One Lincoln Street (A) After more than six months of seemingly daily e-mails, conference calls, and presentations, John Hynes still couldn’t believe what he was hearing on the other end of the phone from Frank Mattson, a Real Estate Investment Officer for Midwest State Teachers Retirement System (“STRS”). “Wait a minute. I know it looks like a good deal. But John, I’ve tried to be clear from the start: we’re a public pension fund. Our policies are we only invest in fully entitled land and, even then, we don’t build on spec. We need at least 25% pre-leasing. And I still want to talk to you about that residual profit split. All I can say right now is get me those revised unlevered cash flows and maybe I can bring the issues up at the Investment Committee meeting this week. But don’t get too optimistic – we learned our lesson the last go-round, and it wasn’t pretty. I’ve got to get home for dinner or my kids are going to forget my name. I’ll be in early tomorrow. Thanks, partner.” “O.K. then, Frank, I guess we’ll talk in the morning. Bye.” As he released the call from his speaker phone, John Hynes muttered angrily: “Spare me that partner crap, please! Partners take risks.” John knew his discussions with Frank needed to evolve. He just worried that he didn’t have much time. Context John B. Hynes, III was the Senior Vice President and Principal in charge of the Boston office for Gale & Wentworth LLC (“G&W”), a diversified real estate investment and services firm. Gale & Wentworth owned approximately 12 million square feet of suburban office properties and provided fee-based services to another 17.5 million square feet of such product. Gale & Wentworth had offices in seven states and the United Kingdom, employing over 350 people. This case was prepared by W. Tod McGrath for the purpose of class discussion. The case describes an actual situation, but in the interests of confidentiality, certain names and other identifying information have been changed. The situation described herein is not intended to illustrate either effective of ineffective handling of a fiduciary situation. Revised October 2003.John Hynes was G&W’s newest addition to its senior management team. A lifelong Bostonian and real estate professional, John was transitioning from a successful career in commercial brokerage back to one centered on real estate investment, development, and management. John had been there before. From 1983 to 1992, he directed Lincoln Property Company’s Boston office as its Operating Partner and developed approximately 850,000 square feet of office space in Boston and Chelsea, Massachusetts. John’s primary responsibility at G&W was to use its resources and network of relationships to expand its presence in the Boston office market. John knew that the principal resource available to him was the $50 million in capital that had recently been raised in MSGW III, G&W’s latest opportunity fund co-sponsored with Morgan Stanley Real Estate. Similar to its two predecessor funds, MSGW III had been launched to acquire (with leverage) about $200 million of “value added” real estate (i.e., largely empty buildings in improving markets). Levered investment returns were targeted at about 25%, down considerably from the 40%+ returns achieved in MSGW’s first fund. G&W had recently finished investing MSGW II, the second opportunity fund it co-sponsored with Morgan Stanley. This fund was subscribed in 1997 with $50 million of equity and, somewhat unexpectedly, became fully invested in a single transaction with the levered acquisition of a national portfolio of office properties known as the Chubb Portfolio. John was well aware that it had become increasingly difficult to find existing investment opportunities that both matched MSGW III’s investment objectives and could deliver the targeted level of investment returns. In many respects, the Boston market as of mid 1999 didn’t seem to offer a great deal of promise in terms of opportunistic investing. Over the past 5 years, the vacancy rate for Class A & B space in the City of Boston had dropped from 13% to less than 4% and asking rental rates had more than doubled (Exhibit 1). John knew he was late to the party, but also felt that a dynamic metro area such as Boston would continue to offer smart investment opportunities over time. Others thought so, too. That’s how John came to meet Frank Mattson. STRSFrom the standpoint of commercial real estate investment, STRS was one of the mostprogressive public pension plan sponsors in the country. Unlike most of its peers, STRS had made a conscious decision to internally staff its real estate investment function as opposed to outsourcing such responsibilities to third-party pension investment managers. More significantly, perhaps, STRS was willing to venture a little further out on the risk/reward frontier than most other plan sponsors. But STRS appetite for risk was buffered by a strategic decision to concentrate their investment in only about 10 MSAs nationwide. The rationale for such concentration stemmed from the practical requirements of both internal management efficiency and depth of external investment resources (i.e., joint venture partners) in the private property markets. 2To be blunt, in order not to be preyed upon in the quirky and inefficient private real estate equity markets, STRS Real Estate Investment Committee wanted to make sure they were aligning themselves only with the most reputable partners and only in those markets with the most depth, stability, and transparency. STRS had come to regard Boston as one of those markets.As of mid 1999, STRS commercial real estate portfolio had a market value in excess of $5.5 billion and funding commitments for another $700 million. Although the portfolio was generally well diversified across property types, geographic regions, and investment structures, Frank Mattson believed that additional investment exposure to the higher cost, supply-constrained Northeast property markets was desirable. As he continued to follow the rapid escalation of rents and asset values in the Northeast, he began to more formally explore investment opportunities in Boston, both for STRS on its own and with selected joint-venture partners. Early in 1999, G&W had been recommended to him as a possible source for investment opportunities by his contacts at Morgan Stanley Real