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JERER 3,2

Performance of private equity real estate funds

Ilkka Tomperi
Finance and Financial Accounting Research Group, University of Vaasa, Vaasa, Finland
Abstract
Purpose This paper aims to focus on the performance of private equity real estate funds. Since many institutional investors have special programs to invest with rst time managers, or emerging fund managers, it also seeks further evidence on how persistent the performance of real estate funds is and how the growth in fund size affects the realised returns of a fund. Design/methodology/approach The analyses performed are based on a large global sample of value-added and opportunistic private real estate funds. Different model specications are used to study the fund and sponsor-related factors correlation with fund performance. Findings It is shown that the realised performance is positively correlated with fund size but negatively correlated with the sequence number of the fund supporting the fact that emerging managers are likelier to achieve good returns. The data also reveal trends in fund performance and the growth of the fund size. Evidence from private equity buy-out funds has also shown that better performing fund managers are likely to raise follow-on funds and often larger funds than poorly performing fund managers which is also conrmed by the ndings of this paper. There is also an evidence that top-performing funds do not grow proportionally as much as the average funds. Research limitations/implications Actual datasets used in the regression models are often limited by exclusion of immature funds to enhance reliability of results. Originality/value This paper expands the recent studies on private equity to private real estate, an area that has experienced substantial growth during the past ten years. Keywords Equity capital, Real estate, Property, Investments Paper type Research paper

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Journal of European Real Estate Research Vol. 3 No. 2, 2010 pp. 96-116 q Emerald Group Publishing Limited 1753-9269 DOI 10.1108/17539261011062592

1. Introduction Institutional investors including pension funds in Europe and elsewhere have increased their commitments in indirect real estate investment vehicles, mainly private equity real estate funds, over the past few years. According to INREV[1], the amount of capital commitments raised in Europe over 2005-2008 was e54.2 billion. INREV (2009) shows that fund managers raised e10.2 billion in Europe in 2008 compared to e19.0 billion raised in the peak year of 2007. The global fundraising of value-added and opportunistic real estate funds over 2005-2008 was $349.8 billion compared to $84.2 billion raised during the preceding four-year period of 2001-2004 according to data collected by Preqin[2] (Figure 1). Based on these data, the number of funds raised almost tripled from 217 to 605 from the earlier period to the more recent years and the average fund size grew from $388 to 578 million. The benets of adding real estate in an investment portfolio have been documented widely, e.g. by Stevenson (2004) and Lee and Stevenson (2006). Studies have shown that real estate can provide both diversication benets and reduce overall risk of
The views expressed are the authors own.

a multi-asset portfolio. Real estate can also provide hedge against ination in addition to potentially providing attractive returns which have been reported to exceed bond returns and at times being competitive with equity returns (Darst, 2003). Property can be seen as a true third asset class, separate from equities and bonds because it is a physical asset and requires regular management and maintenance, its income stream is governed by long contracts, and the supply side is regulated complicating the effects of economic forces (Baum, 2002). Still the performance of real estate is, like all assets, ultimately linked to the performance of the economy and capital markets. Like in equities, international diversication has been shown to have positive characteristics, e.g. by Ball et al. (1998). The individual real estate markets, typically very local by nature, have their own supply and demand drivers and the correlation of rental growth, property yields and returns have been relatively low between different countries and markets. The latest shock that has faced the real estate markets has been capital markets driven and has not left almost any markets or regions unaffected raising questions on the benets of international diversication. Many investors have also questioned the benets of diversication across a number of asset classes. Despite of the recent shock, an asset class that is signicant in size and which tends to be uncorrelated with other assets still provides diversication benets in a multi-asset portfolio (Fisher and Sirmans, 1994). Until the Summer 2007, the boom to diversify portfolios in private equity and private real estate caused private equity real estate funds to collect historical amounts of investor commitments. These amazing fundraising vintages were characterised by a strong demand from institutional investors to increase their allocation in private real estate. As a consequence, a record number of new private real estate funds were launched and larger than ever funds were raised. The demand for real estate increased and together with the availability of debt nancing the volume of property transactions grew to record levels in 2007 when global quarterly real estate transaction volume peaked at close to $250 billion in second quarter of the year. After the peak in the Summer of 2007, the transaction volume has declined to around $50 billion during the last quarter of 2008. Very much demand driven, the property yields reached their all time lows in many liquid but also emerging markets and the spread between riskier secondary markets and prime locations decreased (RREEF, 2009). The typical structure for a private real estate fund is a closed-ended (nite life) limited liability partnership. Many of the European non-listed real estate funds are structured as limited partnerships with structures similar to English LP or Luxembourg Fonds Commun de Placement. The key topics to be considered in a fund structure are limited partners limited liability, funds tax transparency, regulatory constraints, and cost
140 120 100 $ billion 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008

Private equity real estate funds

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Figure 1. The total commitments raised by private real estate funds globally in 2000-2008

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efciency (Grabenwarter and Weidig, 2005). During the fundraising period of typically 12 months, investor signs a subscription document to commit a pre-specied amount of money in the fund. Investors become limited partners of the fund while the sponsoring organisation acts as the general partner of the fund responsible for actual investment decisions and management of the fund. The general partner typically has a management agreement with a management company acting as an advisor to the fund and the general partner. General partner is often owned by the sponsoring organisation and possibly its individual partners while most of the fund management team is employed by the management company. A private real estate fund has a set investment strategy typically dening the geographic and sector scope of the fund as well as the risk prole, leverage, and target return of the fund. Limited partners commitments will be invested typically in ten to 20 investments and drawn down over a period of three to four years from the fundraising. The typical holding period of underlying investments varies from two to ve years depending on the investment strategy. Limited partners receive their original capital back along possible capital gains when the investments are sold if the investments were successful. Ljungqvist and Richardson (2003a) have documented that it takes several for capital to be invested, and over ten years for capital to be returned. They interpret the excess returns gained by private equity funds to represent compensation for holding illiquid investments. It has been documented that buy-out and venture capital private equity fundraising is cyclical, the same is likely to be true in private equity real estate (Gompers and Lerner, 1998; Meyer and Mathonet, 2006). One way to measure the demand for private equity real estate is to compare the achieved nal fund size to the original target size. The demand can be driven by historical returns, which attract new investors to the asset class and increase the commitments of investors already active within the asset class. Figure 2 shows the measure of the nal fund size compared to the target in 2000-2008 based on the sample of this study. It clearly shows that the demand increased until 2006 after which the closed funds have again been closer to their original target size indicating a decline in investor appetite. 1.1 Purpose, relevance, and hypothesis The study will investigate the performance of private equity real estate funds. Using a large global sample of value-added and opportunistic private real estate funds, we study the fund and sponsor-related factors correlation with fund performance. These factors
140 Final fund size as % of target size 120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008

