Offshore funds – a REIT-off?
The Channel Islands compete with London and Luxembourg as a jurisdiction for the establishment of real estate funds. The challenge for lawyers and accountants advising on fund structures is to provide a balance between minimising tax at the fund level and the burden and costs of regulation.
Investment in real estate funds and other structures domiciled in Jersey and Guernsey is reckoned to be in excess of £100bn (€150bn). A large proportion of this comprises UK assets, with the majority of the balance being in Europe, held via Luxembourg. Will London land a killer blow with the arrival of the UK REIT on 1 January next year.
The UK REIT offers tax transparency, but at the considerable regulatory cost of a listing on a recognised stock exchange and restrictions on any investor holding more than 10%. The focus is on income return from well let property investment portfolios, designed to deliver a core investment product. It does not cater for core-plus and opportunistic investment strategies focused on capital returns.
Investors seeking greater returns will continue to find them offshore in both unlisted funds and more closely held co-investments. Many unlisted funds are well known and covered by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV), while co-investments have a lower profile and are generally established for a single asset or portfolio. The investors in both are a globally diverse mix of tax-exempt and tax-paying institutions. These structures provide tax transparency in a relatively light regulatory environment, on condition that access is restricted to professional and expert investors.
To maintain their market leadership the offshore jurisdictions must continue to focus on the regulatory environment. In Jersey an ‘expert fund' can be established in 72 hours by a regulated service provider. This is achieved by the delegation of the establishment and ongoing regulatory role to the service provider. Some 214 expert funds have been established since their introduction in February this year. The status is a variation of established Collective Investment Funds regulation and is dependent on restricting access to qualifying investors. In essence a minimum investment of $100,000 (€78,600) is required, although many expert funds set a far higher minimum investment.
The status is available for any kind of entity and during 2006 the author has established expert funds structured as limited partnerships, unit trusts and investment companies. Guernsey has introduced the qualified investor fund to meet the same need. The Jersey regulator is now considering whether the regime can be improved.
The expert fund is also winning regulated fund business to the Channel Islands from Luxembourg. Real estate funds with a European focus have tended to be established in Luxembourg. Expert fund establishment is considerably faster and cheaper, and recently several new funds have chosen the expert fund route. These funds are structured with a Luxembourg holding structure below the Jersey investor entity.
Introducing new investment structures to meet changing needs is also crucial to offshore jurisdictions maintaining their competitive advantage. Guernsey has attracted considerable business to its ‘Protected Cell Company' and in 2006 Jersey introduced its own legislation. The structure
provides for segregated investment entities each with its own investors, linked by common management and control. Individual cells can be established as professional investor schemes or expert funds and can be created within 72 hours. This structure is particularly suitable for fund managers establishing a series of asset or portfolio specific co-investments. The Jersey legislation also provides an incorporated cell company option under which each cell has a separate legal identity.
Attractive fund regulations and entities are a necessary condition for competitive advantage, but on their own are not sufficient. The third element of the regulatory environment is corporate governance. Listed real estate funds are subject to high standards of governance as a condition of being exchange listed. In the UK the Combined Code will apply to UK REITs. The relatively light offshore fund environment applicable to professional and expert investor schemes leaves governance to be agreed between fund managers and investors. Institutional investors in offshore real estate funds are increasingly demanding standards of governance comparable to those expected of structures in onshore jurisdictions.
Substantive governance not only ensures that management and control remain offshore, but is also effective in managing reputational risk. Institutional investors are subject to ever increasing media and regulatory scrutiny and pay considerable attention to safeguarding their reputations at an enterprise level. Investments in third party managed funds should be subject to similar standards of governance if reputations are not to be damaged via the ‘back door'.
Leading offshore service providers are meeting this demand through investment in training and recruitment of sector experts. In Jersey several chartered surveyors and other professionals with considerable property experience are employed by fund administrators. Highly trained staff have the experience and confidence to exercise effective corporate governance of the managers of unlisted funds and co-investments. This can assist the timely identification of matters of concern, but more importantly provides an important defence to media allegations of poor fund governance. These are particularly hard to rebut if standards of fund governance can be unfavourably contrasted with statements in the annual accounts and on the websites of investing institutions.
So does the UK REIT herald the end of the offshore real estate fund? In the immediate future the answer appears to be no, but it is likely that the UK government will refine the structure as has happened in the US and Australia over the last two decades. The offshore fund will only endure in the longer term if it continues to adapt to provide a competitive product. Revising regulation and legislation to meet changing needs is crucial, but these hygiene factors will not secure the future on their own.
To retain blue chip institutional and corporate real estate funds in an ever more demanding regulatory and media environment, offshore service providers must invest in highly trained staff capable of exercising standards of fund governance on a par with those of investors' domestic markets.