Experiences of winding up funds have been mixed for investors and managers. Deborah Lloyd highlights the latest efforts to create best practice
Over the past few years a number of real estate funds have reached the end of their life and undergone liquidation or restructuring. Success in each case has been somewhat diverse (see case studies).
One of the main concerns of investors, particularly since the financial crisis, was that funds had become illiquid and very difficult to get out of, even at the end of their life. The time had come to bring some guidance to the real estate funds industry and to create best practice.
The European Association for Investors in Non-Listed Real Estate Vehicles (INREV) and Association of Real Estate Funds (AREF) were both considering best practice in this areas. They combined with the Investment Property Forum (IPF) to sponsor a report, The End of Fund Life Report 2016. A working group was created with representatives from across Europe and the US – a necessity to achieve the ‘buy in’ for a global product.
The working group reviewed feedback from over 30 real estate fund professionals on their experiences with funds winding up.
In March 2016 the draft report was released and workshops were held in London, Amsterdam and Jersey. The feedback was extremely helpful and gave the working group the opportunity to make changes to reflect industry views.
The report, launched in September, is relevant to any open-ended or closed-ended real estate fund.
It looks at the options for wind-up:
• One or two-year extensions, where all investors remain;
• Longer extensions, where some investors can exit (this is where most problems have arisen);
• Convert to an open-ended fund (for successful funds – perhaps those moving from a value-added to a core strategy);
• Roll assets into a new fund;
• Initial public offering.
The process of wind-up is dealt with in a flow diagram (see figure), a timeline and a technical appendix on winding up vehicles in the most common European jurisdictions – UK, Jersey, Luxembourg and Germany.
The key part of the report looks at conduct during wind-up. This has been translated into four guiding principles:
• Communication – transparency and timeliness;
• Fund documentation – explicit, yet flexible;
• Conflict of interest – recognise and manage;
• Management decisions – be mindful of the fund termination date.
The interviews with real estate fund professionals consistently placed importance on good communication, transparency and timeliness.
Ensuring a smooth-running process is not just the responsibility of the fund manager but is shared with the investors. It was clear from feedback that it was the action of discourteous investors that caused delays or problems in the wind-up or extension process.
Everyone was amazed at the time it took to make decisions and extend a fund, so starting the consultation process early was crucial.
It was apparent that different fund managers ran the consultation process in different ways. Some fund managers have minimal discussions with investors. Others hold one-to-one meetings or round-table discussions to understand investors’ views. The report states that best practice is that “all investors should receive the same level of written information simultaneously”.
One recurring frustration cited was that the senior management team in place at the start of a fund were not there at the end and had been replaced by more junior staff with less experience. Equally, investors were sending to meetings junior team members who were unable to make decisions.
Case study 1
A well-regarded fund was coming to the end of its life. There was support from investors to extend it. The fund manager and investors began what turned out to be protracted discussions about the terms of the extension. Problems arose with the pricing of the units for investors looking to exit.
There was a lack of transparency and clarity in the documents about the specific cost that were included in the exit price calculation. Items were included that had not been expressly stated by the fund manager when it initially provided a worked example.
Many investors felt the charges were unfair and that their inclusion had been poorly communicated. The incident inevitably placed a strain on the relationship between the fund manager and investors.
This case study highlights the importance of the need for clear and transparent documents.
Case study 2
Fund documentation contained a pre-emption right for the fund manager to buy out the investors. This created a conflict of interest that had not been dealt with in the document.
It transpired that the fund manager was seeking a new investor to buy the portfolio and retain the fund manager to continue to manage the assets.
The original investors were concerned that the fund manager would not achieve the best price for them – it could be below market value.
There was also concern that information had been withheld from other potential buyers. In the end, investors insisted that multiple agents be asked to provide a sale valuation and to support the fund manager to sell in the open market.
This situation could have been avoided if the documentation had anticipated the conflict and drafted protection and processes around it.
As fund termination approaches, the logical place to start is to look at fund documents. In some cases the fund documents were not fit for purpose, definitions were missing or were ambiguous, with the end-of-life process not clearly set out.
“As fund termination approaches, the logical place to start is to look at the fund documents. In some cases the fund documents were not fit for purpose, definitions were missing or were ambiguous, with the end of life process not clearly set out”
So what needs to be in fund documents? The report lists the detail that fund managers should consider. Each point should be agreed commercially and then drafted with clarity into the fund documents. It is not helpful to be vague on issues that may be tricky to settle at the outset; it creates chaos and resentment down the road.