Figure 2. The total commitments raised of the original target size of funds closed in 2000-2008

include the size of the fund, the size and maturity of the fund manager, and the number of predecessor funds raised by the fund manager. We will also try to identify trends in fund performance and the growth of the fund sizes as well as the timing of the fundraising. While private equity real estate investing should be counter cyclical, the fundraising is typically positively correlated with the performance of the underlying investment market returns, i.e. more and larger funds have been raised during times when property prices have already increased while the level of fundraising has dropped after falls in capital values. The best performing vintages have thus been those raised during times of distress and limited competition. Evidence from private equity buy-out funds has also shown that better performing fund manager are likely to raise follow-on funds and often larger funds than poorly performing fund managers. There is also evidence that top performing funds do not grow proportionally as much as the average funds according to Kaplan and Schoar (2005). Since many institutional investors have special programs to invest with rst time managers or so-called emerging fund managers, we also seek further evidence on the persistence of performance of the real estate funds and how the growth in fund size may affect the realised returns. The contribution of this study relates to extending the recent studies on private equity to private equity real estate, an area that has experienced substantial growth during the past ten years. The common structure and organisation of traditional buy-out and venture capital funds and private equity real estate funds makes this comparison and extension of past studies interesting. There has been a wide range of studies with focus on private equity markets, fund performance, and structures but the availability of studies with a private real estate focus is still limited. The lack of available data and the still short history of private equity real estate have not made the situation any easier. The signicant growth of private equity real estate fund market and institutional allocations into the sector have increased the need of reliable studies on the performance and drivers of the fund success and size. The study grows knowledge on the linkage between fund returns and underlying property markets, the persistence of performance, and factors affecting fund returns and fundraising. Most relevant past studies to this paper are from private equity and it is likely that the same ndings should apply to real estate funds reported in buy-out or venture capital funds. Kaplan and Schoar (2005) have show that private equity fund returns are positively linked to both the fund size and sequence number of the fund. They have also reporting signicant persistence in realised returns. In addition to the study by Kaplan and Schoar (2005), which has provided the foundation for many of the ideas analysed in this paper, Lerner and Schoar (2004) have studied the private equity fund raising and have shown that transfer restrictions on LP interests are less common in later funds by the same fund manager when the continuity of the investors in successive funds gets less important. This is based on the assumption that the information asymmetry is more severe when a manager is raising its earlier funds. They have also shown that sophisticated investors are able to anticipate funds that have poor subsequent performance. Phalippou and Zollo (2005) have documented that private equity performance co-varies positively with both business cycles and stock-market cycles. Ljungqvist and Richardson (2003b) have studied the investment behaviour of private equity fund managers showing that managers accelerate their investment volumes and earn higher returns when investment opportunities improve

Private equity real estate funds

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and demand for capital increases. Similarly, an increase in supply leads to tougher competition for deal ow causing managers to cut their investment spending. They also report with investment level data the persistence in returns shown by Kaplan and Schoar (2005). Diller and Kaserer (2008) have analysed the determinants of returns generated by mature European private equity funds. Apart from the highly signicant impact of fund inows to private equity, they also show that private equity returns are driven by market sentiment. They do not nd a connection to stock market returns and report a negative correlation with the growth rate of the economy. Their ndings support the persistence in fund returns. An analogy from the mutual fund industry can be drawn from the ndings of Carhart et al. (2002) who nd that funds in their sample disappear from the market primarily because of continuously poor performance. They also report evidence of performance persistence and show the linkage to the survivor bias. Cochrane (2005) has shown that venture capital returns are very volatile and that later stage deals have less volatility. This may also be the case in real estate funds where the spread between the top and bottom quartile performance is lower in follow-on funds compared to the fund with the sequence number one. Hahn et al. (2005) have studied the persistence of returns in real estate opportunity funds using a relatively small sample of funds launched during 1991-2001. Their study used only past funds performance as an indicator of future performance while our model includes a number of fund-specic and macroeconomic factors. They did not study the fund size at all, while we are using current fund size and growth in fund size as explanatory variables for returns and evaluate the factors contributing to the fund size and growth. 1.2 Outline and main results The study begins by evaluating the effect of fund size and sequence to fund performance. We show that the fund size has a positive linkage to the realised returns while the sequence number is negatively correlated to internal rate of return (IRR) unlike previously reported with a sample of private equity funds but supporting the case for emerging managers. Second, we evaluate the persistence in fund returns to see if historical returns can be a guide for future success and conrm that past performance is an indicator of future success in private equity real estate while growth in fund size has a negative linkage to IRR. Third, we try to estimate the key quantiable factors affecting the fund performance and by studying both fund-related characteristics and market factors show that funds raised during periods of low gross domestic product (GDP) growth are likelier to perform better. We also show the positive and expected linkage between underlying direct real estate market performance during the fund life but also conrm a signicantly positive correlation between ination during the fund life and subsequently realised returns. Fourth, we study the factors behind the fund size and show that larger funds typically have larger sequence numbers providing support to the fact that only well-performing managers are able to continue in the business and raise multiple follow-on funds. The realised returns from the predecessor funds support the increase in the fund size and non-US focused funds are larger possibly because a wider range of target markets. Smaller funds are raised during periods of high GDP growth possibly linked to the fact that these periods attract new emerging market entrants to enter the fundraising market.

