Corporate governance has been described as the “architecture of accountability”. How satisfied are primary investors with the accountability of real estate managers and their funds? IPE asked several major investors for their views on the subject.
Our questions – which were supplied by Jonathan Fenton at law firm DLA Piper Rudnick Gray Cary - included the following:
n Is limited liability essential in terms of your commitment to a fund?
n What kind of protection do you insist on under the fund’s documentation? (Including: diversification and concentration limits, maximum gearing limits, investor consent on disposals and acquisitions, manager’s liability for losses incurred through breach of terms, professional indemnity insurance, investor consent on fundamental changes to fund terms, investor advisory committee rights, loss of key individuals from manager teams)
n What kind of transparency do you expect from managers’ fee structures? (Including: base fee calculation, performance fee calculation, introduction fees, abort cost accounting, clawback and retention arrangements for profit share not justified over life of fund)
n What are your feelings on manager conflict of interests? (Including: creating new funds with competing investment objectives, availability of co-investment opportunities, obligation on managers to present all suitable investment opportunities to the fund)
n Are the frequency and content of managers’ reporting procedures sufficient for your needs?
n What guarantees do you expect regarding the closing/possible extension of fixed term funds?
n What kind of frequency do you expect for redemption rights in open-ended funds?
n Do you insist that a proposed fund is regulated by a national, supervisory body?
n What is your attitude to a manager’s disciplinary history with supervisory bodies?
Ilmarinen Mutual Pension Insurance Company
According to Ilmarinen’s investment policy, we don’t make investments with unlimited liability (partly due to the investor’s limited decision-making ability in these funds). It’s a part of our diversification strategy.
All the investor protections you identified in fund documentation are either quite important to us or absolutely unconditional. The precise content may vary according to the nature of the fund (core/opportunistic) or how much confidence you have in the manager’s work and organisation.
It also depends on the structure of the fund (open-end or closed-end). As for open-end structures, they should have quite flexible investment limitations due to changing market conditions. However, we insist on well-defined investment restrictions which are legally binding (not just guidelines) for closed end funds. All major changes in funds documentation should be made with the investors’ consent - at least 66% approval.
Transparency in fee structures is good especially in a vehicle like an indirect fund where the investor’s role is limited to a seat in the UAC.
I do understand the manager’s business logic in putting together a fund and running it, but in order to create a mutual understanding (alignment of interest) between the investor and manager there should be room for discussions about all the issues you have highlighted. It creates confidence that the manager is on the same side of the table as the investors. If that is not possible the investors will probably not make any commitments to the fund.
Manager conflict of interests is a very tricky territory. We do know that some managers have an appetite to develop new funds or activities (and they have the right to do so). The more the fund manager is willing to inform and discuss beforehand the better. Unfortunately these issues are very difficult to resolve because the logic of the investor and manager business is totally different.
In terms of reporting procedures, this can easily been taken care of when negotiating the deal with the manager so the answer is “yes, they are adequate”. We are happy with quarterly reporting. However, the fund managers should try to squeeze the timetable of the delivery process.
When it comes to who should bear the cost of establishing a fund, I think it would be fairer if the fees would be charged on actual costs. Most of the big fund managers already have their organisation and skills in place when establishing a new fund.
If the fund has an open-end structure it’s very important that it’s regulated. As for closed-end funds it’s not required.
The track record of the fund manager has to be good in respect of the appropriate supervisory bodies. If not, it will be a deal killer.
FENNIA MUTUAL INSURANCE COMPANY
Limited liability is essential in the sense that we can’t take any responsibility above and beyond our investment in a fund. Our due-diligence process is designed to ensure there won’t be any terms which increase our responsibility in the case of the fund incurring debts.
A fund’s documentation limiting the authority of the management company is extremely important. And the clauses should not be just targets, they should be complied with 100% by the manager.
Neither should they be able to change them over time, we look at this particularly carefully. We expect the investors to be consulted and to vote on any changes to the documentation. We also insist that there should be a unanimous decision when changing rules as we are usually a minor investor.
Conflict of interests, such as a manager setting up competing funds, is a difficult issue. You have to rely on the manager’s good faith to do what they say they will.
Legally, I don’t think it’s possible to oblige them to follow a certain course of action.
Mostly managers are not thorough enough on reporting, but they do tend to be flexible: if you need more information they won’t deny it. But it would be better if they had a system satisfactory to all investors so that you don’t need to ask them.
When it comes to opportunities to extend the life of closed-end funds we are very supportive because the absolute necessity to sell off the properties in a fund within a certain timeframe could be very harmful to values.
The fees and costs of setting up a fund are usually covered by the capital in the fund once it has “succeeded”. Mostly, these fees are huge. We understand that the risk for gathering the investment money is of course with the management company, so they should be rewarded if they are successful. But the fees could be more realistic.