The key points discussed at the workshop centred on voting thresholds and representation of minority investors. No decision should require 100% vote, but documents that give investors a legal exit right must be honoured, even if this means the fund winds up against other investors’ commercial interests. Another best practice point is that all investors should be represented on an advisory committee.
Conflicts of interest
Most organisations have their own conflict of interest policies. However, these are often general rather than specific to a particular fund. When approaching the end-of-life stage, the fund manager should prepare a paper outlining the potential conflicts, the risks associated with them and how they will be avoided or managed.
The report sets out the main areas of conflicts, the issues related to them, and how they might be managed.
It may seem obvious that the strategy should match the termination date, but sometimes this cannot always be achieved. This needs to be communicated as soon as possible to investors, who should be involved in the decision as to whether the fund should be extended to deal with any additional value creation.
The sales process is a key area that could lead to delays or problems at the end of fund life. The report sets out issues for the manager to consider when entering this process. The key is to avoid liabilities that run beyond the end of the fund.
There have been bad experiences at the end of a fund. This report seeks to ensure fund managers and investors have best practice guidelines for better experiences in the future. The next step is to incorporate the guidelines into the INREV guidelines and the AREF code of practice.
Deborah Lloyd is an independent consultant and chairman elect of AREF
From the beginning, prepare for the end
Clemens Kueppers & Melville Rodrigues
The End of Fund Life Report 2016 usefully highlights insurance solutions in addressing real estate fund residual liabilities. We suggest that it is in the interest of both investors and managers when establishing a fund to put in place the mechanics that will adopt such solutions.
Investors naturally expect their final distribution payment as soon as reasonably practicable after the disposal of the last asset, and this would ordinarily be a shared expectation with managers who would then look to receive their incentive fee, or ‘promote’.
Both have aligned goals to ensure that residual liabilities are managed during the life of the fund, and those liabilities do not delay payment of the final distribution and promote.
In establishing and operating the fund, managers should adopt a forward-thinking approach, address the risk of liabilities that could extend beyond the fund term and identify these liabilities within the manager’s risk management policy, including for AIFMD purposes.
These liabilities invariably relate to the assets held directly or indirectly by the fund, and could arise from the contractual protection given to the purchasers on historical disposals:
• Direct: replies to pre-contract enquiries;
• Indirect via a special purpose vehicle (SPV): risks remaining within the fund (risks a buyer did not accept, or were excluded in the buy-side warranty and indemnity insurance policy).
In recent years, many UK real estate funds exiting an SPV investment have introduced the concept of a stapled buy-side warranty and indemnity (W&I) policy, which has capped the selling fund’s liability at £1 (€1.1). This has assisted many funds to mitigate a significant amount of residual risks.
However managers should take into consideration other potential residual liabilities and accordingly implement end-of-life insurance strategies, using an economy of scale (in the case of multiple assets), and could consider a further insurance solution that ‘wraps’ the residual liabilities.
Essentially, the insurer ‘steps into the shoes’ of the entity and provides an alternative route of recourse. The process for arranging such a policy would, of course, be facilitated if the majority of the liabilities have expired and the fund has identified and ‘tracked’ the life of its liabilities.
Other fund operational risks may arise following the termination of the fund, such as the following:
• Tax insurance: where a fund may have provided tax indemnities ‘after the event’ in relation to known tax issues and where there are issues over the validity of a tax position. The insurance policy can provide retrospective cover in respect of the tax indemnities.
• Title: policies usually cover items such as title to underlying real estate assets, title to shares, physical defects and can cover missing permissions, access restriction, defective leases as well as demolition costs.
• Environmental: impairment liability insurance provides cover for historical liabilities associated with real estate assets owned by a fund, and would cover remedial work to prevent or limit losses arising out of the pollution or contamination.
Managers could, for example, arrange ‘data room’ facilities when disposing of assets. These contain the disposal transactional documentation, tax and legal opinions and other disclosures of residual risk issues.
Identifying and managing these risk issues assists the insurance underwriting process – and could lead to more attractive insurance premia. Investors may well expect the manager (as opposed to the fund) to pay the cost of insurance in so far as the manager fails to identify and manage the risk issues.
In recent years there has been increasing demand for end-of-fund-life policies. As this sector of the insurance market has matured the breadth of the coverage has increased. We anticipate that these types of liability wraps will become a useful and strategic tool for fund managers to maximise return, ensuring cleaner exits and more efficient final distribution and promote payments.
Clemens Kueppers is an executive director at Willis Towers Watson, and Melville Rodrigues is a partner at CMS