Finally, we evaluate the drivers behind the growth in fund size and show that the growth rate declines along the increase in sequence number. Stronger growth is supported by good track record (higher realised IRR of the predecessor fund) and booming property markets during the fundraising year. The next section provides details of the data used in this study and is followed by Section 3 with focus on performance. Section 4 studies the factors behind fund size and growth while Section 5 includes the conclusions. 2. Data The empirical analysis of this study is based on a sample of private equity real estate funds raised during 1980-2009[3]. The original sample covers all real estate funds with performance data listed on Preqins private equity real estate online database in March, 2009. This sample has been extended to 896 funds by including also the funds without performance data but with details on fund size and year raised (vintage) from the same fund manager and by adding funds and performance data from the authors collection of fund documents. The challenge in studying the performance of private equity funds is the lack of data as the investment vehicles are private by nature and fund-specic details, including the performance, are seldom publicly available. One public, but not perfect, source of performance information are the public disclosures of US public pension funds who have started to release the performance gures of their investments in response to Freedom of Information Act. The data collected includes the name of the fund, sequence number of the fund, fund vintage, fund size, target size, performance data, and geography (Table I). The fund manager-related details collected include the year of establishment to enable to estimate the experience of the manager. The measures of performance are the IRR, the total value to paid-in capital multiple (TVPI) and the distributed capital to paid-in capital multiple (DPI). These performance measures are calculated from the investor level returns net of management and performance fees. IRR has been adopted as the standard to measure private equity performance and is the key performance indicator in this study. The benets of IRR include that it takes into account the timing of the cash ows and values shorter investment periods over longer holding periods assuming equal exit values. While IRR has been so widely adopted, many professionals focus also on comparing money multiples because of the simple attractiveness of this measure. By most investors, a TVPI of 2.5 and an IRR of 26 percent with a four-year investment period is preferred over a 50 percent IRR but

Private equity real estate funds

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IRR (%) Mean Median Maximum Minimum SD No. of observations 14.61 14.10 80.00 2 71.97 17.17 339

Descriptive statistics TVPI Size (emio) 1.37 1.30 6.00 0.00 0.57 513 437 260 7,662 7 639 734

Sequence 2.5 2.0 11.0 1.0 1.9 896

Table I. Descriptive statistics of the key variables of the complete data set

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a 1.5 multiple achieved in one year. The sins of IRR and the technical problems with random positive and negative cash ows have been documented widely. If negative cash ows follow positive cash ows, the IRR may have multiple values. These problems are overcome by using the simple money multiple TVPI (Brown, 2006). Because of its importance, IRR has been used as the primary measure of performance in this study. Some of the models have also been estimated by replacing IRR with the equity multiple TVPI. Where performance data of the current fund is used, the sample has been limited to include only funds raised before year 2000 and those newer funds with a DPI . 80 percent. This is necessary as the performance reported by younger funds is heavily dependent on unrealised returns and the valuation policies used by private real estate funds vary a lot. To minimize the effect of the different valuation methodologies applied by the funds, limiting the sample to include only the more mature funds with a substantial part of their portfolios already exited should help to overcome this problem and make the reported performance gures more reliable. Where possible, we have also compared the performance numbers gathered from alternative sources to check the reliability of the performance data. Vintage, the year when the fund was launched, is a key when comparing funds returns and benchmarking private equity real estate funds. There is a visible correlation between better performance of a private real estate fund and the timing of the fund raising. The simple fact that buying cheaply increases the likelihood of decent returns is also true in private real estate. Thus, by looking at the annual IRRs achieved by the funds, vintages surrounded by low or negative direct property returns and GDP growth typically have achieved higher than average IRRs. The variance of the returns across funds is also more remarkable than, e.g. in mutual funds. A spread between the returns achieved by the top and bottom quartile European private real estate fund can be huge while the difference between the returns of the best or worst mutual fund investing European equities is typically far less signicant. This variation in returns highlights the importance that an investor should be able to pick the over performers and at least try to avoid the less successful funds. In order to evaluate the possible differences between small funds and large funds, two sub-samples have been used in some of the tests. A small fund is dened in this study as a fund with total capital commitments of maximum e300 million. Large funds are those with commitments exceeding this threshold. The cut off point has been chosen based on the mean and median size of the funds included in the total sample. As a consequence of the remarkable growth of the industry during the past few years, many investors consider funds targeting less than e500 million as small or mid-sized funds. The average fund sizes raised have grown signicantly over the last ten years. Figure 3 shows the average fund size of the funds included in our sample by year raised. The chart excludes the years prior 2000 because of a very low number of funds with details on fund size. The market data used in this study include both real estate market and macro economic indicators. The National Council of Real Estate Investment Fiduciaries (NCREIF) property index (NPI) annual returns have been used to estimate the effect of the underlying direct real estate market on the fund returns and fund raising. NPI is a longstanding and comprehensive unleveraged total return index on US properties collected by NCREIF. We also considered the use of regional investment property databank(IPD) indices but due to the short data series and lack of reliable regional data kept us using the NPI as a proxy for real estate market returns for all funds. Many of

900 800 700 600 million 500 400 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 2007 2008

Private equity real estate funds

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Figure 3. The average fund size per year raised of funds closed in 2000-2008

the funds in the sample are also international and using a more focused market indicator would not be practical and public real estate investment trust indices are highly correlated with the overall public equity market volatility. For the underlying economic conditions, the annual growth of the US GDP and US ination consumer price index (CPI) are used in the study to be in line with the real estate market data series. 3. Fund returns Investors are attracted to invest in private equity real estate funds partly because of the returns the funds have been able to provide. While historical returns should not be used as an indication of future returns, there is evidence that better performing private equity fund managers are also those with above average returns in the future. Ljungqvist and Richardson (2003a) have provided evidence that private equity generates excess returns above the public equity market. Kat and Menexe (2002) have analysed hedge fund performance and found that the persistence of performance is less evident but there is signicant persistence in the risk prole of hedge funds. Hahn et al. (2005) have shown that relative performance in real estate opportunity funds is persistent for consecutive funds both for good and bad funds. They also nd less persistence in returns net of management fees suggesting that successful fund managers are able to charge higher fees on subsequent funds. To enable capital to invest in new opportunities, the general partners need to raise new funds as soon as most of the capital from the existing fund is invested. This means that fund managers continuing in business will raise new funds every three to ve years. The lifecycle of a new fund manager begins with the rst fund which is a period to enter the market and establish the operations. For investors, evaluating these so-called rst time managers is always more demanding than picking an established manager. Since the rst fund is typically relatively small in size and the terms can be more stringent than in follow-on funds the managers typically continue in the business with a follow-on fund. The second funds are typically raised by managers, whose track record from the rst fund has been good enough and who have been able to establish a loyal limited partner base committing capital also to the follow-on fund. Sood (2003) has warned that it is the re-ups that have really hurt investors highlighting the need of reliable and strict due diligence while making investment decisions to continue to invest with an existing fund managers follow-on fund. As shown in Figure 4, the fund size may grow substantially along the later funds; the team may also experience

