How Real Are Brookfield's Private Fund Returns?

Financial disclosures for BAM-managed funds supplied by BPY show financial distress; yet, the projected returns for the funds are robust. What accounts for this apparent contradiction?

Most of the time Brookfield financial disclosures convey less meaning that one thinks they should.  I’m thinking here of the massive non-controlling interests on Brookfield company financial statements that make the public shareholders of the given entities minority owners.  It makes me wonder if the IFRS statements are at all relevant to public holders.  However, there are those rare times when financial disclosures convey information that extends beyond its most obvious use.  This is the case with Brookfield Property Partner’s (BPY) disclosures on the LP Investment segment. 

Financial disclosure for the LP Investment segment represents BPY’s proportionate financial position and performance stemming from ownership in a cross-section of BAM-managed private equity funds.

I think it is likely that the funds are currently deeply distressed, as indicated by BPY’s reporting, but the models used to project the IRRs assume full recovery in both cash flows and asset values.  If this is the case, how real are those projected returns if dependent on a robust recovery in assets such as Class B malls, which are experiencing secular change?

BPY segment reporting suggests that not only are BPY assets distressed but assets in Brookfield Asset Management (BAM) private equity funds are troubled as well.  Yet, projected returns for the funds appear robust.  The chasm between recent financial performance and projected returns is a gap both private equity investors and BAM shareholders need to close. 

BPY’s supplemental disclosures include performance information broken-down into three segments – Core Office, Core Retail and LP Investments.  Core Office has exhibited the most stable performance recently, investor focus has been on Core Retail, the LPs troubled Class A mall and retail segment.  The least examined, worst performing, and in my opinion, the most revealing segment is that the LP Investments. 

The funds hold a variety of assets, some of which have a higher risk ratings than BPY’s core segments.  Assets include, non-core office, non-core retail, which are largely Class B properties stemming from the acquisition of Rouse Properties, hospitality, logistics, student housing and the like.  However, in 2019, retail and hospitality accounted for ~44% of segment net operating income (NOI).  Both of these asset classes have been ravaged in the Covid-19 induced downturn.

The key issue with the segment, as with BPY as a whole, is leverage. BPY is 2-3x more levered than comparable companies.  In 2020, the LP had an interest expense to NOI ratio of 64%.  In contrast, mall operator Simon Property Group (SPG) had a leverage ratio of 22%.  Vornado Realty Trust (VNO), more New York and office centric, had a ratio of 25%. 

Leverage in the LP Investment segment is much higher than the aggregate figures at BPY.

In the table below, I provide some basic financial information for the LP Investment segment.  Leverage is measured by the ratio of interest expense to NOI.  I include a prorated allocation of LP interest expense as well.  I also provide cash flow after interest expense. 

The segment’s leverage ratio has increased significantly over time.  It rose to 89% in 2020 from an already elevated 60% in 2018.  The ratios increase was driven by a steep 46% decline in NOI, which was partially offset by a much smaller 21% decline in interest expense. 

In the three years from 2018 and 2020, cash flow after interest expense collapsed.  It decreased 85% to $50M from $324M from 2018.

In 1Q21, the segment crossed the Rubicon.  The leverage ratio was 114%, indicating that the segment entered into a phase Hyman Minsky defined as Ponzi Finance, when leverage increases to the point where cash flows no longer cover the interest expense. 

The financial information shown does not tell the whole story.  There were asset sales over the period as funds liquidate, so the decline in NOI represents a combination of eroding results and fewer assets.  However, it is indisputable that the remaining assets are both more highly levered and, for now at least, performing much worse than historical aggregate fund performance. 

The logical extension of stress in the LP Investment segment is to assume that the BAM-managed private funds from which the segment financial are derived are similarly troubled.  After all, they are identical.  However, dismal current cash flow characteristics do not appear to be having a material impact on the reported long-term projected returns of the underlying funds, as shown below.

The stability in BSREP I is not surprising. As an early vintage fund I would expect it to be largely realized.  However, this is not the case with the other funds, particularly for the large BSREP II and BSREP III funds.

How is it that the long-term projected IRRs of these funds are so stable when the current cash flows underpinning those returns have collapsed? 

I have limited information on the private funds.  However, BPY’s LP Investment segment provides a window into fund performance, if not a full view.  Evidence suggests that that financial distress extends across BAM’s real estate platform. 

If I am correct, the problems we have seen bubble to the surface over the last year are just a coming attraction. The feature has not started, but the preview suggests it is more Freddy Kreuger slasher than Forest Gump feelgood.