buy directly
• Roll-over into the GP-led recapitalization

Hypothetical GP-Led Recapitalization

A GP is managing a diversified fund portfolio of commercial real estate assets. 

The portfolio is considered high-quality for several reasons:

• The assets are more than 90% occupied, with an approximate five-year weighted-average lease term
• The expected average cash-on-cash yield is in the high single digits
• The tenants are high-quality and operate in strong industries
• Cash flows are stable with mark-to-market upside in rents
• The assets are in a city with strong rent growth, low vacancy rates and other attractive characteristics.

After negotiating financing and other terms, the GP enters into an exclusivity agreement with a strategic long-term investor. Through the agreement, the investor will acquire up to 95% of the portfolio from existing LPs while the GP commits 5% to the continuation fund. The GP’s incentives are also reset based on current net asset value and the current return profile of the investment. 

Going forward, the GP will be able to continue to manage the assets, receiving the capital it needs to realize additional upside, while adding a strategic long-term investor to its investor base. The secondary investor, meanwhile, is able to gain exposure to these high-quality assets with a strong alignment of interest with the GP.