Fund Size in million

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500 400 IRR (%) 300 200 100 0

25 20 15 10 5

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Figure 4. The average and median (dark and light bar) fund size and achieved IRR of the funds in the sample by sequence number

0 I II III I II III Note: The chart on IRR includes only mature funds which have been raised before year 2000 and those with a DPI > 80 percent from the more recent vintages

turnover or the performance can start to lag the overall market. Limited partners may then decline or if the performance remains consistent, even if not top quartile, the manager may continue in business (Meyer and Mathonet, 2006). 3.1 Size and sequence Among the most, basic characteristics of a private equity real estate fund are the total investor commitments made to the fund (size) and the sequence number of the fund. The model estimated is analysing these two factors relationship with the actual IRR reached by a fund. The equation is as follows: Returnit b0 b1 Sizeit b2 Sequenceit 1it where Returnit is the realised IRR, Sizeit is the amount of total commitments, and Sequenceit is the sequence number of the fund. The sample includes only mature funds, i.e. those raised before year 2000 and younger funds with DPI . 80 percent. This criterion is set in order to guarantee a higher reliability of the IRR as it will be less dependent on the valuation of the remaining assets. Table II shows the relation between fund performance and fund size and sequence. For the whole sample, three different specications have been estimated. The rst column includes only the fund size, the second column only the sequence number, and the third column these both explanatory variables. The results across these three specications are equal both variables remaining signicant and with same sign. It has been shown that the returns of a private equity real estate fund have a positive correlation with the fund size; larger funds having better returns. IRR is negatively correlated with the sequence number supporting the fact that rst time funds and younger fund managers perform better than established fund managers with a number of follow-on funds. The result regarding the linkage to the sequence is different from that of Kaplan and Schoar (2005), who found that larger private equity funds and funds that have a higher sequence number have signicantly higher realised returns. We have also run the same models replacing the IRR with money multiple (second panel of Table II). The estimation results differ from those with IRR since only the negative relation to sequence remains signicant.

Estimated coefcient t-stat. 14.660 1.673 2 1.171 * * 2 2.296 0.021 5.27 * * 202 166 180 19.984 * * * 13.533 20.526 * * * 0.005 * * 2 1.343 * * 1.756 * * * 1.859 * * * t-stat. t-stat.

IRR Estimated coefcient t-stat. Estimated coefcient Estimated coefcient

Multiple Estimated coefcient t-stat.

Estimated coefcient 1.852 * * *

t-stat.

17.629 * * * 0.004 *

Intercept Size Sequence Adjusted R 2 F-statistic No. of observations

0.011 2.8 *

12.159 32.078 29.042 24.367 1.987 2 0.000 2 0.039 0.000 0.259 2 2.410 2 0.051 * * 2 2.279 2 0.047 * 2 1.813 0.039 2 0.006 0.019 0.007 4.34 * * 0.00 5.19 * * 1.64 216 180

166

Notes: Signicantly different from zero at the *10, * *5, and * * *1 percent levels, respectively; sample includes all fund vintages until 1999 and newer

funds with a DPI over 80 percent

Private equity real estate funds

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Table II. Fund performances connection to fund characteristics

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In order to evaluate the possible difference between large and small funds, we have split the entire sample to two sub-samples based on the total commitments of the funds. Small funds are those with maximum e300 million of capital commitments and large funds are all funds with more than e300 million of commitments. The results between these two samples differ from each other. As shown in Table III, the realised IRR of small funds is signicantly negatively correlated with both the fund size and sequence. This supports the belief that emerging fund managers are likely to reach above average performance and that along the growth in fund size and the increasing sequence number the realised IRRs start to decline as shown in Figure 4 in the previous section. The right part of the panel shows that larger funds have higher returns in the regression and the effect of the increasing sequence number is not anymore signicant although the sign remains negative. This can be interpreted as a sign of maturity where truly established managers are both able to raise and invest large funds without compromising on returns. The growth of large funds is likely to be less remarkable and thus more manageable than the growth of small funds, which is more likely to cause troubles reected in poor future realised performance. 3.2 Persistence of returns Since there is a linkage between fund size and sequence number to realised returns, we now continue studying if historical returns achieved by the predecessor fund can predict the future success, i.e. if private equity real estate fund performance persists. The model used in the study is again using the realised IRR as a measure of fund performance (Returnit), IRR-1it2 1 is the realised IRR of the predecessor fund, Sequenceit is the sequence number of the fund, Sizeit is the amount of total commitments to the fund, and Growthit is a measure calculated by dividing the current fund size by the predecessor funds size: Returnit b0 b1 IRR 2 1it21 b2 Sequenceit b3 Sizeit b4 Growthit 1it Table IV provides the estimation results of the different model specications used. In all versions through columns from one to four, the IRR of the predecessor fund is positively and highly signicantly correlated with the realised IRR of the current fund similar to the previous evidence from private equity and as shown by Hahn et al. (2005) with a sample of opportunistic real estate funds. Fund size is also found to be signicantly and positively correlated with the realised IRR similar to the ndings of Kaplan and Schoar (2005) with a sample of private equity funds when the performance of the past fund is included but the sequence number of the fund is not anymore signicant and its sign turns positive. Interestingly, but not surprisingly the growth in fund size is signicantly and negatively correlated with fund returns supporting the assumption that too signicant and rapid growth in fund size is not benecial to fund returns and that better performing fund managers do not raise remarkably larger follow-on funds. To compare the possible differences between the results from smaller and larger funds, we have used the two sub-samples (Table V). The size of the sample is declining to less than 40 funds per sub-sample. For the large funds, the estimation results remain the same as for the entire sample. For the small funds, the predecessor funds returns remain signicantly and positively correlated with the IRR of the current fund while the model with all the variables does not have statistical signicance.