Management fees are complicated by the fact that there are many different types of organisations involved in the fund management business and they all have their own systems. They are very reluctant to explain them thoroughly. It’s important to know, for example, that the personnel they are proposing to handle our investments are happy with their employer and their remuneration. More information in this area would be welcome.
In answer to your question about the disciplinary record of managers with their supervisory body, I would have to say that our view would depend on the issue and how serious it was.
Jens Christian Britze
ATP REAL ESTATE
ATP is a pension scheme supplementary to the Danish state pension. Contributions to ATP are compulsory in respect of all Danish employees. The total investment assets as per 30 September 2005 amount to €42.3bn, of which approximately 5% is allocated to investment in domestic and international real estate.
Limited liability with respect to investing in property funds is crucial. We need an absolute investment limit on each fund investment.
Generally we seek investments of a size that will allow ATP representation on the fund’s advisory board. This is not to get involved in the fund’s day-to-day business or in specific investment transactions, but to make sure that ATP’s voice is heard should important changes to the fund terms be proposed subsequent to our subscription.
We would expect that fundamental changes to fund terms are subject to investor approval – and preferably by “supermajority”, depending on the issue in question.
We insist that a fund’s investment strategy is well defined from the outset. This would include preset limits on sector and country allocations and maximum gearing.
In relation to the fund management team, we define who we see as the most crucial people for the fund’s success and will usually seek key-man protection on these individuals. This, however, will differ with the fund’s strategy type, the extent of the fund manager’s affiliation to a larger organisation and so on.
Should an appropriate replacement for a key-man not be identified by the fund manager we want the ability to stop further draw-downs and/or wind-up the fund.
Professional indemnity insurance cover will be required for the fund manager.
The fee structure will need to be very transparent and we welcome fee simulations to fully-appreciate the working of the structure. Our analysis of the fee structure should be seen in the wider context of both evaluating the general attractiveness of the fund and the alignment of managers’ interests with those of investors.
Our view on structuring a fee package is that the base fee should not be profit-generating for the fund but that it should be the mechanism for recovery of costs. The profit element should be contained within the performance-related part of the fee package. The performance-related part of the fee should be back-ended, although we would perhaps consider a carefully drafted clawback mechanism combined with an effective escrow arrangement. We will not be put in a situation where we are dependent on the fund manager’s ability to repay an over-allocation of performance fee.
We would also encourage fund managers to relate costs to the fund types. For example, a core fund with a lower IRR target and gearing should, inter alia, have lower asset management fees due to limited active management resources.
It’s important that the fund manager’s organisation is able to provide its full attention and ability to the particular fund invested in by us. Where this is not achievable, the procedure for managing the conflicts between different fund products must be convincing and well documented, and must be supported by the fund manager’s track record on this issue.
We would much rather concentrate our time on ensuring that the terms of the fund are appropriately drafted to make sure that the risk of conflicts of interest is reduced as much as possible, rather than act as an arbitrator through our advisory board representation. But saying that, should conflicts of interest arise, we would expect to be involved in solving them through our advisory committee membership.
We welcome – and in higher risk products, require - co-investments by the fund manager and key employees as a method for ensuring alignment of interests.
As regards frequency of reporting we see that fund managers usually appreciate the investor need for frequent reporting. Regarding detail of reporting, the standard differs substantially between fund managers. We would always carefully analyse a fund manager’s standard reporting package as part of our due diligence procedure and will, more often than not, require that further detail be provided.
To make sure that we get the required reporting from a fund we’ve invested in, we would always ask a fund manager to commit to our proprietary “Information Requirements” up front.
We would usually expect that a wind-up of a fund prior to expected life-end requires unanimous or “supermajority” consent. For an extension of a fixed term fund, the reasons for extension beyond the possibilities allowing for a proper wind-up would need to be evaluated taking circumstances into account. The business case for extension must be strong. We would also expect that investor consent is needed.
Our requirement for frequency of redemption rights in open-ended funds would depend on the individual fund. What is obviously important is to strike the right balance between allowing investors to leave and not disturbing the fund operations unnecessarily.
We don’t insist that a proposed fund is regulated by a national supervisory body. A manager’s disciplinary history with a supervisory body is an important issue for us because it will be a reflection of the firm’s internal controls.
Limited liability is essential for us when it comes to investing in funds, we don’t invest on any other basis. The kind of protections investors enjoy through the fund documentation are very important, we’re very vigorous on this, and it forms an important part of our due-diligence process.
Our potential role on the investor advisory committee depends on the size of our commitment to the fund. If it’s a strategic investment then we expect a voice on the committee, if it’s a smaller, fringe investment then we would not expect to be represented.
Transparency on fee structures still has some way to go. The situation has improved but it can still be a problem and there is a lot to be done.
