The comfort factor

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In the area of real estate investing corporate governance focuses on the way funds are run, including their board structures, how decisions are made, how the strategy is set and how the results are reported to investors. Guidance exists aplenty in the listed sector, but not in the unlisted sector. Unsurprisingly therefore, the standards of corporate governance are lower in the unlisted sector and this is being addressed by INREV.

This article examines how corporate governance is good for investors, managers and funds in the unlisted real estate fund sector and the initiatives INREV are undertaking to address these issues.

There is plenty of evidence in the equities markets that activist investor funds which engage through good governance significantly outperform the returns of their markets. The converse is also true, namely that bad governance leads to underperformance. There have been many spectacular examples of extreme corporate failure and in almost all cases, bad governance was endemic. Put simply, good governance leads to better managed funds which outperform in the long run.

In the unlisted real estate funds, investors should seek better governance when investing in funds run by entrepreneurial managers operating in less regulated markets. Likewise, managers should strive to demonstrate better governance as a potential source of competitive advantage. For example, good corporate governance is often cited as a reason why institutional investors would choose listed vehicles, such as REITs, over unlisted vehicles. If this point of difference is removed, then funds can compete more directly for those investors.

INREV (the industry body for unlisted real estate funds in Europe) has been seeking to address corporate governance in unlisted institutional real estate funds. Survey evidence gathered by INREV indicates that nearly half of all investors and managers believe corporate governance is not adequate in most unlisted real estate funds in Europe. Although the position improves slightly in 2006 compared to 2005, there is much to do.

In response to this issue, INREV constituted a working group of investors, managers and advisers from across Europe, together with a consultant with a legal background. Draft principles and guidelines were presented to the INREV Rome conference in April 2006. After a period of consultation, the final principles and guidelines are due to be published later this year.

INREV have based the guidelines around seven key principles which should be inherent in the way funds are run, applied to managers, non-executive officers and investors.

These are:

q Laws and regulations;

q Constitutional terms;

q Skill, care, diligence, integrity;

q Accountability;

q Transparency;

q Acting in the investors' and the fund's interests;

q Confidentiality.

The main features of the guidelines are the need for managers to be accountable to investors, for transparency in fund reporting (balanced against reasonable confidentiality) for interests of all parties to be aligned as far as possible, for conflicts of interest to be managed and for all parties to exercise skill, care and diligence.

A key feature of corporate governance is the mechanisms for investors to control their investments. Investors require some checks and balances on the way a fund is run. This can be achieved by reserving certain key decisions for investors and this can work effectively where a small number of investors are involved.

In many funds, however, there are too many investors for this to be practical. The solution is the appointment of a person or persons independent of the management (and crucially not remunerated in line with performance) who can be involved in the workings of the fund and act as a control over the manager in the interests of all investors, the non-executive officer role.

There are many situations where non-executive officers can bring real value to a fund. For example, the X-Leisure Unit Trust is an unlisted fund investing in leisure property in the UK in which Hermes is the fund manager, but which also has two independent directors. These independent directors are actively involved in the business of the fund, and give comfort to investors, particularly if there are conflicts, such as if the fund acquires assets from the manager.

INREV's objective is to encourage good governance in unlisted real estate funds throughout Europe. This can only happen if investors demand information on corporate governance in the first place.

Managers should 'comply or explain', which means that they report on corporate governance in their own funds, and how they measure up against the guidelines. If a fund does not think that a particular recommendation is appropriate, then they should explain why. This review should be completed at the launch of a fund and thereafter annually.

As more information becomes available, evidence will grow demonstrating that better-managed funds deliver better returns for investors. This creates competitive advantage for those funds. Over time, therefore, a corporate governance 'virtuous circle' should emerge.

In the current market with considerable investor demand for all investment products, failure by a manager to pay full attention to corporate governance may not be detrimental to that fund's success. Markets can change however, and there will be a time when managers will have to compete more strongly for available investors. In such times, good corporate governance will be a competitive advantage.

INREV's goal is for corporate governance to be better understood in unlisted real estate funds in Europe and to become a key factor in pointing investors towards better performance.

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