Estimated coefcient t-stat. 22.201 * * * 5.779 2.378 2 1.787 * * 0.041 5.44 * * 0.091 6.17 * * * 104 62 0.071 5.66 * * 104 11.130 26.094 * * * 10.595 2 0.034 * * 2 2.571 2 2.333 2 1.614 * * 2 2.155 14.782 * * * 0.007 * * 21.771 * * * t-stat. t-stat.

IRR small funds Estimated coefcient t-stat. Estimated coefcient Estimated coefcient

IRR large funds Estimated coefcient t-stat. 8.062

Estimated coefcient 16.785 * * * 0.007 * *

t-stat. 5.031 2.385 2 0.936

22.986 * * * 11.314 2 0.036 * * * 2 2.728

Intercept Size Sequence Adjusted R 2 F-statistic No. of observations

0.059 7.44 * * *

2 0.736 2 0.879 2 0.756 2 0.004 0.069 0.77 3.26 * * 62 62

104

Notes: Signicantly different from zero at the *10, * *5, and * * *1 percent levels, respectively; sample includes all fund vintages until 1999 and newer

funds with a DPI over 80 percent; large funds are all funds with total commitments . e300 million

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Table III. Fund performances connection to fund characteristics between small and large funds

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IRR Estimated Estimated Estimated Estimated coefcient t-stat. coefcient t-stat. coefcient t-stat. coefcient Intercept 6.848 * * * 3.099 IRR-1 0.673 * * * 4.819 Sequence Size Growth Adjusted R 2 0.213 F-statistic 23.22 * * * No. of observations 83 5.165 0.699 * * * 0.388 1.379 5.394 4.737 0.523 * * * 0.558 0.317 0.007 * * * 1.401 3.285 0.448 3.019

t-stat.

108
Table IV. Persistence of fund performance together with other fund characteristics

0.206 11.67 * * * 83

0.262 9.39 * * * 72

9.518 * * 2.242 0.604 * * * 3.577 0.128 0.176 0.007 * * * 3.159 2 3.246 * * 2 2.182 0.28 7.63 * * * 69

Notes: Signicantly different from zero at the *10, * *5, and * * *1 percent levels, respectively; sample includes all fund vintages until 1999 and newer funds with a DPI over 80 percent

IRR small funds Estimated Estimated coefcient t-stat. coefcient

t-stat.

IRR large funds Estimated Estimated coefcient t-stat. coefcient

t-stat.

Table V. Persistence of fund performance together with other fund characteristics between small and large funds

Intercept 10.380 * * * 4.454 12.137 * * 2.471 6.081 1.375 9.828 1.186 IRR-1 0.362 * * 2.421 0.305 1.419 0.820 * * * 3.164 0.631 * * 2.293 Sequence 0.159 0.191 2 0.025 2 0.021 Size 2 0.003 2 0.207 0.009 * * 2.484 Growth 2 0.550 2 0.329 2 5.007 * 2 1.888 Adjusted R 2 0.122 2 0.041 0.205 0.330 F-statistic 5.86 * * 0.67 10.01 * * * 5.18 * * * No. of observations 36 34 36 35 Notes: Signicantly different from zero at the *10, * *5, and * * *1 percent levels, respectively; sample includes all fund vintages until 1999 and newer funds with a DPI over 80 percent; large funds are all funds with total commitments . e300 million

3.3 Return factors The two previous sections have shed light on how the fund-specic characteristics and the track record are connected to the realised returns of a private equity real estate fund. In order to cover some other quantiable fund-specic characteristics, we now add Experienceit and Focusit to the model specication. Fund manager experience is measured as the age of the management company at the time when the fund is raised (fund vintage). Since many of the funds in the sample are managed by US fund managers and have a pure US focus, a dummy variable has been used to separate funds investing only in the US markets from those investing outside the USA or in multiple regions many of them being global in focus. The dummy for fund focus has the value of one for funds with a pure US focus and value of zero for international funds. In order to evaluate the effect of the economic conditions and the underlying market returns, US GDP growth and change in CPI are added. The real estate market performance is measured by NCREIFs NPI index. From all the market factors, both the value of the current year (fund vintage) and the average value of the four future years

starting from the rst year after the fund launch have been used. The model specication is as follows: Returnit b0 b1 Sizeit b2 IRR 2 1it21 b3 Sequenceit b4 Growthit b5 NCREIFit b6 NCREIF Futureit124 b7 GDPit b8 GDP Futureit124 b9 CPIit b10 CPI Futureit124 b11 Experienceit b12 Focusit 1it Table VI provides details of the estimation results with different model specications in the columns from one to four. The second and third panel of the table include again the results from the two sub-samples of small and large funds. Across the entire sample, the size remains positively correlated with the realised returns while the sequence has a negative sign in the columns three and four where we use a smaller number of explanatory variables. The performance of the predecessor fund is positively correlated with the IRR and the growth in fund size has a signicantly negative relation to the performance as indicated earlier. The experience of the fund manager measured by the age of the sponsoring organisation never becomes signicant. Among the small funds, those with a US focus have had better performance. This could be explained by the fact that smaller funds investing in multiple countries are likely to have fewer resources and thus the risk of underperformance is higher. Also, the ination of the launching year is positively and signicantly correlated with realised IRR. The third column includes a model with focus on economic conditions around the fund launch indicating that funds launched during periods of strong economic growth measured with the GDP growth perform worse possibly indicating the booming periods when asset prices are already inated and the funds acquire more expensive assets. The fourth column includes a model specication focusing on evaluating the effect of the market conditions during the fund life. Since the GDP growth and property returns are quite highly correlated, we have only included the NPI index and CPI to this specication and excluded the GDP growth. This model specication is still consistent with the nding that fund returns are declining along the sequence number supporting that emerging fund managers may earn higher returns. It also shows the signicantly positive connection between the underlying market performance and ination and the realised returns. These ndings are not surprising since increasing property prices overall should support the fund performance. The linkage between ination and realised returns is also in line with one of the rationales to diversify in real estate, the inbuilt hedge against ination through the rent reviews increasing the cash ows earned from the properties. 4. Fund size According to Shiller (2005), the same forces of human psychology that drive equity prices have the potential to affect other markets. The historical evidence shows that real estate markets follow a path of boom and bust caused, e.g. by speculative development. These booms in real estate are typically caused by a conuence of multiple factors, none of which is by itself large enough to explain these events. What is different in the current crises compared to the previous severe corrections in property markets is that this is a capital markets-driven correction. In many countries, the overbuilding has not been the

