There is growing evidence that limited partners in real estate funds are seeking to delay capital calls. Richard Lowe explores what this means for alignment of interest and the options investors have when capital commitments cannot be met

Clear signs began to emerge from the end of 2008 that pension funds and other institutional investors, particularly in the United States, were struggling with a lack of liquidity within their multi-asset portfolios and an over-allocation to illiquid alternatives like private equity and real estate due to the denominator effect from falls in the values of global equities.

Reports in the press suggested many institutions were struggling to meet capital commitments from private equity funds, with some putting pressure on general partners to delay such calls or to negotiate a reduction in commitment.

For example, private equity firm TPG announced a number of compromises at the end of last year aimed at easing the liquidity pressures of their fund investors, many of whom were experiencing an exposure to private equity above their target allocation due to falls in the values of more liquid and frequently priced investments.

Limited partners (LPs) were given the option to scale back their commitments by up to 10%, and told they would benefit from a cut in management fees and a promise not to call on more than 30% of their committed capital during 2009 (unless otherwise approved by the firm's advisory committee).

Less has been reported about a similar trend arising in the closed-ended real estate fund sector, although there is evidence to suggest it is happening. In January, IPE Real Estate reported that a number of real estate fund investors were defaulting on capital calls or asking fund managers to delay them as they looked to rebalance portfolios and generate liquidity.

"We have experienced some of these issues already in a few funds where we have seen limited partners who were not able to pay their capital calls," said Michael Nielsen, head of real estate at Denmark's largest pension fund ATP, which is invested in a number of unlisted European and US real estate funds.

"We have also seen investors who try to convince managers to postpone capital calls," he added. Anthony Frammartino, principal at The Townsend Group, an adviser to US pension funds, is not aware of any closed-ended real estate fund managers replicating the measures introduced by TPG.

What he has seen is a number of investors negotiating with general partners (GPs) when they are committing to new strategies, such as in terms of how much capital may be committed over a given period. Frammartino says this is simply seen as a form of "cash flow management" on the part of institutional investors, given the current squeeze on liquidity.

Frammartino envisages that LPs could start asking for their capital to be returned if a particular fund strategy is "stale at this point". But he says a more likely scenario is fund managers will want to hold on to limited partners' capital to deal with liquidity issues within the fund itself or to ensure they have "a back stop there for potential issues down the road."

Heather Christopher, associate at another US consultancy, Ennis Knupp + Associates, does not have first hand experience of LPs in real estate funds looking to delay capital calls or reduce their capital commitments. But she certainly has "heard stories" to this effect, including a larger US pension fund - the lead investor in a fund - asking the GP to sell assets.

Christopher, who oversaw a $2bn (€1.54bn) indirect real estate portfolio for the Ohio Public Employees' Retirement System before joining Ennis Knupp in 2007, explains that it is much more of an issue for larger US pension funds, which are more likely to have a greater exposure to illiquid alternative asset classes.

"Real estate allocations are now above their target and many of these funds also have liquidity issues," she says. "There have been cases where, just in terms of cash, [it] has been difficult to get it from custodians just to make monthly payments to their members."

Michael Dudkowski, managing director at Wilshire Consulting, another investment consultant to a number of US pension funds, agrees that there are LPs in funds seeking to delay capital calls. However, he points out that most GPs that Wilshire works with are attempting to be "a little more proactive with their clients", such as providing advanced lead times and better, fuller communications, so that capital calls "don't just show up unexpectedly".

Meanwhile, Greg Wright, a consultant who moved from Mercer to KPMG at the beginning of the year and who has experience of advising UK and continental European pension funds, says clients he has worked with who chose to invest in closed-ended funds had always been advised to hold "plenty back in reserve" for capital commitments.

He understands why investors have run into such liquidity problems though, especially since very few predicted equities to fall quite as drastically and comprehensively as they have done.

"What's caught investors out are assets they thought would be relatively liquid, which… they can't really call upon now," he says. "Equities have fallen in value and they won't want to realise those, and, similarly, if they've got corporate bonds, those have become very expensive to trade as well. So, probably the only the things you can realise at the minute would be gilts. And I guess a lot of institutions don't want to do that, because they are there for a reason: to match liabilities."

If certain LPs in a fund feel compelled to ask fund managers to delay capital calls, this raises questions about alignment of interests among investors. Such moves may concern those investors who are willing and able to fund their capital commitments that the overall performance of the fund is being put at risk.

Nielsen certainly believes there is a very real risk from postponing capital calls. "If managers have really identified a good deal in the market and they cannot do it because investors are not ready to pay them, it is a more serious problem," he says. "It can then, in the end, have a negative impact on the overall returns of the fund." Nielsen also points out that fund managers have no alternative to LPs' equity to turn to.

