Optimus Prime
What the defence industry could teach us about CRE strategies
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In 1961, President Dwight D. Eisenhower first observed the growth of the “military-industrial complex.” The Primes, as they are now known, are the top contractors of the US Federal Government and include Lockheed Martin, Boeing, General Dynamics, Raytheon and Northrop Grumman. In “Unit X: How the Pentagon and Silicon Valley are Transforming the Future of War,” authors Raj Shah and Christopher Kirchhoff launched the Defence Innovation Unit Experimental (DIUx) in 2015 to help the U.S. military make faster use of emerging commercial technologies. Raj, the co-author of the book, was a U.S. fighter pilot in the F-16 Viper. Although he flew a $30 million jet built by a Prime, the navigation systems didn’t work and so pilots would download a commercial $300 gadget available on the high street to aid navigation so as not to cause an international incident when on sorties. In fact, the DIU team were shocked to encounter in the Combined Air Operations Center (CAOC), the U.S.’s main international Air Command Centre based in Qatar, that rather than the high-tech operations one might expect from the Air Force’s public image, they found that Microsoft Office was being used to manage weapons systems – a far cry from the advertised cutting-edge technology. Dominant firms, defence or otherwise, are often considered more effective to smaller firms. Fundraising is easier and often performance is disproportionately favourable. But as Bill Gates said, “Success is a lousy teacher. It seduces smart people into thinking they can't lose.”
In 2024, prominent private equity firms are expected to dominate fundraising efforts, as highlighted in Hamilton Lane's 2024 Market Overview. The report notes that "funds larger than $10 billion accounted for around 20% of all funds raised in 2022, the highest level in over a decade." Drew Schardt, Hamilton Lane's Head of Investment Strategy, explains that in uncertain macroeconomic conditions, "investors generally take comfort with firms that have greater resources, more data, more information and more analytics." This preference has led to increased allocations to larger, well-established firms. Additionally, the report highlights that "nearly 75 percent of private wealth clients plan to increase their allocation to private markets in 2023-24." Larger firms are better positioned to tap into this capital due to their scale and brand recognition. Schardt adds, "Size and scale matters in the [private wealth] market, too."?
According to McKinsey’s Global Private Markets Review 2024 the impact of consolidation, often referred to as a ‘flight to familiarity,’ has significantly shaped the fundraising landscape, with the largest and best-known funds capturing an ever-growing share of investor commitments. The top 25 fundraisers captured 41% of all commitments, with the top five alone representing almost half. This concentration leaves smaller and newer funds struggling; fewer than 1,700 funds under $1bn closed in 2023, the lowest since 2012. New manager formation also fell to the lowest level since 2012, with just 651 new firms launched in 2023.
Preqin data from mid-2024 echoes these figures. Of the $590bn raised across 1,324 closed funds, $302bn went to the top 50 funds alone, with the largest 100 funds collectively securing nearly 67% of committed capital in the first half of 2024, well above historical norms. This ‘consolidation crunch’ poses an even greater challenge for smaller funds: those ranked at 301-downward have raised only $56bn so far this year, compared to $356bn in 2023.
Smaller managers need an edge in today’s competitive fundraising environment, as described in Charles Allen’s commentary in Green Street News, with larger players capturing an increasing share, leaving smaller managers to compete over shrinking portions. Last year’s equity raise was the lowest since 2014, with 2024 equally difficult. Allen notes the capital has "to be shared across a larger number of managers,” while James Jacobs of Lazard describes today’s landscape as “more competitive than ever.”?As Jacobs observes, many investors now view mega-funds as safe, diversified entry points to asset classes, complementing these with country- or sector-specific investments expected to outperform.
The challenges are not solely about scale but also approach. Successful managers now focus on relentless outreach, often “knocking on as many new doors as possible.” Patron Capital’s Keith Breslauer, for example, raised over €860m for their seventh fund by targeting international investors. This outreach resulted in 580 meetings. Breslauer emphasised, “The key was setting up a lot of meetings.”
As INREV reported in ‘The UK Real Estate Fund Industry: A decade on from the Global Financial Crisis’ “The niche managers benefit from being nimble and benefit from having good relationships with investors. People associate these managers as being specialists in their particular sector and the providers of alpha” and “The nimble specialist managers with unique skills will always be wanted, as will the large multi-asset houses which can offer a one-stop-shop solution. I think it is the managers in the middle ground, often dominated by a set culture, which may be in the danger zone."
