After Years of Growth, Debt Funds Pull Back

The debt-fund bandwagon has hit a speed bump.

The number of active and planned high-yield debt funds has slipped to 68 from 73 a year ago, according to an annual review of high-yield real estate funds by sister publication Real Estate Alert. That reverses a five-year string of increases (see list on Pages 9-11).

More notably, the funds have significantly lowered their aggregate equity goals, in a bow to the difficulty of attracting capital from loss-ridden investors. The total amount of equity being sought now is $33.6 billion, down 31% from $48.4 billion a year ago.

The review tracks both funds seeking to raise equity and fully operational vehicles that have invested less than 75% of their total equity. The debt funds identified in this year's review have already closed on $14.3 billion of commitments, or 43% of the aggregate goal. Overall, the review identified 414 property and debt funds seeking annual returns of at least 10%, after fees. Debt funds accounted for 14% of the total equity being solicited, down from a 16% share a year ago.

The number of debt funds had risen steadily from 24 in 2005 to the peak of 73 last year. While the number slipped to 68 this year, it is still the second-highest annual total.

Most debt funds have the capability of either buying distressed debt or originating mortgages. A handful focus exclusively on originations. Among the funds that can do both, most have concentrated on debt acquisitions thus far.

Debt funds are now facing competition for capital from opportunistic property funds, which often can buy distressed debt as a way to gain control of the underlying real estate.

The sharp drop in aggregate equity goals stems largely from two factors. First, several high-profile operators slashed their original targets. Also, nearly a dozen operators shelved or canceled vehicles in the wake of a sharp pullback in commitments from institutional investors battered by investment losses across all asset classes.

Lone Star Funds alone accounted for $6 billion of the reduction in aggregate equity goals. The veteran operator launched a distressed-debt fund with an ambitious $10 billion goal, but within months cut it to $4 billion after struggling to lure pledges. In order to move more quickly, LoanCore Capital swapped a proposed $4 billion origination vehicle for a planned series of $500 million funds. The first of those funds is already half-raised.

Another $3 billion of targeted equity was eliminated when 11 operators canceled planned funds. Among them was Angelo, Gordon & Co., which halted efforts to raise $300 million for its second debt fund after lining up two large separate accounts. AREA Property shelved a €500 million ($680 million) fund to invest in European debt. Lane Capital canceled a $500 million fund and will instead pursue joint ventures and one-off deals. And Sorin Capital dropped a $250 million vehicle.

A few operators are seeking capital for origination funds that fall below the high-yield threshold. Babson Capital Management is soliciting about $1 billion for a fund that would write plain-vanilla mortgages. The vehicle is targeting a 7-8% return. And fund operator PCCP is trying to raise $500 million for PCCP First Mortgage Fund 2, which would shoot for an 8-10% return.

The annual review tracks funds that have raised or are seeking to raise at least $50 million of equity. Included are funds that have invested less than 75% of their equity, as well as vehicles that are currently raising equity or plan to start doing so by the end of this month. Vehicles that invest overseas are included if they raise capital at least partly from U.S. investors.

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