When it comes to private real estate funds, bigger is not always better. This statement may seem counterfactual given that the 50 largest private equity real estate funds accounted for 70% of all capital raised in this space through 2022, however, individual investors will generally find both superior returns and favorable incentive alignment investing in smaller funds. As I’ll explain further in this post, fund selection boils down to fit and while large fund managers are clearly very good at attracting and deploying capital, their structures and mandates are often not ideally suited to the individual investor.
As a bit of context, 2021 was a record setting year for private real estate funds with $213.5B flowing into this universe with 2022 not far off at over $160B. Over the past two years we have also witnessed the rise of some truly gigantic fund vehicles. In 2022 alone Brookfield Asset Management closed their $17B Brookfield Strategic Real Estate Partners IV fund and TPG closed their $6.8B TPG Real Estate Partners IV fund. These funds individually are larger than total AUM (assets under management) many top tier managers in the alternative asset space have amassed yet still pale in comparison to Blackstone’s gargantuan $30B Blackstone Real Estate Partners X fund. So, if the premise of this post is to be believed and individual investors are better served placing their money with smaller managers and funds, what is behind the prevalence of such large funds?
The answer lies in the challenges faced by large pools of institutional capital such as pensions, nonprofits, and endowments. Pension and retirement funds for public entities, such as the $500B+ California Public Employees’ Retirement System and $300B+ California State Teachers’ Retirement System, are often extremely large and must carefully manage their ability to meet growing benefit liabilities among pensioners. Likewise, large corporate organizations also have sizeable retirement funds with Boeing, IBM, and AT&T each managing pools of over $60B. These institutional pools of capital live and die by their ability to construct portfolios focused on diversification, principal protection, low volatility, and cash flow sufficient to pay retirees while maintaining a stable principal base able to meet future obligations.
With so much capital to deploy and such strict mandates among the various pensions, nonprofits, endowments, etc., firms with institutionally focused asset management groups such as Blackstone, Goldman Sachs, and the like have long recognized the opportunity inherent in assembling fund offerings suited to the needs of these clients. Full disclosure I used to work on Goldman’s team dedicated to managing the hedge fund and private equity portfolios of some of the largest institutional clients in the US. From the perspective of the individual investor, the large fund offerings designed to attract and retain institutional capital can appear relatively boring. Decabillion ($10B+) sized private funds geared towards attracting big chunks of pension or endowment money prioritize scalability, stability, and feasibility and are generally comprised of stabilized core assets acquired through portfolio sales in gateway or tier I markets where liquidity and larger deals are easier to come by. Aside from some of the more opportunistic offerings in the market, these funds tend to have a lower risk profile, stable cash flow, and offer a low beta to the public equity and debt markets.
Now let’s turn our attention to smaller funds and identify how their contrast to larger funds better serves individual investors. It goes without saying, smaller real estate funds, by nature and necessity, target the lower-middle end of the market where deals may range in size from $5M to $50M. Without the competition, cash, and capabilities of larger funds to contend with, this corner of the commercial real estate market exhibits less efficiency, more informational asymmetry, and therefore greater opportunity to capture value. The lower-middle end of the market also contains vastly more properties prime for value-add improvement strategies which hold higher return potential over core assets.
Structurally, small funds and emerging managers also differ from larger funds in ways that better align incentives with the individual investor. Many operators of large funds, such as Blackstone, Starwood, Goldman Sahcs, TPG, and others are publicly traded companies and therefore have an allegiance to shareholders which can manifest as a focus on growing AUM and revenue. Small funds on the other hand are essentially solely beholden to the investors in their funds and rely on delivering returns and building strong track records to keep the lights on. Larger funds also lean heavily on an ecosystem of placement agents, consultants, and other third-party or in-house service providers to help raise, manage, and deploy the astronomical amounts of capital they oversee. These resources can increase the expense load of a fund and in some cases result in a hidden double layer of fees or promote, negatively impacting investors’ net returns. On the other hand, smaller funds are typically more streamlined in their fee structure and can offer investors a greater level of transparency.
Perhaps small funds’ greatest advantage is their ability to deploy investor capital nimbly, capitalizing on shifting trends or market movements. The analogy I use when conceptualizing this advantage is that of a large semi versus a small sports car – when there is no traffic or obstacles a semi can perform well at moving a large amount of cargo at a reasonable speed on a clear highway, however, a sports car will be much better at maneuvering through traffic or bombing through backroads when that highway is closed or congested, albeit while limited to carrying one passenger and maybe some groceries. As market environments and trends in commercial real estate ebb and flow, small funds are much better suited to identifying and executing into areas of opportunity.
This all sounds great – small funds are generally more accessible, cost efficient, and aligned with individual investors’ interests, but how does any of this translate to what really matters…performance? As it turns out, smaller funds seem to outperform their larger brethren by nearly double! In a study conducted by Origin Investments comparing the performance of funds with <$200M in AUM against funds with >$1B in AUM they found these smaller funds produced a net IRR of 11.2% while the big boys only achieved 5.7%. The study analyzed performance over the 2005-2015 period so effects of the Global Financial Crisis on fund performance can’t be ignored, yet still the evidence is compellingly in support of small funds’ ability to achieve higher returns for investors.
It is important to note that the ability to generate return is not a meaningful measure of success or primacy in and of itself. Return and risk go hand in hand, and the manager able to produce sky high returns because they’re swinging for the fences and taking on enormous risk is likely not the best long term investment option for investors of any risk profile. Investors should always seek to achieve the highest return for the cumulative magnitude of risk being taken (Sharpe ratio). For institutional investors, their emphasis on low volatility and diversification make the muted returns of large real estate funds entirely acceptable. For individual investors looking to protect, but also grow their wealth, smaller funds appear to be a much better option for achieving this risk return tradeoff and accomplishing their goals.
Portfolio Manager - Director of Investment
Before joining Axia, David developed real estate experience at Everbank/ TIAA CREF in the distressed MBS trading unit and on one of Colliers market-leading investment brokerage teams. David brings a decade of financial services experience, working at Credit Suisse and Goldman Sachs within their Wealth Management and Hedge Fund Strategies groups, and an MBA from Vanderbilt.