"A manager cannot go to a bank to ask for further borrowings to cover that," he says. Günther Schiendl, CIO and member of the board at Austria's largest pension fund VBV, observes that capital calls in one particular fund in which the pension fund is invested have emerged at a slower pace than originally expected.

"What we have seen is that some capital calls are arriving at a slower pace than expected some 12 months ago," he says.   

However, both US consultants Frammartino and Christopher believe that the risk posed by delaying capital calls is minimal as it stands at the moment.

Christopher says, while the situation may change, there are very few real estate transactions at the moment and most buyers are very cautious. "A lot of these funds that have capital to deploy aren't necessarily anxious," she says.

Furthermore, funds that have invested at the peak of the cycle, in 2007, may be facing significant write-downs on their assets and having to address the disappointment of their investors who may well be "urging them to be more cautious in future," he adds.

Frammartino agrees. He admits the situation could change, but says: "Most managers are not doing much right now anyway. If you really look at the equity strategies, most of them are not buying. For most of the managers, to the extent that they have called capital, it's been for previous commitments and shoring up their own balance sheets… I don't know if hey are going to miss any opportunities because of it."

Dudkowski sees a similar scenario: that GPs are generally not needing to make capital calls, but this could easily change. "I am speaking to a lot of real estate managers who are very excited about the opportunities they expect to find in the coming years as a result of dislocations in the real estate market," he says.

"Some are even bidding on quite a few properties, but the pricing hasn't met their criteria for the most part and so there really hasn't been a significant need for that capital to date - or at least within the last few months.

However, he adds: "At some point that could change and pricing might be such that there are attractive opportunities out there."

While Nielsen is aware of LPs defaulting on their capital commitments Nielsen, the examples so far have only involved "quite small investors", he says. He would be more concerned, however, if LPs with larger stakes in funds were to default or put pressure on GPs to postpone capital calls.

"It will not have a great impact if smaller investors default, but it is more crucial if larger investors default," he says.

Unfortunately, there is not much an investor like ATP can do to prevent this from happening. But investors can be prepared for the eventuality by familiarising themselves with the terms and procedures that will apply should such a scenario arise.

"We have to look into the documentation and see what has been agreed in such a situation and if it differs a lot from fund to fund," Nielsen says. Volker Wiederrich, chief investment officer at fund of funds manager Swisslake Capital, believes the counterparty risk of other LPs is an issue for all real estate fund investors today.

"It is definitely a topic, not only that you know the management of the fund, but indeed that you also know who are the other investors," he says. The consequences for an LP that defaults varies between funds and so Wiederrich says fund managers and investors have been compelled to "read their prospectus again" in recent months.

"Many investors and fund managers have never thought about something like that over the last, say, five years," he says.

While the consequences of defaulting on capital commitments can vary from fund to fund, it is likely to be severely costly for the LP in question. Fund managers can be expected to stand firm on the issue and for these reasons the potential for a growth in secondary trading - where investors sell stakes in closed-ended funds (or units in frozen open-ended funds for that matter) - has come to everyone's attention.

"If there are some investors who are looking to withdraw from something they have committed to… then we would say that is potentially opening up opportunities for other investors to come in and acquire those assets," says KPMG's Wright. "Potentially there could be a reasonable amount of client activity looking to invest on that basis. So, for those who are looking to go back into or into [for the first time] the global real estate market, this could be a good pricing opportunity."

Wright expects it will be difficult to convince GPs to allow investors to negotiate out of capital commitments, that is, "unless all the rules of the game have changed," he says. "The historic response would be: ‘No, sorry, if you can't meet the commitments then you are either in default or you need somebody to take it up on your behalf'. Hence, the potential glut of funds coming onto the market from now on."

There are a number of secondary market fund managers focusing on the real estate sector. Landmark Partners is one such firm and managing director Paul Parker says he joined the firm from DTZ last June because he foresaw a significant rise in secondary trading among real estate funds.

Parker says Landmark is fielding a growing number of calls each week from investors who are looking to the secondary market as a potential solution to free up their capital commitments. "We are seeing unprecedented volumes of transaction opportunities," he says.

Feedback from the market suggests to Parker that GPs of closed-ended funds are by and large sticking to their guns - that is, unwilling or not in a position to allow LPs to reduce or negotiate out of their capital commitments, forcing them to look to secondary trading as their only option.

However, it has been suggested by some sources in the industry that a situation could arise where an investor might conclude that defaulting on its capital commitments was actually a less costly course of action than following through with capital calls.

This might be the case where an investor had committed to a highly leveraged opportunistic fund, which had begun investing at the peak of the market in 2006-7 and whose equity had been completely wiped out. In effect, investing further capital could be seen as "throwing good money after bad".

Commenting on this, Dudkowski says "I haven't specifically heard of anyone considering doing that, but I would imagine that's a case-by-case decision," he says. "That seems like a pretty drastic measure, perhaps even more so than selling your interest on the secondary market at a deep discount."

Dudkowski: LPs delaying capital calls