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Intercept Size Sequence IRR-1 Growth NCREIF NCREIF future GDP GDP future CPI CPI future Experience Regional focus Adjusted R 2 F-statistic No. of observations 0.515 1.050 * * 2 3.078 * 2.063 2 1.894 2 4.446 * * * 2 4.009 1.257 6.476 * * * 1.743 4.725 1.320 * * * 0.851 0.432 1.221 1.300 * * * 2.946 5.788 * 0.091 2 2.916 2 1.305 0.465 * * * 6.99 70 166 166 2 2.501 2 1.269 0.154 * * * 6.02 2 0.765 2 0.399 0.192 * * * 8.85 1.609 1.837 0.856 2.836 * 2 5.277 * * * 2 9.254 * * 2.246 2.788 2 16.432 2 0.010 7.356 * * 0.445 3.14 * * 33 1.915 2 3.390 2 2.781 1.052 2 1.440 2 0.083 2.302 5.568 * * 2 1.803 104

Notes: Signicantly different from zero at the *10, *5, and * * *1 percent levels, respectively; sample includes all fund vintages until 1999 and newer funds with a DPI over 80 percent; large funds are all funds with total commitments . e300 million

Table VI. Fund-specic and market factors effect on realised performance

IRR Estimated coefcient t-stat. 2 1.221 1.735 0.565 2.172 28.041 * * * 0.002 2 1.033 * 6.110 2 10.293 2 1.503 0.883 0.004 * 1.740 2 1.935 2 1.340 * * * 2 2.616 1.976 2 0.699 2 1.793 0.847 2 0.422 1.633 2 1.406 2 0.040 * * * 2 1.355 * 51.098 * 2 0.008 2 1.411 * 0.171 2 0.608 0.999 t-stat. t-stat. t-stat. 2 0.166 2 3.190 2 1.943 2 18.811 0.004 * 0.363 0.341 * * Estimated coefcient Estimated coefcient Estimated coefcient IRR small funds Estimated t-stat. coefcient Estimated coefcient 2 57.985 0.006 * 2 0.290 0.324 2 3.303 0.544 3.953 t-stat. IRR large funds Estimated coefcient 2 1.658 2 16.665 1.739 0.006 * 2 0.316 2 1.078 1.557 2 1.437 0.566 1.471 * * * t-stat. 2 1.484 1.977 2 1.462 2.924 2.004 0.432 2 2.534 2 3.251 6.396 * * 26.489 * 2 0.055 2 0.692 0.234 * * * 7.28 0.197 2 0.953 2 0.645 2.138 1.779 2 0.383 2 3.485 1.047 0.701 * * * 7.44 34 7.734 * 1.961 2 1.450 2 0.510 0.236 * * * 4.76 62

Estimated coefcient

t-stat.

2 20.684 0.005 * * 2 0.334 0.325 * * 2 2.529 * 0.077

2 0.904 2.252 2 0.517 2.168 2 1.893 0.128

0.622 2 2.173 2 3.365 3.814 * 14.646 2 0.066

0.428 2 1.410 2 1.056 1.889 1.410 2 0.639

0.002 0.001 0.567 * * * 8.19

67

key driver to the severity of the ongoing adjustment but the debt-driven demand for real estate as an asset class has been a far more important factor this time. Gompers and Lerner (1998) have documented that shifts in demand for venture capital appear to have a positive and important impact on commitments to new venture capital funds. They have also shown that fund performance and reputation of the fund manager lead to greater fundraising. It has been shown that performance relative to peers in the same asset class is an important factor affecting the mutual fund ows (Sirri and Tufano, 1998). 4.1 Size In order to evaluate the factors linked to fund size, we apply again four fund-specic characteristic and three economic indicators. The sequence number of the fund would naturally be positively linked to fund size as follow-on funds of successful fund managers are likely to grow in size. If track record is followed by investors while choosing the funds in which to invest, good performance of the predecessor fund should be positively linked to fund size. It would also be natural that more experience managers raise larger funds and that international funds would be larger than domestic (US-focused funds). To evaluate the market conditions present in the year when the fund is raised, we again use the GDP growth, direct real estate return and ination: Sizeit b0 b1 Sequenceit b2 IRR 2 1it21 b3 GDPit b4 NCREIFit b5 CPIit b6 Focusit b7 Experienceit 1it Table VII shows the results of the ve different model specications used. As expected, the sequence number of the fund is signicantly and positively linked to fund size. In three models of the four where included the realised performance of the predecessor fund is signicant and positively linked to fund size indicating that investors prefer funds raised by managers with good track record. Non-US funds, often investing in multiple countries, are also likelier to be larger than US only funds. The age of the fund management company is not signicantly linked to fund size and surprisingly has a negative sign. Property returns or the ination in the year of the fundraising are not signicantly linked to the fund size but surprisingly the sign of the GDP growth is negative indicating that larger funds are actually raised when the economic growth is lower indicating a more counter-cyclical fundraising success than witnessed by the number of funds raised or total volume of commitments raised per year. This is, however, logic because during times of economic distress the more established and often larger fund managers might be successful. Also, during the periods of high economic growth and periods often characterised as booms, smaller emerging managers enter the market and thus the linkage between the GDP growth and the fund size can actually be negative. While many mega funds have also been raised during these booming years, even more small funds are raised during the booms. 4.2 Growth factors Finally, we conclude the study by looking at the factors behind the growth rate of the fund size. One could again expect to see a linkage between good track record and growth in fund size. It would also be natural to see smaller funds to grow faster and thus the actual size have a negative connection to the growth rate. Along the same analogy, one could expect to see a negative linkage between the sequence number of

