Corporate governance is becoming an increasing concern for investors in unlisted real estate funds. IPE Real Estate editor Mark Cooper spoke to six major European investors to assess what they are looking for from fund managers and how far the industry is progressing towards serving investors’ needs.

The questions we asked:
How important is corporate governance when choosing between different unlisted funds or (if you invest in them) listed real estate companies? How does it rank compared with criteria such as manager reputation, projected returns and fees?
Do you believe the level of corporate governance in unlisted funds is acceptable? Has there been any improvement over the past few years? Are fund managers adapting to investors’ needs?

Do you believe unlisted funds should have non-executive or independent directors to represent investors’ interests? Are conflicts of interest more or less likely when funds are sponsored by the asset management arm of a pension or life fund which is also an investor?

Should control of the valuation process be taken out of the hands of the fund manager and become the responsibility of the investors or independent directors, especially as fees are often dependent on valuations?

Should investors insist on a “key person” clause, to protect them in the event of a senior person or team managing their fund leaving the fund manager?

What other “default clauses” should be insisted on and what action should investors be able to take (preventing further drawdowns, replacing the fund manager, liquidating the fund) in the event of default? Should there be ‘no fault’ default clauses, enabling investors to change the manager if they are unhappy with performance but cannot point to a specific failing?

Dr Neil Turner, portfolio manager Europe, Alecta
Swedish pension fund Alecta has around €2.5bn of real estate in Europe, of which 5% is in unlisted funds. It has a very small in-house team and outsources asset management of its direct real estate portfolio as well as investing in funds.
Turner believes corporate governance is a key consideration. “It is very important to us when selecting unlisted funds. It ranks alongside all other investment considerations such as projected returns and fees.”
The age-old problem that economists term ‘principal-agent’ is highly relevant to private real estate vehicles. This is the difficulty of controlling those empowered to act on one’s behalf. “Inevitably interests will diverge between manager and investor; and independent non-execs have a potentially powerful role to play here,” says Turner.
“When you invest in private equity vehicles you are voluntarily disenfranchising yourself by handing over the management of the investment to a third party, which is in any case necessary for limited liability vehicles. Because of this, it is essential that there are processes in place.”
Turner believes some fund managers are close to the standard investors are demanding, but that others are a long way behind. Those who are failing are unlikely to see Alecta investing in their vehicles. “It’s hard to give an average of how well the fund managers in Europe are dealing with corporate governance, but the situation has improved recently for the best managers,” he says.
“In the past few years, there has been a lot of money chasing European real estate, so it has been pretty easy to raise capital. If the supply of capital starts to dwindle, fund managers will need to address issues such as corporate governance even more closely in order to differentiate themselves.”
He says independent non-executives are crucially important to corporate governance but the fund management industry has not moved on ain this respect as much as he would like. “Sometimes when people pitch funds to us, we ask about the non-executive directors but find they are not as independent as we would like. In some cases they have been hand-picked by the manager and have financial or personal links to the manager. It is quite likely that such directors might feel loyalties toward the managers and it is possible that they could be compromised in exercising their responsibilities to the investors as a result of such loyalties.”
As conflicts between the interests of investor and manager inevitably arise through no fault of either, Turner says it is essential to ensure independent non-executives can adjudicate in these matters. “We have had a lot of discussions with managers and I believe they are coming round to investors’ way of thinking,” he says.
The valuation process is a classic example of where corporate governance can be improved. “Investors are generally uncomfortable with the valuer being appointed by the manager. In some cases, where the investor may have to pay ‘catch-up’ fees based on valuation it would not be acceptable for the manager to appoint the valuer.
“In unlisted funds, the valuation process is an obvious area for truly independent non-executives to get involved with. Previously, managers tried to argue that anyone but them appointing valuers would lead to a breach of limited liability status, but that is something that has changed for the better over the past 12 months.”
In short-term funds, where the manager gets performance fees based on the value of realised assets, this is less of an issue, says Turner.
A ‘key person’ clause is another important inclusion, he argues. “You need to know what will happen if the star person or team leaves. A ‘no cause’ default clause is also very useful and we have seen more fund managers accept this over the past year.”
Turner believes that if, for example, three-quarters of the investors believe the manager is failing, they should be able to remove it? He says: “It will always be a means of last resort, as it will cause problems for investors – they will have to find new management. Fundamentally, good managers have nothing to fear about such measures.”

