Lone Star Eyes $10 Billion for Distress Plays

Lone Star Funds is gearing up to solicit $10 billion of equity for what would be the second-largest real estate fund ever.

Lone Star Real Estate Fund 2 would invest in distressed commercial real estate, both debt and equity. The percentage breakdown between the two categories is unclear. But most new funds are emphasizing debt investments, which are viewed as offering higher potential returns.

The Dallas fund operator is simultaneously getting ready to raise another $10 billion for a separate fund, Lone Star Fund 7, that would invest in distressed residential MBS, corporate bonds and corporate loans.

The equity goals for the vehicles seem ambitious, given that the financial crisis has squeezed the availability of capital. But Lone Star has had a strong track record of rolling out funds in recent years, rivaling the powerhouse fund operations of Blackstone Group and Morgan Stanley. Just last August, it completed raising $10 billion of total equity for the predecessor vehicles in the two fund series after just a 10-month marketing campaign.

With its new commercial real estate fund, Lone Star seems to be positioning itself to become a major buyer of toxic commercial real estate debt from banks and other holders. Sales of such assets are expected to pick up in coming months as the U.S. Treasury Department and Federal Reserve expand their financial-rescue efforts. A $200 billion Fed program that finances buyers of high-grade consumer receivables is being increased to as much as $1 trillion and broadened to include commercial real estate mortgages and commercial MBS. Also, the government plans to team up with private-sector players to buy up to $1 trillion of toxic assets from banks.

Lone Star has already established itself as a major buyer of distressed debt. The $7.5 billion Lone Star Fund 6 made a big splash last July by acquiring $30.6 billion of troubled assets - mostly related to residential mortgages - from Merrill Lynch at a 78% discount. Around the same time, that fund also acquired a $9.3 billion portfolio of home mortgages and related servicing operations from CIT Group of New York for $1.5 billion of cash and $4.4 billion of assumed debt.

The commercial real estate fund will have a global focus, seeking investments in the U.S., Europe and Asia. But it will likely put a heavy emphasis on the U.S., where there is a rising tide of distressed opportunities. Investors expect the fund to buy a wide range of distressed assets, including CMBS, other real estate securities, whole loans, B-notes, mezzanine loans and foreclosed properties.

Lone Star's funds shoot for a 20%-plus return. The new commercial real estate fund can co-invest with Lone Star Fund 7.

Lone Star declined to comment about its fund plans, but investors were buzzing this week about the aggressive fund-raising goals. "They've got a great record," said one veteran placement agent. "If anybody's able to do it, it's them."

Lone Star's first five funds focused on distressed commercial real estate, while also investing in other types of assets. In 2007, the sponsor split the fund series into separate property and debt funds. The first property vehicle, Lone Star Real Estate Fund 1, raised $2.5 billion, well above its $1.5 billion equity goal. The first debt-focused vehicle, Lone Star Fund 6, lined up $7.5 billion, far exceeding its original $5 billion goal. Both funds have now invested more than 80% of their capital, setting the stage for the follow-up vehicles.

If it meets the equity goal for Lone Star Real Estate Fund 2, Lone Star would stand to tie with Morgan Stanley for bragging rights to operating the second-largest commercial real estate fund ever. The largest is a $10.9 billion vehicle that Blackstone closed in 2007. That fund, Blackstone Real Estate Partners 6, targets opportunistic buyout and restructuring plays. Morgan Stanley is currently raising up to $10 billion for its seventh global fund.

Some investors plowed equity into both of Lone Star's predecessor funds, but co-commitments weren't required. Lone Star traditionally kicks in 1% of its vehicles' total equity.

Lone Star was founded in 1995 by veteran money manager John Grayken, who continues as chairman. Louis Paletta, director of investor relations, assists with fund raising. The firm's funds have raised more than $23 billion in total to date.

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