Investment Funds Navigate Volatile Economics and a Power Flux

During a few years when returns seemed easy and gains and capital inflows hit record levels, general partners of private equity funds could do no wrong. Since inflation, double-digit reductions in asset values across most classes, and a series of banking failures, those days are pretty much over, says a report and survey results from legal firm Barnes & Thornburg.

Specifically in real estate investment, the firm says that caution has become common. “The real estate sector – originally thought to be a solid hedge against inflation – has been grappling with high interest rates, mixed demand, and low occupancy levels in certain assets, like office buildings,” the firm wrote.

Not that investors have given up on CRE, but in every aspect asked about — investor return expectations, rising interest rates, work from home/work from office trends, population redistribution, commercial mortgage rates, cap rates, and selective retail preferences — a majority of PE investors who have real estate as a focus area described each area as either a challenge or a combination of challenge and opportunity.

“As for the broader outlook on real estate PE funds, 27% of respondents said they are investing in other assets, such as equities and bonds,” said the report. “Others are waiting for interest rates to wane (18%), assessing how the recent work-from-home shift might impact investments (18%), or repricing transactions with sponsors (18%). Only 9% said they have liquidity concerns.”

Many expect to take advantage of “distress in the marketplace,” which “might help explain why real estate PE investors expected there to be similar levels of real estate PE fund volume in 2023, but less overall value.”

Also important to CRE investors is shifting dynamics between limited and general partners in PE funds. As GPs have to attract capital, LPs see greater negotiating power in areas like succession, planning, fees and expenses, transparency, and ESG investing.

“Broadly speaking, GPs are more optimistic than LPs when it comes to the near-term fund outlook and the two groups show disparities around topics like GP discipline and LP support,” the firm writes.

“GPs, especially less experienced ones, will have to find innovative ways to attract LP dollars and address concerns about ESG and succession planning,” the report quoted Kerry Potter McCormick, partner in Barnes & Thornburg’s Private Funds and Asset Management Group, as saying. “At the same time, stakeholders on all sides of the deal table will need to make sure they’re getting the right risk-reward balance while making preparations to adapt to inevitable shifts in the markets.”