To secure commitments, managers are creating urgency. Jonathan Reid, managing director at Hodes Weill & Associates, states, “You have to have a real reason for investors to commit.” However, without commitments, managers may need to withdraw from deals, potentially damaging reputations. Flexibility has also become essential. Many managers are turning to co-investments, joint ventures, or one-off deals. Orion Capital Managers, for instance, was reported to transact with individual investors outside the fund structure while moving toward a first close for its sixth fund.
Specialisation is also a potential differentiator in a market dominated by mega-funds. Allen notes, “These days you’ve either got to be really big or you’ve got to be a specialist.” Investors favour high-demand sectors like residential and logistics. Fiera Real Estate, for instance, has focused on industrial and residential, appealing to investors seeking deep expertise in targeted sectors. However, specialisation has its risks; if a niche falls out of favour, managers must often pivot, which can be a costly undertaking. Long Harbour, for example, expanded from ground leases into build-to-rent, single-family housing, and student accommodation, a shift that required significant investment. Today’s market conditions are also driving consolidation. As Allen predicts, “I think there will be quite a bit of M&A and consolidation.” He anticipates that some managers may “look for a strategic partner to recapitalise them at a corporate level and provide some seed equity.” Selling a minority stake, as Round Hill Capital did with CIM Group, can provide capital for navigating tough times.
According to Joseph A. Smith, Partner at Schulte Roth & Zabel, several factors are making it particularly difficult for emerging managers and smaller funds to attract capital. While LPs are often keen to back new vintages that could yield strong returns, their capacity to make new commitments is constrained by limited distributions. Additionally, rising regulatory compliance costs put a heavier burden on smaller managers, who struggle more than their larger counterparts to sustain back-office overheads. However, Smith suggests that as deal flow improves, distribution regularity may increase, potentially easing these constraints and broadening LP risk appetite. In the long term, this could help level the playing field, allowing more diverse managers to thrive within the private capital landscape.
Keith Breslauer of Patron Capital argues that mid-sized managers with the right skills and experience are uniquely positioned to thrive in an environment shaped by higher interest rates, evolving environmental legislation, and a scarcity of high-quality stock. He contends that larger managers, unable to benefit from "beta tailwinds," may struggle to deliver sufficient returns in such a landscape. According to Breslauer, the nuanced strategies and agility of mid-sized managers enable them to adapt more effectively to these challenges, offering a competitive edge in generating returns.
This view is supported by INREV’s quantitative data analysis of fund returns over two decades, which revealed that specialist funds have shown both the lowest returns and the highest volatility among fund types. However, within this volatility, some specialist funds have achieved superior risk-adjusted returns, suggesting that these smaller funds may generate alpha, albeit with increased risk exposure. This is consistent with investor perceptions that specialist funds, due to their targeted focus, can outperform on a risk-adjusted basis in specific sub-sectors.
?Unit X also discusses the strategic importance of anchor investments from Primes. One example was L3 Harris, the 5th largest prime defence contractor with $17bn in annual revenue which invested in a defence focussed VC startup investor, Shield Capital. This partnership created great tailwinds, even though it may seem counterintuitive for defence "Primes" to align with Silicon Valley disruptors.?However, they understood the Silicon Valley maxim that "it's better to disrupt yourself than to let others do it for you." By investing, L3 Harris gained insights into the latest innovations from the Valley and identified promising opportunities to collaborate with startups. This might partly explain why there was significant interest in real estate firms acquiring minority equity interests in institutional alternative asset management businesses over the last cycle.
Aircraft carriers and destroyers have a useful peacetime power projection capability, but they're very vulnerable in a real conflict most maritime professionals believe. One of DIUx portfolio companies developed self-powered autonomous sailboats that could remain at sea for months at a time and conduct ocean surveillance, for a fraction of the price of building and deploying destroyers which carry a price tag of $2 billion or more per ship. The use of ocean-going drones in the Ukraine war for example, often sourced from smaller, innovative companies, highlights that big fleets – acting as a deterrence – isn’t necessarily more effective nowadays. Ocean going drones have enabled Ukraine to effectively neutralised Russia's Black Sea Fleet, turning its 40 ships into what naval strategists call a “fleet in being”: functionally defeated yet still existing.
The dominance of "Primes" in military procurement is reflected in the “flight to familiarity” in the private equity and investment landscape; where well-resourced, established players can offer the perceived stability and consistency that appeal to a cautious investor base. Yet, as Unit X highlights, a concentrated reliance on major players may limit access to emerging, innovative strategies. In a landscape increasingly dominated by beta providers, will investors still pursue alpha opportunities with specialised managers or will large-scale dominance continue to steer the future of investment?