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Public property

Buyout firms and debt managers have found another novel way to tap the public markets for cheap capital. Can this one stick?

Private equity firms and other asset managers are just about always seeking new ways to raise money. The incentive is clear: The bigger their funds, the more they collect in management fees. Consequently, many have long wanted to tap the public markets as well as their existing private partnerships. And lately, they've been doing just that, through an unlikely vehicle: mortgage real estate investment trusts.

Buyout giant Kohlberg Kravis Roberts & Co. and GSC Partners, a $7 billion alternative-investments manager, are among the private investors that have recently floated mortgage REIT shares.

The trend isn't necessarily an indication that KKR and its peers view real estate finance as attractive. Indeed, moving into the sector carries substantial risks, as experts debate whether the white-hot market is due for a fall. Other firms seeking to jump on the REIT bandwagon to raise cheap capital may actually have waited too long. Buyers are balking at new mortgage REIT offerings amid concerns about the potential for a spike in mortgage defaults if interest rates continue to rise.

Rather, several features of the REITs make them an appealing way for firms to gather assets. For one, they aren't limited to mortgages. Legally, they can devote up to 25 percent of their assets to other instruments, a freedom that KKR and others can exploit by making leveraged bets on corporate debt and derivatives.

"We have the capability to manage in all these different credit-oriented strategies, and the REIT can use them all," says Frederick Horton, CEO of GSC Capital Corp., the mortgage REIT that GSC floated in late July, raising $200 million.

Moreover, dividends paid to shareholders -- at least 90 percent of REIT profits must be distributed in this manner -- are not taxable. A REIT's cost of capital is thus lower than that of other public companies. And unlike buyout funds and similar private vehicles, which are subject to redemptions and expirations, the proceeds of a REIT offering are permanent. This allows managers to make longer-term investments and enjoy steady fee income.

There are now 36 mortgage REITs in the U.S., with a combined market cap of $33.2 billion, according to Credit Suisse First Boston (see chart). That's up from fewer than 20, worth $3.2 billion in 2000. Most invest primarily in mortgage-backed securities. Only lately have firms with more complex strategies, such as KKR and GSC, begun to form them.

The firms' interest in the REITs is similar to a wave of filings by buyout shops last year to float business development corporations. BDCs are little-used public investment funds designed to promote investment in private companies. But following Apollo Advisors' $870 million IPO of Apollo Investment Corp. in April 2004, investors chafed at the high fees of private equity BDCs. About a dozen other buyout firms, including KKR and Thomas H. Lee Partners, soon killed plans for copycat offerings.

Like BDCs, mortgage REITs can use leverage and charge performance fees. But there are key differences that make them more acceptable to investors. For one, firms lacking real estate investing expertise are unlikely to simply launch REITs to raise funds for their existing investment activities. KKR, for instance, has hired a team of experienced managers to oversee KKR Financial Corp., which it took public in June.

The benefits for issuers are similar to those of BDCs, though. KKR anticipates leveraging its REIT as much as 12.5 times, according to its offering prospectus. The fees are also attractive. KKR Financial, for example, will deduct from its dividends a management fee of 1.75 percent. Profits exceeding certain benchmarks are subject to a 25 percent performance fee. (KKR declined comment.)

"The REIT structure is a good fit, as it taps into our firm's broad-range investment experience," says Jonathan Trutter, CEO of Deerfield Triarc Capital Corp., a division of Chicago fixed-income manager Deerfield Capital Management. Trutter's firm raised $363.5 million in a June IPO.

Other buyout firms and alternative-asset managers are considering joining the REIT party, but they may have to wait until today's real estate jitters pass. "You will see more people attempt to do this," says Dominic Capolongo, a banker in CSFB's financial institutions group. "But it's certainly tougher right now."

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