Swings and roundabouts
To help investors compare funds and to increase transparency from an early stage, European Association for Investors in Non-listed Real Estate Vehicles (INREV) set up a working party to identify definitions which could become common across the European industry for non-listed funds. One such definition is that of "open-ended" funds, which means different things to different people.
To most people, ‘open-ended' means that the investor is able to invest and redeem their holdings at regular intervals at a price pegged to the net asset value (NAV) of the fund. The regularity of dealing and the pricing of the equity on the way in and out of the fund vary between markets.
A fundamental difference exists between those open-ended funds available to private investors and those focused on institutional investors. Typically, the former offer daily dealing while the latter have periodic redemptions at monthly, quarterly or annual intervals. In extreme market conditions the manager or fund sponsor would be permitted to defer or suspend dealing for a period.
Given this widely held understanding of the "open-ended" perception outlined above, the INREV guidelines makes the following recommendation: "To be defined as an open-ended fund the notice period for redemption of the whole investor's holding should be no longer than 12 months and the fund manager's suspension rights should be for a finite period of no longer than two years."
Are redemptions guaranteed in all markets? In current market conditions where investor demand exceeds property supply it is easy to believe that property markets offer sufficient liquidity to allow frequent redemptions. However, in reality the three-month notice period adopted in many institutional funds is rarely sufficient. Three months from the decision to sell a property asset to the completion of a sale is extremely short even in the most liquid and transparent markets. Therefore, a guaranteed redemption requires the manager to have a close relationship with existing investors and to be prepared for formal notification of changes in redemptions.
As managers and sponsors seek to reach out to more investors, it has become increasingly common for funds to be marketed as "open-ended" or "semi open-ended" even though the redemption provisions do not guarantee exit to the investor. Typically such funds offer redemption on a "reasonable endeavours" basis that requires the manager to meet any request through available capital. The manager may not be required to liquidate investments or increase gearing to meet such a request and therefore the timing of redemption is uncertain. This goes to the heart of the perception issue over "open-ended funds".
Another strategy is to limit the proportion of the fund's equity that can be redeemed at any one time. This is normally on a first-come-first-served basis or pro-rata to the equity held in the fund. Either way the effect is to increase the time that it takes investors to reclaim their capital. These strategies are valid for the well-advised institutional investor who can assess the impact of the liquidity mechanism. However there is a danger that investors are misled into a fund that they understand to be "open-ended" in the traditional sense of the words. It is in no one's interest for this to happen and therefore the INREV definition seeks to limit the use of the term "open-ended" to those that guarantee a level of liquidity.
True liquidity comes at a price. For funds offering daily dealing it is common, and in some countries mandatory, to hold 15-35% of assets in cash or other liquid securities, and gearing is rarely permitted. In rising markets funds that offer frequent dealing will invariably lag behind less-liquid closed-ended funds. This is due to the drag on performance created by their cash holdings and the lack of return enhancement created through gearing. In falling markets assets have to be sold to meet redemption requests even though they may not have reached their potential. Alternatively, for the fund of funds investor, allocations to markets that offer greater liquidity may not be justified by the performance potential of that market.
Portfolio construction must take into account the liquidity rights of investors. For example, portfolios are usually well diversified without significant exposure to a single asset. This may mean that some funds are unable to access all markets due to lot size constraints, ie, the cost of property assets is so high that diversification cannot be achieved with the amount available to invest. In addition, the exposure to development projects or unstabilised assets would be limited as they tend to have limited liquidity until completion. All these issues may impact on the returns that can be achieved.
In some, but not all, markets there is sufficient liquidity in the underlying real estate in most market conditions to offer an open-ended structure that meets the INREV definition. However, there are numerous challenges in constructing the optimal portfolio of sufficient scale, which meets both the liquidity needs and the performance expectations of investors.
Institutional open-ended funds will continue to play a significant role in many markets. They give investors, requiring varying degrees of liquidity, access to property returns based on appraisals as opposed to the volatility of the public markets.
It is important that the opportunities for liquidity are not exaggerated and investor perception and reality remain as one. If industry participants wish to expand the use of "reasonable endeavour" redemption clauses in open-ended funds they will need to change investor perception as to the meaning of open-ended.
The non-listed property funds industry has made significant progress in gaining investor confidence during the last 15 years. It is vital that this is not prejudiced when market conditions weaken and some investors choose to cash in their chips.
Michael Clarke is head of property distribution at Schroders and chair of the INREV working party on industry definitions