Oregon Rewards CMBS Manager Who Blew Up Fund in 2008: Mortgages

Edward Shugrue lost $100 million of Oregon’s state pension fund during the credit crisis in 2008, within three years of getting the money to invest in commercial property debt. The retirement board took just 30 minutes last month to hand him another $125 million.

For Oregon’s $57.9 billion retirement system, it’s a chance to profit from the real-estate recovery with a manager who’s overseen funds for the state since 2004 during the boom and bust. The pension trustees are sticking with Shugrue, the 46-year-old head of Talmage LLC, partly because a separate account he invests on their behalf has returned enough to recoup the loss, and also for his efforts in the depths of the crisis, ultimately unsuccessful, to salvage their holdings.

“I would rather go with an experienced team that’s kind of been through a horrible storm,” said Katherine Durant, one of four council members who voted yes on the investment at the pension’s Sept. 19 meeting in Tigard, Oregon. “Maybe there are some dings. But I think he’s learned things from it,” said Durant, co-founder of a commercial property investment firm in Portland called Atlas Investments.

While Oregon’s decision to invest with a manager who lost an entire $770 million fund in 2008 including the state’s commitment raised an objection from the committee’s chairman, investing in commercial real-estate debt was unanimous.

It’s joining pension funds including the Pennsylvania Public School Employees’ Retirement System in picking investment firms to wager on a recovery as Federal Reserve efforts to jumpstart economic growth by keeping interest rates near historic lows propel gains on higher-yielding debt that had cratered in value during the financial crisis.

Brevan Buys

Bonds created by bundling commercial mortgages in the years leading up to the property boom of 2007 have risen this year as firms including Brevan Howard Asset Management LLP and Angelo Gordon & Co. gather additional money for the investments.

Shugrue, whose New York-based Talmage oversees $1.7 billion and is seeking to raise $500 million for its latest fund, declined to comment.

An index tied to bonds that were originally given top credit ratings during the market’s peak and have been cut to junk trades at 63.2 cents on the dollar, even after gaining 12 percent since 2011. That’s making some of the securities potentially more profitable than buying stakes in the buildings.

Consultant Endorsement

“It is not often that debt gives you a better return than equity,” said Nori Gerardo Lietz, a real estate consultant to Oregon who endorsed the new investment with Talmage last month. “You cannot buy the kind of core assets that you would want to have” at yields of more than 6 percent, she said. “They’re buying yields north of 8 percent.”

Optimism for commercial property securities is far removed from October 2008, when Shugrue had to address the Oregon council in a special non-public meeting to ask for $100 million to meet margin calls on a $770 million debt fund his team managed through a joint venture with Guggenheim Partners LLC.

It approved the lifeline to help Shugrue save the fund, which included the $100 million the state had invested in 2006. Their relationship started in 2004 when the pension invested $50 million with the first Guggenheim fund and also included the separate account set up in 2008, which didn’t use borrowed money.

The injection wasn’t enough. The value of the assets continued to decline in the aftermath of Lehman Brothers Holdings Inc. bankruptcy. That December, lenders including JPMorgan Chase & Co. seized the collateral, terminating the Guggenheim Structured Real Estate Fund II and wiping out Oregon’s initial investment.

Larson Objects

Keith Larson, chairman of the Oregon Investment Council and a managing director of Intel Corp.’s venture capital unit, voiced reluctance last month to approve more money for Talmage.

“Ed should be commended for being transparent,” Larson said at the September meeting. “The concern I’ve got in the back of my head is that Fund II was an unintended consequence of the leverage there. For whatever reason, I mean, we can say it was a black swan event and all of those things, but it still, you know, was a complete loss.”

Shugrue told the Oregon trustees the new separate account doesn’t use borrowed money, to avoid margin calls like the ones that sank the prior fund.

“They’ve made back the money that they lost, which, given how far underwater they were, I would consider that kind of a huge home run,” said Gerardo Lietz, the pension consultant. “There are many, many funds of those vintage years that will not get a one-X multiple.”

Lenders Seize

The investment firm wasn’t alone in having lenders seize collateral after values plummeted. The failure of two subprime mortgage funds run by Bear Stearns Cos. in 2007 helped trigger the financial crisis, which then brought down Peloton Partners LLP, Carlyle Capital Corp., a credit fund overseen by Carlyle Group LP, and as the crisis deepened, a myriad of firms investing in assets from leveraged loans to collateralized debt obligations.

Debt-focused real-estate funds raised in 2006 to 2008 show a median loss of 1.1 percent, based on the internal rate of return performance measure used by private-equity firms, according to Preqin Ltd., a London-based researcher of alternative asset managers. The firm tracked 58 funds with a combined $20 billion of capital raised.

Made Enhancements

The key question when hiring a money manager isn’t whether he’s had a bad period or suffered losses, it’s whether he “has learned from a past mistake and has made enhancements or changes to the process to avoid that issue in the future,” said Mark Yusko, CEO of Morgan Creek Capital Management LLC in Chapel Hill, North Carolina, which has $8 billion in assets and allocates to hedge funds.

Yusko also recommends finding “managers with great 10-year track records that show consistency of process and philosophy who have had a few tough years, as they are likely to revert to the mean and outperform.”

Oregon, which was a pioneer in private equity investing, having backed Kohlberg Kravis Roberts & Co. when the firm began raising buyout funds more than three decades ago, has also proven one of the most successful real-estate investors among pension funds.

Its 10-year return of 9.5 percent from the investments beat the 7.6 percent return over that period for the benchmark NCREIF Property Index. That surpassed the state pension real estate average of 6.7 percent, according to a June 26 report by Cliffwater LLC, a Marina del Rey, California-based adviser and manager for alternative investments.

Oregon Performs

Oregon’s pension turned in the third-best performance for real estate investing nationwide during the 10 years ended June 2011, according to Cliffwater. The range of returns for the 23 state pensions surveyed ranged from 10.4 percent for the leader, State Teachers Retirement System of Ohio, to zero for the lowest, Montana Public Employee Retirement Administration.

“The distribution of 10-year returns for real estate and private equity is very wide for state systems, suggesting that not only is implementation (manager selection) important, but that states have varied in their practices,” Cliffwater CEO Stephen Nesbitt wrote in the June 26 report.

That’s helped the Oregon fund return 6.9 percent year to date through June 30, 13.3 percent during the past three years and 1.8 percent during the past five, according to the Oregon State Treasury. The returns are for the main $57.1 billion public employees’ retirement fund. There is a separate $764 million account.

Latest Commitment

The latest commitment shows increasing confidence the commercial property market is recovering. Building values have recouped 42 percent of their decline since bottoming in January 2010, according to the Moody’s/RCA Commercial Property Price index. They’re still 22.5 percent below the December 2007 peak.

New bond sales have surged to the most in almost five years, with $7.9 billion of the debt linked to shopping malls, skyscrapers and hotels issued last month, according to data compiled by Bloomberg.

For Shugrue, it’s vindication for the efforts he made during the crisis and the performance of the $300 million separate account, after a more than 20-year career in real estate that included serving as chief financial officer at billionaire real-estate investor Sam Zell’s Capital Trust Inc. in the 1990’s. Talmage is the successor to Shugrue’s management company that worked inside of Guggenheim from 2003 to 2011.

“Our last visit here was not as pleasant as today’s,” Shugrue told the council last month. “We’ve turned the corner in a material way.”

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