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Intercept Sequence IRR-1 GDP NCREIF CPI Regional focus Experience Adjusted R 2 F-statistic No. of observations 1.984 3.495 2.032 3.487 3.496 2.281 2.986 3.336 1.614 2 2.357 1.623 2 0.057 2 5.908 2 0.849 6.506 0.648 11.769 0.196 2 564.457 * * * 2 5.917 2 2.248 2 0.525 0.192 8.86 * * * 2 580.360 * * * 0.191 17.67 * * * 213 199 2 6.361 199

Notes: Signicantly different from zero at the *10, * *5, and * * *1 percent levels, respectively; sample includes all funds

Table VII. Fund size is linked to both fund-specic factors and current market environment at the time of the fundraising t-stat. 348.314 * * 89.594 * * * 7.626 * * 456.416 * * * 86.721 * * * 7.761 * * Estimated coefcient t-stat. Fund size Estimated coefcient t-stat Estimated coefcient 167.521 59.580 * * 9.651 * * * t-stat. 1.252 2.237 2.612 Estimated coefcient 181.802 * * * 101.690 * * * t-stat. 4.833 8.474 0.039 5.28 * * * 213 0.088 71.80 * * * 734

Estimated coefcient

627.019 * * * 84.803 * * *

6.080 2 113.907 * * 17.923 2 3.412 2 557.288 * * * 2 3.625 0.211 8.57 * * *

the fund and the growth while booming market conditions should be linked with a faster growth in fund size. To evaluate the connection of these factors to the growth rate, the following model specication has been used: Size Growthit b0 b1 Sequenceit b2 IRR 2 1it21 b3 Sizeit b4 GDPit b5 NCREIFit b6 CPIit b7 Focusit b8 Experienceit 1it The dependent variable of this model, Size Growthit, is the size of the current fund divided by the size of the previous fund. The results summarised in Table VIII proof the assumption of negative linkage between the sequence number and growth in fund size but the size factor itself remains insignicant in all model specications. In all model specications, the realised IRR of the predecessor fund has a positive sign but only in models presented in the second and fourth column this relationship is statistically signicant. As expected, booming market conditions indicated by the positive relation between the direct property returns in the fund raising year and the growth rate have a statistically signicant and positive linkage while ination and GDP growth remain statistically insignicant. The main model in column one does not support any signicant connection between the regional focus or manager experience and growth of fund size. 5. Conclusions This study investigates the performance, size and growth of private equity real estate funds using a dataset of individual funds collected mainly by Preqin. The sample consists of 896 funds raised during 1980-2009. Although there is always a risk that a sample is suffering from a positive selection bias because fund managers are likelier to report the performance of their better performing funds to data collectors, Preqin
Growth in fund size Estimated t-stat. coefcient

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Estimated coefcient

t-stat.

Estimated coefcient

t-stat.

Estimated coefcient

t-stat.

2.968 1.565 * * * 4.434 1.277 * * * 3.147 1.841 * * * 5.673 Intercept 1.776 * * * 2 1.711 Sequence 2 0.175 * * 2 2.434 2 0.146 * * 2 2.158 2 0.158 * * 2 2.323 2 0.110 * 2.273 0.016 1.589 0.021 * * 2.349 IRR-1 0.013 1.283 0.020 * * Size 0.000 1.057 0.000 1.318 0.000 1.191 GDP 2 0.18 2 1.319 2.016 0.035 * 1.753 NCREIF 0.066 * * CPI 2 0.117 2 0.684 Regional 1.805 0.441 1.648 focus 0.447 1.575 0.478 * Experience 0.004 0.352 0.047 0.043 0.052 0.045 Adjusted R 2 3.27 * * 3.20 * * * 4.75 * * * F-statistic 2.16 * * No. of observations 191 205 202 206

Notes: Signicantly different from zero at the *10, * *5, and * * *1 percent levels, respectively; sample includes all funds

Table VIII. Growth in fund size is linked to both fund-specic factors and current market environment at the time of the fundraising

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collects a large amount of data directly from investors and the sample of this study is further supplemented by additional data collected by the authors. Since track record has a signicant role in investors due diligence process and fund selection, only fund managers with decent track record are able to continue in business and those with poor results will disappear and are less likely to raise a follow-on fund. Taking these limitations in the dataset into account, we still believe that the sample is comprehensive enough to provide reliable results. We rst study the realised returns and the relation of the fund size and sequence number to the IRR. We nd evidence that performance increases with fund size but declines with the sequence number. Previous studies with buy-out and venture capital funds have found a positive correlation between the partnerships experience measured by the sequence number while our results suggests that emerging managers and their earlier funds are likelier to achieve higher returns than their later funds. We then focus on the persistence of performance by studying the realised returns of consecutive funds. We nd strong evidence that returns achieved are an indicator of the follow-on funds performance supporting the persistence of returns. This result can be affected by the positive selection bias where only average and better performing fund managers are able to raise follow-on funds while those with poor results disappear from the market. Despite of this fact, the results provide strong support on the performance persistence. The relation between the fund size and performance remains signicant also while including the realised returns of the predecessor fund while the sequence number becomes now insignicant. Growth in fund size is negatively linked to performance providing evidence that better performing managers are more conservative in the size of the follow-on fund and investors should be cautious when the fund size is growing substantially from the previous, well-performed fund. The nal model using realised returns as a dependent variable studies a larger set of both fund-specic and market variables in order to identify the sources of fund performance. In addition to the fund-specic factors still remaining stable, it is shown that funds raised during periods of slow economic activity are likely to have better performance, i.e. the lower the GDP growth during the time of the fund launch the higher the realised IRR. Similarly, the realised IRR is higher if the underlying property markets are performing well during the fund life. There is also a signicantly positive relation between ination and realised returns supporting one of the rationales to include real estate in a multi-asset portfolio, namely the hedge on ination. We then continue to analyse the factors behind the fund size and growth in fund size. The rst model using fund size as a dependent variable shows the unexpectedly positive linkage between the sequence number and the fund size conrming the trend that follow-on funds are typically larger than earlier funds. The importance of the track record is conrmed by the signicantly positive relation between the realised IRR of the predecessor fund and the size of the follow-on fund. Non-US funds are also larger as the dummy variable separates between US only and international funds. Most of the non-US funds are multiregional. The negative sign on GDP growth in the fundraising year could be a consequence of the fact that during booming economic conditions more new managers enter the market and the median fund size declines while also some of the more established managers are still likely to raise larger funds. The second fund-size related model is using the growth in fund size (compared to the predecessor fund) as a dependent variable. Not surprisingly, the higher the