Similarly, on the attribution of costs in funds: some managers are working on this and making it clearer, but in general you still have to ask an awful lot of questions before you get what you want.
Manager conflict of interest such as the creation of new funds with competing investment interests, or not presenting all suitable properties for acquisition, has always been a problem and continues to be so. You always have to be alert and work on it and you can only manage it through good communication with your investment managers. But basically it remains a problem with no real solution. You can’t really look to legislation or law to help you with this.
Managers’ frequency of reporting is sufficient for us, but the content we work on with the manager to meet a common structure or platform. It’s always a problem when you have several managers, each supplying information in a different way.
When it comes to a manager’s key personnel I take a very big interest in the subject. If key personnel intend to leave I like to know in advance. But I would not be involved in choosing their replacements, that’s the manager’s responsibility.
When fixed-life funds are approaching their end I want to get out and don’t want to be mixed up with other interests of other parties. So I would not be comfortable with extensive arrangements to extend the life of fixed-life funds.
In open-ended funds, the frequency of redemption rights is a key question. It depends on the structure and the way you conduct the business.
But the manager must work with the investor to understand their needs: at times there has to be some way out of the fund. But conversely you don’t want so many transactions that you de-stabilise the fund. It’s a balance and good communication and flexibility are required to make it work.
As far as your question on funds being registered with supervisory bodies is concerned, I have to say that we can’t work with the German bodies all the time. We like special vehicles and we make use of Dublin-based vehicles, Luxembourg vehicles and so on. When it’s possible, we welcome supervision, but it’s not a pre-condition of investing.
We enjoy good communications with the German supervisory bodies and if they had a problem with a manager we would know about it and act accordingly. Obviously, our response to the situation would depend upon the seriousness of it.
Blue Sky Group for the KLM pension funds
The limited liability status depends on what you’re trying to achieve. There is no simple answer but we try to keep it as an individual issue rather than a fund issue.
The clauses in the fund documentation are very important and we take them all seriously. But the difficulty about the debate - especially in terms of private funds - is that the documentation tends to be the view of the fund manager and it assumes that all investors are thinking alike about these topics.
Take a simple example like fund liquidity, one investor could be saying that the way I make sure my liquidity is safe is by making it a closed-end fund, while we tend to be proponents of open-ended funds with certain pre-arranged dates when a fund manager and its shareholders will sit together and decide whether to continue or not. It’s the same with corporate governance in general, you could say that at the end of the day the manager is fully-responsible for it or he could also create a process through his entire policy where he makes sure that, for example, once every three years he will communicate with his shareholders about the strategy to pursue.
This would avoid him becoming frustrated by interference in his day-to-day running of the fund – which we want to avoid also. This shareholder approach is still lagging a bit and we would like to see it more widely adopted.
The investor voice on the advisory committee is not so critical to us providing all other conditions are being met. I might be quite knowledgeable on real estate in general but if a fund decided to invest in Turkey I wouldn’t know if it was a good idea or not – what would be the point of my voice in an investor’s committee? It’s more important that the total checks and balances are in place.
There’s a long way to go on transparency in fees and cost structures. I’m making a presentation shortly for which I researched the UK unit trusts and found there was no relation between fixed fund costs and performance nor any relationship between fixed fund costs and the size of a fund. Our philosophy is that a fund should be paid on an annual basis sufficient to keep it up-and-running in the proper way (otherwise it would also hurt your assessments) and pay for performance when it is delivered. Alignment is key.
A lot of fund managers are launching a series of funds one after another so you may wonder which funds have their priority. One of the things we are looking at in this regard is the key-man clause because if you have an agreement with Mr X, then Mr Y replaces him and fundamentally disagrees with you, what does that say about the agreement?
In terms of reporting procedures I think it’s important that managers do not regard themselves as being on “automatic pilot” when it comes to reporting. For example, we have a manager in the US who is has recently acquiring a building which was damaged by the hurricanes. His reporting frequency is quarterly but lately he has sent an e-mail to all investors explaining the situation and estimating the damage. Then you know how it’s playing in your investment. That’s how it should be.
On redemption rights in open-ended funds our view would be maximum flexibility.
But most managers are wrestling with how they should tackle the costs involved because buying and selling buildings is expensive. How should it be treated on a fair basis to existing shareholders? It can be resolved as long as everybody agrees, but there can be big disagreements.
Fund supervisory approval is
not always possible because local markets can insist on different legal requirements such as valuation procedures and so on. Sometimes
you can use INREV’s best practice rules to try to achieve common agreement.
A disciplinary record is not a good thing, obviously, but it depends on the circumstances. If it’s a serious, illegal practice then I’m sure that we wouldn’t invest with such as manager. But it would have to be considered on a case-by-case basis.