Given the financial meltdown and real estate slump, many property fund managers still in business will have lost money, even if they haven’t yet realised losses. But their misfortune is not solely attributable to the crisis. It has also come to light that some funds made poor decisions.
A combination of bad investments and inappropriate financing leveraged their returns but also raised the risk. As a result, investors have lost trust in certain fund structures – and some fund managers. “People are looking for the right product, the right fee structure and alignment of interests,” says Simon Redman, head of European product development at Invesco Real Estate. “They are also looking for stable fund management businesses. We had an industry that grew very quickly and not all the practices aligned investors and managers properly.”
Deborah Lloyd, a partner at law firm Nabarro, adds: “Most investors think most managers failed to manage debt well. Now they want to know how it will be managed, who will manage it, and the risks.” In the current climate, gearing is a sensitive issue. With investors now keen to place some limits on borrowing, leverage levels are more in the 40-50% range than the 65-80% range.
Gearing will also soon be subject to strict regulation. The European Commission’s proposal for a Directive on Alternative Investment Fund Managers aims to place restrictions on leverage and introduce capital adequacy tests for funds. Cross-collateralisation is also unpopular with investors. Some managers secured debt against a pool of assets, rather than on an asset-by-asset basis, because this approach allowed them to secure better financing terms. As investors have discovered, this formula exacerbated risk because if one asset fell, they all did.
It is also common for established fund managers to have a revolving bank facility, so they can respond to investment opportunities quickly, rather than drawing down capital from investors. But leverage-wary investors are now seeking to ensure that the size of borrowing facilities is capped and that there is an obligation to repay by a set date.
“Investors don’t want anything smart or stupid – they want something that’s going to reduce the risk,” says Dominic Field, business development director at Grosvenor Fund Management. “Managers need to put someone in front of them who is going to arrange the debt, to explain how they are hedging interest rate risk and currency risk, for example. Investors are now analysing the risk and returns in more detail than they were before.”
Investors are looking at different return metrics, such as equity multiples, which indicate how many times their initial equity they are likely to get back at the end of the fund’s life, rather than just the internal rate of return (IRR), which is a time-weighted calculation of returns and thus very sensitive to the timing and magnitude of investments.
“People are very focused on the multiples, particularly now, because you can have a very high IRR but a very low multiple,” Field says. “You can’t bank an IRR, so investors want to know how much money they’re actually going to make and for that they need to look at the multiple.” The focus on aligning investors’ and managers’ interests is sharper than ever before. In funds launched during the 2003-2006 boom years, the balance of power lay with managers.
“The parameters of investor control over issues like voting mechanisms, debt levels and investment restrictions have been severely tested during the downturn,” says Albert Yang, director of institutional business at Henderson Global Investors. “The lessons learned have been incorporated into new fund documentation leading to more focused and complex investment solutions.”
Investors in these funds are finding it difficult to assert control because of the level of discretion they originally gave to managers. But now that capital is scarce, equity providers are feeling more empowered and are looking for structures that will ensure that managers don’t wander off-piste. “Investors want more alignment between the manager and fund, so they’re asking for co-investment from the house, even on core funds,” says Grosvenor’s Field.
“Having co-investment in itself doesn’t make things better, because when the market goes down, everyone loses money. But it makes investors feel better, as they think the manager will look after their money.” With fund raising still very challenging, managers are more willing to negotiate points (within reason) to get investors on board. Peter Hughes, a partner at law firm Salans, cites a deal where the fund manager agreed that the sponsor’s equity would be treated as subordinated to other investors’ capital. “This put a real onus on the sponsor to back an idea they were confident would be a possible fund, because they had to put in the first chunk of capital,” he says. Some – mainly larger – investors are eschewing funds as an indirect route into real estate altogether. “This year and possibly next will be the years of separate accounts and joint ventures, as opposed to the years of co-mingled funds,” notes Field.
Pooled funds out of favour
Large pooled funds have fallen out of favour somewhat, because with so many investors involved – not all of whose interests are the same – decision-making can be tortuous. This is especially true when, as Field puts it, “strong but sensitive leadership is hugely lacking”. Corporate governance has also been tested – and in many cases found wanting. Some funds’ advisory board members have been reluctant to get involved when difficulties arise. “They don’t want to be put in the firing line,” says Hughes. “Investors are spending more time on corporate governance.”
The relationship between fund managers and investors has also come under stress, prompting pressure for ‘no fault divorces’ – US-born clauses that allow a fund’s limited partners to vote to remove the general partner if they lose faith in it or are dissatisfied with the fund’s performance. Without this clause, investors must prove the manager was negligent or fraudulent. However, divorcing your general partner is an extreme move and one that is likely to remain the exception.
“As unpopular as it may be with managers, they feel there are few circumstances in which divorce clauses would be invoked – the notion is that it gives investors a greater sense of control over their money,” says Henderson’s Yang. As with marriage, communication between partners in funds is crucial to the health of the relationship. Reporting mechanisms are being beefed up and fund managers will be wise to flag up any problems early on. Field concludes: “When the market falls, investors are understanding of bad performance, but they’re not understanding of bad behaviour.”
EU cracks down on fund managers’ pay policies
The European Union’s original draft directive on alternative investment fund managers (AIFM) did not tackle fund managers’ pay. But the latest version, due to come into effect in 2012, includes measures that would heavily regulate the way fund managers are remunerated.
It says that:
Pay policy must promote “sound and effective risk management and not encourage risk-taking that exceeds the level of tolerated risk of the fund”.
- Performance-related pay must be assessed over a “multi-year framework” that is appropriate to the lifecycle of the fund and spread over a period “which takes account of the underlying business cycle” of the fund, and the business risks.
- At least 40% of performance-related pay or bonuses must be deferred for at least three years, and if it is a “particularly high amount”, at least 60% must be deferred.
- The fund’s annual report should disclose the pay of highly paid individuals.
- Large fund management houses, or those managing large or complex funds, must have an independent remuneration committee for pay policies and incentives.
- Only funds that market to investors across EU borders will be subject to these rules. So some fund managers won’t be affected and will still be covered by national laws, which are not expected to change in Northern Europe. But more protectionist countries like Spain and Italy may prohibit managers from marketing there unless they operate under the new EU directive.
- “Only one or two people have said they won’t operate under these regulations,” says Nabarro’s Deborah Lloyd. “Some clients think it will be good for them because they only want to market in one jurisdiction so won’t have to comply with the directive.”
- As well as tackling pay, the EU directive says a regulated fund has to have its main decision-maker authorised. As most limited partnerships’ general partners aren’t authorised, decision-making in these funds may have to shift to the investment partner.
- The directive also requires regulated funds to have a depository: a custodian that ensures the assets, eg share certiﬁcates or title documentation, are secured. APUTs already have trustees, but LLPs don’t.