Fund of funds can play a vital role for investors keen to diversify in a crowded funds market. However, conflicts of interest and double fees remain a concern, as a recent INREV study shows. Andrea Carpenter reports
It has taken just eight years for the property fund of funds sector to grow to €20bn and for these vehicles to become important players as both managers and investors on the European non-listed property funds scene.The strong growth has also been matched by the increasing breadth of the vehicle's appeal; it is now attracting a broad range of investors, throwing off its image as a vehicle that is the preserve of the smaller investors. In addition to the smaller investors that were first attracted to fund of funds, large institutional investors are now using the vehicles to gain access to emerging markets and best-in-class managers while the sector is also attracting new investors for their first allocations to non-listed real estate.
INREV commissioned a piece of research recognizing the fact that alongside the growth of the sector there was a need for more understanding on how fund of funds work and their key distinguishing features as well as benefits and drawbacks. This also needed to include some of the issues raised in relation to fund of funds: the facts behind the payment of ‘double fees' and concerns about conflicts of interest.The growth of fund of funds is linked to the increasing number of real estate funds in Europe, which has made fund selection progressively more difficult for investors. This has made it almost inevitable that a bridging service between the investors and the underlying funds would be capitalised on by fund of funds managers. This potential is expected to continue to grow as the number of fund offerings increases globally.Recent major trends in the non-listed real estate funds industry have also been integral in supporting this growth. The trend to diversify beyond domestic borders has resonated through all sizes and types of investor. Fund of funds have therefore been attractive to those investors looking for diversification but which feel constrained by the size of their real estate allocation, their own internal resources or the sheer scale of the investment into infrastructure required to put the proper resources in place.Latterly, development in fund of funds has extended globally. The concept is portable and works well in taking experienced and non-experienced investors to emerging markets where few investors have a track record such as Asia. Some fund of funds have also sold themselves on a ‘manager' strategy, offering the opportunity to benefit from its ability to select best-in-class managers. While the benefits for investors vary, fund of funds managers seek to offer investors one or more of the following benefits: Diversification by gaining access to a wide range of investments (and large pool of underlying assets) via a single allocation; Ability to gain diversification with a lower allocation compared with setting up individual non-listed real estate funds; Access to the real estate market without the need to set up a real estate team or local infrastructure; Exposure to a diversified mix of countries, sectors and/or players where investors do not have expertise or local representation; Outsourcing of manager and fund selection.
The INREV funds of funds database comprises 46 fund of funds, run by 23 managers, with total target equity of €16.1bn compared with €2bn in 2000. INREV estimates that this database covers about 90% of the universe for Europe and Asia. It estimates that the size of the universe is around €20bn total target equity, which also allows for the five funds in the database that did not disclose their target total equity.
The first fund of funds was set up in 2000. However, the significant growth by number has taken place in the past three years, with 13 new funds set up in 2006 and 16 in 2007. By region, 55.5% of the target total equity is focused on Europe with 28.2% targeting Asia. While some bias in the data is possible because of INREV's focus on European players, the proportions do typically reflect the global development of fund of funds which interviewees confirm is driven by Europe and Asia. Fund of funds have become established in Europe following rapid growth of the underlying funds market.
By sector, office and retail are the most popular target sectors in the database at 32.6% and 27.8% respectively, which mirrors their popularity in the general INREV Vehicles Database, which covers non-listed real estate vehicles.
By style, 41.1% of funds are targeting a value-added approach but in line with most fund of funds this is likely to be a strategy based on a blended investment approach across the three styles. Core and opportunity strategies are equally targeted by fund of funds at 29.0% and 29.8% respectively.
In terms of investor size, the preconception that fund of funds are mainly for smaller investors comes as it attracted those investors that do not have a large enough general allocation to real estate to make direct or non-listed allocations individually.