sequence number the slower is the growth rate. It is natural that the growth declines along the larger absolute fund size. A successful fund manager is neither able to scale up investments that much and thus the growth rate is likely to decline along the sequence number. Better performing managers are likely to raise more follow-on funds and higher sequence numbers are typically linked to established and well performing fund managers. Past performance measured with the realised IRR of the predecessor fund is linked to the higher growth rate. Positive property returns during the fundraising year are also linked to increase in the growth rate in fund size. This is supporting the theory that past performance and strong market performance increase the demand for real estate asset class and the private equity real estate funds grow faster during these demand-driven periods. While these results provide a lot of evidence on the persistence in private equity real estate fund returns and give an insight to the factors behind the fund returns, more detailed research would be needed in order to differentiate the true alpha generated by private equity real estate funds and to show that the good returns are not just compensation for the illiquid nature of the investments or market returns ballooned via the use of leverage. In order to use more reliable indicators on the investment environment, one should consider using more focused regional or global GDP and ination data and consider replacing the NPI index with regional IPD indices where available.
Notes 1. INREV is the European Association for Investors in Non-listed Real Estate Vehicles. 2. Preqin Ltd was founded in 2002 to collect and provide data on private equity and private real estate funds. 3. Ca. 94 percent of the funds in the database have been raised since 1995. References Ball, M., Lizieri, C. and MacGregor, B.D. (1998), The Economics of Commercial Property Markets, Routledge, London. Baum, A. (2002), Commercial Real Estate Investment, Estates Gazette, London. Brown, R.J. (2006), Sins of the IRR, Journal of Real Estate Portfolio Management, Vol. 12 No. 2, pp. 195-9. Carhart, M.M., Carpenter, J.N., Lynch, A.W. and Musto, D.K. (2002), Mutual fund survivorship, The Review of Financial Studies, Vol. 15 No. 5, pp. 1439-63. Cochrane, J.H. (2005), The risk and return of venture capital, Journal of Financial Economics, Vol. 75 No. 1, pp. 3-52. Darst, D. (2003), The Art of Asset Allocation, McGraw-Hill, New York, NY. Diller, C. and Kaserer, C. (2008), What drives private equity returns? Fund inows, skilled GPs, and/or risk?, European Financial Management, Vol. 15 No. 3, pp. 643-75. Fisher, J.D. and Sirmans, C.F. (1994), The role of commercial real estate in a multi-asset portfolio, Journal of Property Management, Vol. 59 No. 1, pp. 54-9. Gompers, P.A. and Lerner, J. (1998), What drives venture capital fundraising?, Brookings Papers on Economic Activity: Microeconomics, July, pp. 149-92. Grabenwarter, U. and Weidig, T. (2005), Exposed to the J-Curve, Understanding and Managing Private Equity Fund Investments, Euromoney Books, London.

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Hahn, T.C., Geltner, D. and Gerardo-Lietz, N. (2005), Real estate opportunity funds: past fund performance as an indicator of subsequent fund performance, Journal of Portfolio Management, Vol. 32, pp. 143-53. INREV (2009), Capital Raising Survey Equity Capital Flows to the European Non-listed Real Estate Funds Market, INREV, Amsterdam. Kaplan, S. and Schoar, A. (2005), Private equity performance: returns, persistence, and capital ows, Journal of Finance, Vol. 60 No. 4, pp. 1791-823. Kat, H.M. and Menexe, F. (2002), Persistence in hedge fund performance: the true value of a track record, Working Paper, Cass Business School, Alternative Investment Research Centre, City University, London. Lee, S. and Stevenson, S. (2006), Real estate in the mixed-asset portfolio: the question of consistency, Journal of Property Investment & Finance, Vol. 24 No. 2, pp. 123-35. Lerner, J. and Schoar, A. (2004), The illiquidity puzzle: theory and evidence from private equity, Journal of Financial Economics, Vol. 71 No. 1, pp. 3-40. Ljungqvist, A. and Richardson, M. (2003a), The cash ow, return and risk characteristics of private equity, working paper, Stern School of Business, New York University, New York, NY, January 9. Ljungqvist, A. and Richardson, M. (2003b), The investment behavior of private equity fund managers, working paper, Stern School of Business, New York University, New York, NY, October 30. Meyer, T. and Mathonet, P.-Y. (2006), Beyond the J-Curve Managing a Portfolio of Venture Capital and Private Equity Funds, Wiley, Chichester. Phalippou, L. and Zollo, M. (2005), What drives private equity fund performance?, INSEAD working paper. RREEF (2009), Global Real Estate Investment and Performance 2008 and 2009, RREEF, London. Shiller, R.J. (2005), Irrational Exuberance, Princeton University Press, Princeton, NJ. Sirri, E. and Tufano, P. (1998), Costly search and mutual fund ows, Journal of Finance, Vol. 53 No. 5, pp. 1589-622. Sood, V. (2003), Investment strategies in private equity, Journal of Private Equity, Vol. 6 No. 3, pp. 45-7. Stevenson, S. (2004), Testing the statistical signicance of real estate in an international mixed asset portfolio, Journal of Property Investment & Finance, Vol. 22 No. 1, pp. 11-24. Corresponding author Ilkka Tomperi can be contacted at: ilkka.tomperi@iki.

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