Reassess investment processes; address alignment and look again at fee structures; invest opportunistically. These were among the issues Danish investors were dealing with when Martin Hurst visited some of them recently.

It might seem unusual that a group of major investors in a small country like Denmark would allocate so much to the home market, but as some of them pointed out the country is one of the most stable in the world. Consequently large domestic holdings have stood some large investors in good stead during the recent market turmoil. "Our positive return was only thanks to our Danish investments," noted one.

For the most part the much cited wait-and-see approach persists; what investing there is has been opportunity driven. There is interest in the UK direct market with a recognition that secondary markets may still have some way to fall. The US is also popular, especially on the listed side. Investors are interested in possible distressed sales in both markets. Asia is also of interest but there is concern that "it adds nothing as a diversifier - in the recent crisis it went the same way as the other markets. So is it worth the effort?"

In the wake of the recent turmoil investment processes have been subject to review. One investor noted: "We have optimised our internal monitoring of existing funds. We have identified five or six main risk areas, for example bank covenants, LP defaults and manager defaults. The whole team has become much more critical and we have a lot of focus on all risks regarding new products."

The turmoil has been a source of shock therapy for some. "We never before made a worst case scenario as part of the investment process - eg that values in the UK may fall as far as they did," one investor noted. "What we have learned is that we have to really do our worst case analyses before making an investment."

In Denmark, as elsewhere, there is a growing focus among pension funds on the quality of property management. "The best manager will be the one that can deliver the best asset management service with good business plans and good information for investors," noted one pension fund manager. "We have the feeling some fund managers have forgotten about property management because they were too focused on financial engineering. This is the time of proof for them."

"We have always been very focused at the asset level and on which is able to manage the buildings in the portfolio and improve cash flow," he continued. "Even in the good times when values were rising automatically we were very focused on the asset level."

The predominance of blind pooled funds in the market presents additional challenges to investors in the area of due diligence and monitoring. "We have to examine the fund manager's previous achievements and feel comfortable that it will achieve the performance we are expecting," said one investor. "It is important for us to have a seat on the advisory board. Usually we get this and it means we have a big influence on what is going on."

Communication is a key issue with investors stressing the need for managers to communicate more. "Some management houses are being more proactive in communicating all the information we need, while others are not. Our preference is clear: we don't want any surprises."

There is a feeling among investors that managers should - and indeed will - have to work harder to win and maintain business than they did when the market was booming. "In times of the wall of money managers had too much power," noted one investor. "I expect I could achieve more favourable terms and conditions these days."

On the subject of fees and fee structures it is perhaps a time for reflection. "The discussion about fees is not a polarized one about higher or lower fees but is more a discussion about the fee structure," said one pension fund manager.  

A number of investors feel strongly that fees should be based on what the product ultimately returns - although some managers argue that this places managers under too much pressure to invest the capital committed. "The fee should be based on realized investment performance at the end of the fund life, because that is what we get as investors," said one investor. "We don't mind paying for good performance."

He added the structure of the performance fee is critical and that some fee structures "are not adequate as a means to align interests. If the fund aims at say a 15% net return and there is a hurdle rate at 8-9% after which there is a full catch up to say 20% of all profits, why is it that the manager is fully compensated only half way through the return target? The point at which this happens should be around 12%, or in any case closer to the target return. A cut in the hurdle rate from say 12% to 8% is nothing but a transfer of the risk from the manager to the investor. Managers clearly have a different target to the investors if the return targets are at different levels".

"Alignment of interest is absolutely essential," said another investor. "We look for the carry structure -where the fund manager makes their main profit only when it performs well. I would prefer to keep acquisition fees, management fees and selling fees to a minimum. They should co-invest - that is a sign that they believe in their own concept."

Co-investment is increasingly preferred by investors as the best way to ensure that investor and manager interests are aligned. "The level of co-investment from managers and key people is up for discussion," noted one pension fund manager. "If the co-investment is equivalent to the management fee for the first year of the fund we don't think that constitutes alignment. A lesson we learned in downturn is that if the performance fee no longer exists and the co-investment is so small then what is the motivation for the manager to work? Do they want to have us as client in the longer term?"

He added: "The performance fee has been preferred by some managers. If the manager has no money in the fund himself he can take as much risk to maximize performance as he wants to; but if things go wrong he can walk away. Co-investment keeps the manager mindful of and committed to the investment in both the upside and downside."

He also noted that the appropriate co-investment structure could depend on where the fund in question sits on the risk curve. "With core funds it wouldn't be a deal breaker if there were no co-investment by the individual manager because core funds are more of a beta play. However we would want to see corporate co-investment to keep the firm focused on the fund. We want to see personal co-investment in value-add and opportunistic funds."

In terms of who is in the fund, and the level of engagement, it's important to ensure you are at the same level, according to one investor. "We don't want to be in a club where there is one very active investor but also two very passive investors because the active investor will set the whole agenda. We can create a much better product if we have say three investors from the same level creating the club."

The Danish Real Estate Club has been operating since 2005 and won the Award for Outstanding Industry Contribution at the IPE Real Estate Awards the following year. The grouping of five leading investors - PKA, Pen Sam, Kommunernes, PFA Invest, and Finanssektorens Pensionskasse (FSP) - was not set up as a vehicle through which to invest but more as a means to share the costs of research and due diligence. So has it come up to expectations?

"There are many positives," commented one Club member. "We have received a lot of good information from the manager about the fund they are managing for us. Managers see the club as a chance to get into dialogue with five larger pension funds; it wouldn't have been as easy to achieve that dialogue in the past before the Club was established.  We have also been able to learn - we have been come together and have shared thoughts not only about individual investments but also about strategy and the market situation."

Views on Club members investing together vary - this was not the original aim of the club. "On the investment side we have learned that we are five different investors with individual strategies. But in future we could try to do some investments together, said another club member. "In today's market there will be fewer possibilities to get finance; together we will have more opportunities," he said. 

The upheaval in the industry has made pension fund managers think about new ways of investing in real estate. One investor commented: "We see ourselves as a long-only investor so approach is mainly strategic rather than tactical, and our focus will remain non-listed real estate. However we are reviewing derivatives; I see some value in it as a risk management tool so it might be something we use going forward."

Liquidity is an ongoing concern for investors. "The most illiquid market is the unlisted market," noted one. "Today it is easier to make your own market timing via the direct or the listed markets, so in the future we will use more of a mix of direct, unlisted and listed."
 
Continuing on the liquidity theme, one investor asked: "will it be possible to have a more transparent secondary market? The problem with the secondary market us that it is difficult to be sure of the number of deals or the size of the discount."