News & Analysis

When I was six, my parents bought me a fish tank full of minnows.

They didn't last long. Over time, the water grew stagnant and clogged with algae, the fish hovering zombie-like at the bottom of the tank. What it needed was a good cleaning from an ultra-powerful aquarium filter. Instead, it was dumped in the backyard.

A challenging economic environment can work like one of these filters, sifting through the markets and discarding weak or toxic elements. This cleaning process has been particularly conspicuous in the world of private real estate investing, where a confluence of crises—a pandemic followed by a war and a banking crisis—has worked much like the Fluval FX4 Canister Filter, a multichambered, $200 aquarium filter my parents probably should've bought from PetSmart.

In private real estate in particular, these difficult market conditions work much like the turbo-charged cleaning device, categorizing certain managers as healthy and others as waste. But in the world of private markets, it's a bit more nuanced than in a home aquarium.

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Amid high interest rates, unrelenting inflation, and the ongoing denominator effect, total private real estate fundraising fell 28.4% from 2021 to 2022 and dry powder levels fell by over $60 billion, according to PitchBook's Global Real Estate report for the second half of 2022.

But the effects of a tightened fundraising environment weren't equally distributed across the asset class. Private real estate's performance over the past year saw a deep divide along the lines of fund size and strategy. LPs gravitated toward experienced managers—private market investors with the most recognizable names. Established GPs received 79.2% of total capital allocations in 2022 with emerging managers raking in a relatively paltry 20.8%. At the same time, funds with over $1 billion received 80.5% of total capital raised last year.

The big funds kept getting bigger. In 2022, 81.1% of real estate funds were larger than their predecessor vehicles, increasing by a median of 58.1%. Just last week, Blackstone, one of the world's largest and most widely recognized asset managers, announced the final close of its Blackstone Real Estate Partners X fund at $30.4 billion in total capital commitments—the largest real estate drawdown fund close on record.

"When Blackstone or Brookfield or Oaktree or one of these large managers who are multistrategy diversified managers come in, it's far easier for capital allocators to give them a large allocation and have them spread it across their various strategies via debt, equity, etc.," said Sean Hehir, CEO of Trinity Investments, a private real estate investment firm.

This effect is enhanced during periods of market turmoil, when LPs flock to safety in the form of managers with proven track records. The propeller in our fancy, metaphorical aquarium spins faster.

"LPs tend to find comfort in the familiar and very experienced investment teams that come from these big blue-chip asset managers, given not only their track records, but that they may have been through more market volatility and macroeconomic turmoil," said Anikka Villegas, a fund strategies and sustainable investing analyst at PitchBook.

At the same time, Hehir said capital allocators are also gravitating toward specialists, private real estate managers with niche strategies that focus on one specific sector. For example, PitchBook analysts found evidence of mounting specialization in 2022 in the closing of two massive self-storage funds: Prime Storage Fund III at $2.5 billion and GCP Securespace Property Partners Fund at $1.5 billion.

"There is a desire to enter into these spaces made attractive by idiosyncratic drivers and all of the other disruptive forces at play," Villegas said.

What's more, an anticipated correction in the real estate market in the US and Europe amid declining values in areas such as office space is pushing investors into other strategies like self-storage.

Already this year, Brookfield Asset Management defaulted on a $750 million debt for two office towers in Los Angeles and a $161 million mortgage for a dozen office buildings in Washington, D.C. With areas like office space in freefall, LPs are more open to opportunities in other sectors and strategies.

"It's a compelling case, given the uncertainty of the economic environment, to create a fund or strategy that focuses on taking advantage of those opportunities rather than starting from a more generalist approach and pivoting if they see something interesting—plus, with the former, LPs know what they're going to get," Villegas added.

Instability prompts the filter to work harder 

This isn't a new idea. Market disruption is often a catalyst for mounting trends. 

The COVID-19 pandemic triggered a slew of fast-tracked phenomena: the hybrid working world and the decline of office space, the rise and fall of digital assets in institutional portfolios, a newfound reliance on virtual communication tools like Zoom, and the breakdown of the global supply chain.

When the S&P 500 dropped over 5% from 2021 to 2022, and LPs suddenly found themselves over-allocated to the private markets it created the denominator effect.

Suddenly, LPs were pulling back and hiding from headwinds in the hands of the largest and most diversified managers. From 2021 to 2022, total PE fundraising activity dropped around $100 billion with the top 10 closed funds representing nearly a third of total funds raised, according to PitchBook's 2022 Annual Global Private Market Fundraising report.

As institutional capital gravitates toward massive generalist private market managers with well-established brands or niche, often boutique strategies, the private market is becoming increasingly bifurcated—particularly in the real estate space. Here, the players who operate somewhere in-between—middle-market general firms—fall to the wayside, caught in the filter like pebbles and fish flakes.

Nevertheless, while LPs may find some degree of portfolio protection in mega-managers and specialists, the recent market turmoil might be encouraging a bit of an overfiltration. Just as the Fluval filter might inadvertently sift out some of the good stuff—the healthy bacteria—in the private real estate market, the less-than-top tier, generalist mid-market firms could suffer as LPs gravitate to either end of the GP spectrum.

"I think if you're stuck in the middle—if you're a small or medium sized, multistrategy manager—it's a far more challenging fundraising environment today," Hehir said. 

Featured image by Jenna O'Malley/PitchBook News