The opportunity fund model must sink or swim as it faces its greatest stress test as the recession begins to bite. Steve Hays reports

The modern opportunity real estate fund was born in the early 1990s to profit from the last big market dislocation. But now that model itself, and the relationship between managers and investors, faces its first great stress test as a global recession takes hold, says New York-based fund of funds manager Clerestory Capital Partners in a market briefing.

Clerestory principal Joanne Douvas says: "The effects of worldwide deleveraging and systemic recession are leading to a re-evaluation of the general partner (manager) and limited partner (investor) relationship. Our view is that if a manager did what they said they would do and there are performance and/or other issues, then investors need to be supportive and engage as good partners. Conversely, if managers have engaged in investment style drift, utilised poor judgement, or behaved in a way unbefitting to a fiduciary, then investors have a right to voice concerns and seek productive solutions," she adds.

The main pressure points in the downturn for general partners are likely to include the adequacy of reserves and the inability to refinance debt as it matures. With carrying costs mounting on investments that are ‘under water' general partners may find themselves pressed to fund the capital that their investments require, or to pay the fees and expenses of their fund.

Among limited partners, many may encounter stress due to the declining values of their pension plans and the resulting over-commitment to real estate created by the ‘denominator effect', where the relative value of other assets such as equities and bonds has fallen faster than investments in property. Other problems include the lack of transaction activity and the resulting contraction in distributions from investments, as well as the inability to fund existing capital commitments.

The dilemmas and ethical challenges these situations are likely to create could range from general partners approaching limited partners for additional capital and both parties struggling to determine the cost of that capital and the appropriateness of a recently formed vehicle providing funding to one of earlier vintage. Other questions posed might include whether large investors in a fund represent the ‘equity of last resort', and if minority investor rights are protected.

General partners who counted on distributions from prior funds may find they cannot meet capital calls either, so do investors need confirmation following every capital call that all capital was funded and that penalties were enforced? Perhaps investors now need to analyse the counterparty risk of other limited partners and should be informed if the subscription facility lender excludes a previously included investor due to a credit rating downgrade.

Back in the 1990s there were no common corporate governance guidelines for the private real estate funds industry to reference, particularly in troubled times. Two years ago, however, European Association for Investors in Non-listed Real Estate Vehicles (INREV) pulled together a framework of principles for real estate funds to address common governance themes across national borders. These include fairness to shareholders, clear accountability by the board and management, and transparent, accurate and timely reporting.

"The first port of call for managers and investors facing governance issues should be the INREV guidelines," says Clerestory principal Tommy Brown, who is also a member of the association's corporate governance committee.

"Both general partners and limited partners can then measure the actions they propose to take against the principles that have been hammered out in extensive consultation with a broad cross-section of the industry," he adds.

Brown says that in the next investment cycle, general partners and limited partners will each be judged by how they treated one another during times of stress. Clerestory has established its own touchstones for navigating the general partners/limited partner and limited partner/limited partner relationships through the tricky shoals that lie ahead:

Communicate early and often - Problems should be reported by general partners in a timely fashion after thorough investigation. Investors expect to hear about falling valuations before they have been written down. Tools for early communication include quarterly conference calls with all investors, timely memos to investors with current issues and thoughts, detailed reporting with a schedule of capital calls that are expected over the following 12-24 months and a detailed schedule of debt maturities. The potential loss of key personnel can also pose a risk for investors, and general partners should share this information early along with measures taken to mitigate this risk; Do the right thing - A manager's ethical code is constantly tested by the many little decisions that are made that no one else knows about and these should be ‘black and white', with uncertainty always translating into results that favour the investor. A general partners is best served by not putting itself in a position of potentially having a conflict of interest in the future. Limited partners who have over-committed their plans may attempt to dissuade the general partners from calling capital rather than defaulting or selling their interest at a discount. General partners need to treat all capital the same and partnership agreements should require that all capital is called pro rata. Cash-strapped limited partners may look to general partners to facilitate secondary sales and general partners can be supportive of this process by increasing transparency to potential buyers; Listen to your investors - In difficult times, managers should be especially mindful of creating a proactive partnership with advisory board members, who can provide much needed guidance to a fund and act as ambassadors to the broader limited partner base. Unless there is a conflict of interest requiring that board members withdraw, they should vote on all matters and have a view on key issues. Advisory boards also may want to consider exercising limited partner rights for independent third-party valuations or audits if these measures seem appropriate.

Invoking the ‘not for cause general partners removal' should be reserved for ‘bad acts' or situations in which the general partner in place will cause a further erosion in value and new management will do a better job of preserving and extracting value. It should not be used because investments turn sour. Investors need to keep level heads and not express anger at the markets by being vindictive with their general partners. In most instances, the manager who made the investment is best suited to work it out.

"General partners and limited partners need to take a long-term view," Joanne Douvas says. "We all need to concentrate on the fact that substantial investment returns can be achieved during periods of great distress and that losses can be minimised through creative and orderly restructuring plans that focus on the long-term recovery of the markets," she concludes.

Steve Hays is a founding director of Bellier Financial based in Amsterdam