However, with the majority of responses to the survey coming from INREV investor members, the fact the 43.3% are already invested in fund of funds starts to knock this preconception. Investor members of INREV tend to be larger pension funds, insurance companies and sovereign wealth funds. Participation by larger investors is also supported by the results of the survey, which show that 41.7% of the sample has allocated €50m or more to fund of funds. At 58.3%, the majority of investors have only invested in one fund, with 25% invested in two and 16.7% in three. These larger investors are now using fund of funds for a range of strategies such as to access new markets or those with a keen focus on sourcing best-in-class managers.
Larger investors have also been joined by investors new to non-listed real estate. Results from the fund of funds managers' survey show that 74.4% of fund of funds include first-time investors in non-listed real estate in their vehicles. These are investors that wanted to take advantage of the performance of fund of funds but were restricted by resources or expertise to do this individually.It has been viewed that the vehicles would be an education route for these new investors into real estate who would use it as a learning curve before investing directly into non-listed funds on an individual basis. The results from our investor survey question this theory, with 75% of those respondents who do not have other underlying fund investments having no intention of pursuing this.
The research also examined what both investors and fund of funds managers saw as the pros and cons of fund of funds. Diversification ranks highly with both categories as did the outsourcing of manager and fund selection.
The lowest-ranked benefit was seen to be the outsourcing of reporting and other operational infrastructure but this might result from the sample including fewer smaller investors. Again, fund of funds managers who were interviewed said this was a main advantage for investors, particularly those with small real estate teams or no dedicated real estate experience in house. In many cases, this benefit came up as part of the justification from fund of funds managers in terms of the two layers of fees.
For drawbacks, the costs involved with fund of funds are still seen as the main obstacle for both the managers and investors. Around 93.3% of investors cited this reason.
The basic fee structure is a simple two-layered approach but is more commonly known in the industry as ‘double fees'. In addition, 73.5%, the majority of fund of funds, charge a performance fee.For many established investors, this additional management fee is difficult to swallow knowing that they have the resources and expertise to make this investment on their own behalf. For smaller investors, though, many justify it as the pay-off for not having the real estate experience and infrastructure in place to undertake the investment, whether in home markets or target international markets. The increased interest in funds focused on emerging markets also shows that more established investors are prepared to take on the fees to give them access to markets they have less experience in themselves.
The lack of portfolio allocation/weightings control was the second greatest obstacle with 53.3% of investors and fund of funds managers reporting this. However, with more than 50% of the sample invested in non-listed but not via fund of funds, this may be more a reflection of the sample. The two obstacles that were highlighted by investors but downplayed by fund of funds managers are those of potential conflicts of interest and alignment of interest. Conflicts of interest are in many cases linked to the strength of the Chinese walls within organisations, an issue that pure fund of funds managers sidestep easily. Fund managers that do not have a multi-manager or fund of funds operation have raised concerns about distributing fund memoranda to fund of funds working within broader real estate fund management houses as these in theory could be passed on to the funds' team and used for competitor analysis.There are also concerns over fund of funds managers investing in their own in-house funds. The concerns from investors for this practice are whether the in-house fund is the best-in-class fund of that type within the market. There are also issues around the fund management house receiving two lots of fees from the investor. Fund of funds managers that invest in internal funds stress that their team would work independently from the funds team and that it maintains a strong scrutiny process for this type of investment. The results from our fund of funds survey show that investing in the fund managers' own funds is not a favoured approach within the industry, with 20.6% ruling out the approach for their current strategies. However, this is influenced by the fact that some respondents run stand-alone fund of funds operations so have no funds to invest in. When a fund of funds manager runs several vehicles, investors commonly raise concerns about which fund investment is allocated to which fund of funds, particularly as many invest across the style classifications to produce a blended return. Fund of funds managers tend to have a policy to deal with these potential conflicts with the solution likely to be that each fund of funds gets a pro-rata share of the investment. In practice, the likelihood of it happening tends to be rare as fund of funds managers with several vehicles will have gone through the investment periods for these vehicles at different times and work this way to avoid the conflict.
How do funds of funds operate?
Fund of funds managers have developed via four different operating platforms:
Andrea Carpenter is director of research and market information at INREV