Chris Taylor, fund management director, Prudential
The Prudential life fund is one of the UK’s biggest real estate investors, with £9.5bn (€13.5bn) invested in the UK, 5% of which is in direct assets. It has allocated £1.5bn to real estate outside the UK, of which a third to 40% will be indirectly invested. About a third of the overseas allocation has been spent so far.
“Corporate governance is a very general term,” says Taylor. “But it goes with the territory of management independence, disclosure, transparency and the checks and balances an investor needs to be reassured about.
“It’s almost a brand – would you trust these people with your money? How do they deal with conflicts; is their independence of mind as well as wallet? It all boils down to trust.”
The standard of corporate governance in European unlisted real estate funds has been pretty poor until recently, reckons Taylor, with corporate governance left of the list of major issues. He cites the launch of INREV two years ago as a turning point, as it provided the first forum, apart from in the press, for investors to air their views on these matters.
“The INREV committee looking at this has made good progress but it’s still early days,” he says. “We may end up with a code of practice which could be useful for investor and fund manager alike. Prior to this, investors have had to feel their way.”
Taylor also believes non-executives are crucial to sound corporate governance. He says: “How they are appointed shows how seriously the fund manager takes the whole issue. Progress is being made all the time. In five years time, I can see that lots of investors could be sitting on the boards of each others’ vehicles to deal with conflicts.
“This would mean we have a pool of experienced and knowledgeable non-executives who can see conflicts from both sides but remain neutral. There would be a virtuous circle. Where investors would take their non-executive roles seriously in order to ensure their peers did the same in vehicles they invested in.”
If the fund manager is part of a life or pension fund which is also an investor in one of its funds, conflicts become more difficult. However, it could be argued the fund manager has a vested interest in serving the needs of what will inevitably be his largest client – which shouldn’t be to the detriment of other investors in the fund.
“If the investment case is set out clearly from the outset, a lot of these problems are less likely to appear,” says Taylor. “I am a big fan of clearly defined investment proposals; it’s only where they are vague and woolly that you get problems. It’s one of the reasons we go for sector-specific funds. If a fund is committed to investing in distribution parks above 30,000m2 which are within a few kilometres of a motorway junction, then there isn’t much room for departing from the investment plan the investors bought in to. In a more opportunistic fund, with a lack of focus, you are much more reliant on trusting the manager to do the right thing.”
Taylor says he does not believe ‘no fault’ default clauses will ever be widespread in European unlisted real estate funds. “I don’t believe fund managers will accept them,” he says. For one thing, fund managers are partially valued on the security of their forward fee income, and this valuation could be threatened if investors could pull out or replace a manager without specific reason.
He does not believe the valuation process needs to be committed to the hands of a fund’s non-executive directors. “The process needs to be an arms-length one and, moreover, the investors need to be adequately reassured that is the case. The non-executives only need to be involved to ensure it is all done properly.”

Rob Bingen, real estate portfolio manager, ABP
Dutch pension fund ABP is one of the world’s biggest investors in real estate, with more than €15bn invested worldwide. Since the early 1990s, ABP has changed its focus from being a direct investor to going indirect.
Bingen says corporate governance is a
key part of the equation for ABP. “It’s very important for all our investments, but especially in private vehicles as exits are limited. When we are deciding whether to invest, it is a balance of the management, the business plan, returns etc and corporate governance that we look at.”
He believes that corporate governance is improving, partially due to the pressure exerted by investors such as ABP, but also from the focus that INREV has brought to the topic.
ABP believes it is not necessary to have independent non-executive directors in unlisted funds, although they are obviously part of the boards in its listed investments. “High standards should be kept for both public and private funds,” he says.
The appointment of valuers should approved by an advisory board which has investor representation, says Bingen, and valuers should be rotated. “Fees shouldn’t be dependent on unrealized gains,” he argues.
A number of default provisions should be put in place and investors need to be able to step in and take action when things go wrong. Key person default clauses are necessary when a fund’s performance is reliant on a few key individuals, says Bingen.

Michael Nielsen, managing director, ATP Ejendomme
Danish pension fund ATP has a €1.4bn domestic real estate portfolio and has invested more than €200m in nine indirect funds across Europe. It plans to invest €600m in 15-20 funds by the end of 2005.
Nielsen says ATP has a number of crucial areas which it needs to be satisfied with when choosing funds and that corporate governance is one of these. “The key is alignment of interest and corporate governance is one way to achieve this. We also like to see the fund manager or its owner having a substantial interest in the fund.”
He believes clear delineation of the responsibilities between the fund manager and investor can prevent a lot of problems from arising. “The investors need to be involved only in the major decisions; day-to-day management is the fund manager’s job. What you need is a clear understanding of who does what. You do not buy in to funds in order to do everything yourself!”
Nielson does not believe funds need independent non-executives to look after the interests of investors but says: “There is definitely a case, in specialist funds for example, for having an independent third party who can give expert advise to investors.
“For example, if we were investing in a Spanish logistics fund, ATP’s knowledge of this area is not great. So we would need an advisor to gives us an independent steer on matters. However, you don’t need a non-executive to mediate between fund manager and investor.”
Nor does he believe no fault default clauses are necessary. “We have a key person clause, because what you are paying for is individual or team skills. As part of our due diligence, we will look at the team involved and pick two to three people who need to be covered by such a clause.
“There are other default clauses, but these are only for major events. We don’t have no fault clauses because we believe having the alignment of interest secured – even insisting that key staff have a personal stake in the fund in some cases – is more important.”
He believes the corporate governance picture for investors has improved in recent times. “A few years ago, all the power belonged to the fund managers, but this has improved over the past 18 months or so.”

