The denominator effect has caused many investors' level of exposure to real estate to increase artificially and has placed pressure on their liquidity management. Richard Lowe talks to three European pension funds about their experiences

Position: Chief Executive
Total Assets: €1bn
Real Estate Allocation: 15%

De Eendragt Pensioen, the pension provider for the paper and packaging industry pension fund in the Netherlands, is currently nursing an over-allocation to real estate due to falls in values across many of its other investment classes - otherwise known as the denominator effect.

The pension fund has a sizeable portfolio of closed-ended non-listed real estate funds, which, in the words of chief executive Philip Menco, "did reasonably well" during 2008 when equity markets tanked indiscriminately across the globe. The result is a relative over-weighting to these illiquid investments.

An attempt was made, beginning in the summer of 2008, to reduce De Eendragt's real estate investments, but it proved a difficult endeavour. Menco's only option was to look to sell stakes in funds on the secondary market, but this was unsuccessful.

"Already buyers had disappeared," he remembers. "With non-listed
real estate you are very dependent on other parties that are interested to buy and there is no market where you can trade."

For this reason, Menco would love to see more liquidity in non-listed real estate funds and a more efficient secondary market. But he cites reasons why secondary trading has not developed to the extent it has among non-real estate private equity funds: primarily, fund managers want to retain control.

"They are frequently participating themselves with large amounts in real estate and see the fund as a way to sell their participations after a while," he says of general partners.

"They have no interest in the possibility of investors selling their portion to other investors, because they like to do that themselves. That is part of their growth and their marketing, and they are making money partly on that as well."

Investors are also more likely to be attracted to funds that appear to be more liquid should they want to exit at a later date. But having said this, Menco admits that liquidity always comes with a price. For example, theoretically speaking, if the prices of closed-ended funds become dependent on market forces, they could be affected in a similar way to the public markets.

"Then you will get the situation that we see now with listed real estate, where the price is only partly determined by the net asset value and the rest is demand and supply," Menco says.

Peter Olsson - AP PENSION FUND
Position: Head of Real Estate Investment
Total Assets: €4bn
Real Estate Allocation: 15%

AP Pension is a customer-owned and independent pension company in Denmark that manages some €4bn of pension savings. Approximately, 15% of assets are allocated to real estate, including - since 2007 - investments in commingled funds in Europe and Asia Pacific.

Unlike some pension funds in Europe, AP Pension has not struggled with the denominator effect - an artificial increase in real estate exposure due to falls in equities - and Peter Olsson, head of real estate investment, explains that the institution has not required more liquidity from its real estate investments in the current environment.

AP Pension does invest in open-ended funds, but the majority of its portfolio is made up of stakes in more illiquid closed-ended real estate vehicles, where there "is a target for the manager to perform".

Olsson does agree that a more developed secondary market among property funds would probably help investors who are struggling, but from AP Pension's perspective he does not see a major need for more liquidity in non-listed real estate markets. The current scenario, he says, by no means amounts to a "big problem".

Günther Schiendl - VBV
Position: CIO and Member of the Board
Total Assets: €4.2bn
Real Estate Allocation: 3-5%

VBV, the largest pensionskasse in Austria, has a relatively modest exposure to illiquid "alternative" investments, including real estate, and has no private equity investments (although it has considered entering into the latter). For these reasons, the losses that VBV incurred in the equity markets has not caused any need to rebalance the more illiquid section of its portfolio.

The pension fund's medium-term investment strategy is to increase its allocation to real estate to above 5% of total AUM, but due to the market turmoil and uncertainty of the past 18 months it is has maintained an exposure of somewhere between 3% and 5% of total AUM.

Günther Schiendl, CIO and member of the board, says VBV's modest level of exposure to alternatives like real estate - and, consequently, its situation regarding the denominator effect - is likely to be representative of Austrian pension funds as a whole.

"Our situation," he says, "is that we had up to, let's say, 7-10% of our investments in alternatives, including real estate… and given the fact that we didn't have private equity investments at all - we had no capital calls - we did not have a liquidity problem like some of the big US endowments or pension funds."

In retrospect, Schiendl says, the difficulties being experienced by some pension funds and institutional investors in the US, which have a significant exposure to illiquid alternative assets, only serve to reveal that they "had incurred a massive liquidity risk". He adds: "They got a good premium for several years. But last year the risk really materialised."

Generally speaking, Schiendl does not see the need for any significant level of liquidity within VBV's real estate investments. The pension fund invests in closed-ended real estate funds, eschewing open-ended vehicles or listed property investments.

"The point in real estate is the investor has to be sure about his own time schedule, about expected paybacks," he says. "Somehow he has to match a cash flow expectation."