Corporate governance is a hot topic, especially in the listed corporate arena. Most in the UK have heard of Higgs, and in the US, of Sarbanes-Oxley. To add to the international flavour of corporate governance, the Tabaksblat Committee code came into effect on January 1, 2004 in the Netherlands. It is not yet clear if the implications of these initiatives are fully understood for listed real estate.
Why start here in a paper about institutional investment in private property vehicles? The answer is that I believe the unlisted real estate vehicle will become subject to the same pressures as in the listed arena.
As a result of Tabaksblat, Dutch companies will have to communicate via a ‘comply or explain’ principle in their 2004 annual reports. The key aim of the code has been to improve transparency and integrity which were found lacking in the Dutch response to the Peters Committee proposals of 1997. This is relevant because Peters was voluntary, and few complied. Regulation is not just on the horizon, it is with us and the implications should be grasped now.
The Higgs report in the UK lays down a new code for company boards of directors: their composition, remuneration, number, attendance, recruitment, appointment, induction and professional development and access to shareholders.
If Higgs argues this is crucial to strong corporate governance in the listed sector, the private sector should not seek anything less.
For example, how many private property funds have non-executive directors? Of those that do, where do those directors come from? Ideally there would be several non-executives, or independent directors sitting on a board of management. Those directors should be experts in fields highly relevant to the business area. Impeccable reputations for honesty, integrity and no-nonsense dealing would be essential.
Perhaps there is a role for a new provider of services to our unlisted real estate investment market – the professional non-exec, beholden to no-one and paid properly for his or her services. These non-execs might accept more than one appointment, but not anything conflicting.
Higgs also proposed a senior executive director to keep the CEO honest. There may be a role in the unlisted industry for such a provocateur. Investors would value a professional on their side, empowered and trusted to be there looking after investor interests. Would investors be prepared to pay the additional cost? Definitely.
Typically the general partner (GP), or the fund manager orchestrates the valuation process, whilst investors pay for it. GPs and fund managers may be paid performance fees on the results of those valuations, sometimes immediately.
Such an alignment of interest appears fragile. Investors should ‘control’ the process. Given that they often cannot, for statutory reasons, this is a role for non-executive directors.
Investors will increasingly move to take control of the valuation process, especially when fees are dependent upon valuation results.
Significant change will occur in these areas in the next few years. Key men clauses are of value to investors. They establish a mechanism whereby the investor can influence the ongoing relationship rather than controlling the fund negotiation and commitment phase, but relatively little thereafter. The loss of a key man might provide investors with mechanisms to prevent further drawdowns, or at the extreme, terminate the fund, though I am not aware that this has ever occurred in the UK.
Investors are spending more and more time understanding the staff working on a fund, checking they are suitably rewarded to retain and attract the best, and understanding how they work and think. Having made an investment, investors do not want to see staff leaving. It is surprising that some fund managers do not take a similar perspective.
Default clauses come associated with stringent gross negligence conditions. This will change. However, it is increasingly common to agree the more straightforward definition of simple negligence, so investors at least have a chance in court, though no one would ever wish to resort to this. Nonetheless, investors are now looking for ‘no cause default clauses’. These are already being accepted and are likely to become much more standard.
The days when investors will back long-dated fund manager appointments with no default clauses (save perhaps in gross negligence) are numbered. Investors offering segregated accounts do not have to give such commitments, so why do investors accept it in fund raisings.
The great advantage of the ‘no cause default clause’ is that it renders many other terms unnecessary; key man, for example. I believe that investors would see improved performance from the fund manager working under a ‘no cause default’ clause, than the manager who cannot be fired.
Fees payable in fund vehicles are becoming ever more complex. Increasingly investors are expressing frustration at the difficulty in understanding the total fees that are payable in a fund or vehicle. Currently, investors must work it out. In this subject area, they have a duty to be cynical and suspicious.
If total fees were presented in ratio form, investors would have the key information required and could compare products. They might even concentrate less on the detail of the fees, comfortable that the overall level was appropriate.
Investors are not just trying to reduce the fees they might have to pay. Contrary to what is often assumed, investors are often not unhappy paying performance fees and making fund managers seriously rich - so long as the payments have been aligned with fund performance.
Corporate governance matters and investors are taking it seriously. To illustrate INREV, the newly formed European association for unlisted real estate vehicles, has a dedicated investor platform that nominates 60% of its overarching and controlling management board. That is the right way round and will lead to improved transparency and liquidity in unlisted real estate vehicles. INREV also has a specific working party considering governance and other issues.
We can expect to see pricing of funds, especially in the secondary market, explicitly influenced and dependent upon the corporate governance practices in those funds. As the industry evolves, the spectre of disenchanted investors is inevitable. However, those funds with the very best, transparent, investor friendly corporate governance, with truly independent directors, valuations owned by the investors, no cause default clauses, clear total expense ratios, will enjoy premium pricing and secondary market liquidity.
Transparency is beckoning and regulation is coming. Alignment of interest between investor and fund manager is everything. Base fee levels will have to fall, especially in an environment of lower prospective returns. Greater performance orientation is needed, but for those that achieve it, fund manager rewards will be no less.
If the industry can move as one to offer best standards of practice then there is an exciting future. If a party fails to adapt, evolutionary forces will render them extinct.
There are reasons to be afraid, but also to be encouraged. The industry is evolving, terms are becoming more acceptable, and more and more investors are prepared to use indirect vehicles.
Peter Pereira Gray is head of property investment at the Wellcome Trust in the UK. The views are those of the writer and do not necessarily represent those of the Wellcome Trust.