Peter Pereira Gray, head of property investment, Wellcome Trust
The wide variety of fund products available to investors is heartening, says Pereira Gray, but the same range of options is not available in terms of structure and corporate governance. “There is some reluctance on the part of fund managers, but as investors get more sophisticated, they will clamour a little louder for this.”
The way fees are structured (rather than the absolute level of fees) is an important part of corporate governance, he argues. “No-one minds paying high fees to a fund manager, but if you are paying high fees and not getting the performance in return, then it’s not acceptable.
“One example is fees on commitments. I’m not comfortable with this and don’t believe it is useful to apply to real estate. Another is the base cost for managing the assets, which is often very high. We are a direct investor and acquire and manage assets, but it doesn’t cost this much. Fees should be structured so performance is rewarded, not just being there.”
Pereira Gray argues for a total expense ratio to be published, which would give an estimation of the level of fees over the life of a fund. If it became an accepted standard, it would make judgements easier for investors.
He believes independent non-executives are central to ensuring good corporate governance and its desired result: alignment of interest between investor and fund manager. He says: “We need an investor say in the appointment of independent directors. They need to be experts with relevant skills, with strong reputations for fair dealing.”
The valuation process is an obvious area for strong independent directors to step in, says Pereira Gray. “Investors should ‘control’ this process, but as they often are unable to for statutory reasons, it is a role for the independent directors.”
Pereira Gray is also a supporter of ‘no fault’ default clauses. “It is not unreasonable for investors to ask for the ability to remove a manager for reasons other than with fraud or negligence – but with due notice and compensation.”
He does not like to see agreements where the fund manager is settled in for 10 or sometimes 20 years without investors having the power to remove it, apart from in the case of fraud or negligence.
“Changes can occur to an organisation over time. A fund manager can be very good now but be poor in five years time. Similarly, the manager’s circumstances can change, especially with so much consolidation in the fund management industry. If a fund manager is bought by a rival, it becomes a different company. This may be a positive in the long run, but it still means investors are not getting what they signed up for.”
Pereira Gray says investors are starting to demand no fault default clauses and are starting to get them from some fund managers. “The best fund managers understand this is not something an investor is going to do on a whim,” he says.
He points out that corporate governance is not just about pleasing investors, it benefits fund managers. Most fund managers would like to see the development of s secondary trading market in their funds. In the future, corporate governance practice could affect the pricing and liquidity of these secondary markets.

Timo Kankuri, head of real estate, Ilmarinen
Finnish pension fund Ilmarinen has more than €2bn invested in real estate, mostly in directly-owned property in its native Finland. However, Ilmarinen is now moving towards having more investments abroad and it is targeting indirect funds.
Corporate governance is an important part of the process in looking at new funds. Since drawing up an initial shortlist of potential funds, Kankuri has already declined to invest in two of them, mainly because of corporate governance concerns. The major problem was the ability of the fund manager to change strategy without consulting investors.
“It’s not just important to look at funds on an individual basis and see how their corporate governance is, we must look at evolving the whole concept. The increasing amount of institutional money allocated towards real estate funds means this type of discussion is increased,” he says.
He believes alignment of interest is the key to the process and that institutions need to be more involved in order to assure their interests are looked after. “It should be that major investors are part of the decision-making process. It needs to be more cooperative that before.”
He believes that a fund should be run by its board, with independent directors, with the fund manager concentrating on the real estate side. “The board should gives guidelines and take a steering role as with a company,” he says. “Independent directors are an easy solution to these issues. It is important that they are not too closely involved and of course not remunerated through the deals.”
Without corporate governance, a fund manager is free to run his business with other people’s money without accountability, he says.
Improving corporate governance will also benefit those who develop funds, Kankuri believes. If corporate governance standards are met it will serve the needs of longer term investors, who want to invest for more than five years. Funds with a longer life will, of course, benefit the fund managers.
Kankuri believes that who appoints the valuer is not as important as ensuring that valuers are rotated every three or four years. He is also keen to see a standardisation of valuation processes across countries and vehicles.
He also believes that consistency of management is important. “You need to have people there for several years.” In the event that things go wrong, Kankuri believes investors need to have the option to remove the manager, but not necessarily to liquidate the fund. “It’s not normally the assets that are in default, but the management.”
However, he says that it becomes difficult to remove the manager if it also sponsors the fund and especially if it also is a major investor in the fund. “You need to be able to take action, but it is hard to say what. If sponsor/investors have a role in the decision-making process than other investors don’t have the same rights.” he says. This is why, he says, having a balanced board which represents the interests of all concerned is so important.
Bodies such as INREV have a key role to play in the arena of corporate governance, he says. “We need to get it right early, rather than building up problems.”