Recent liquidity problems in UK investment funds highlight the need for modernisation, writes Tristan Capital’s Simon Martin
Runs on open-ended UK property funds and the demise of the UK’s best-known stockpicker, Neil Woodford, have re-ignited the debate over how best to manage and value illiquid assets in open-ended funds across all asset classes.
This is a problem that the investment management industry has struggled with for decades. Liquidity crises have periodically created problems in the UK property fund market, the most recent example of which hit the headlines just a few weeks ago.
A liquidity crisis also led to the near-complete disassembly of the German open-ended property fund industry in the early 2000s.
The days of pooling unqualified investors with huge institutions and offering everyone promises of guaranteed daily, weekly and monthly liquidity must be numbered.
With many UK funds now running big cash balances, returns are being suppressed and this is triggering even more redemptions. This, in turn, is forcing some high-profile funds to ‘gate’, increasing the level of regulatory scrutiny directed at these funds.
In our view, the first step towards resolving these recurring issues is for investment managers to reset their clients’ expectations; somewhere along the line we seem to have forgotten that real estate is an illiquid asset class with no easy in or out. Once we acknowledge that simple truth, we can explore superior structures that offer liquidity options but not guarantees.
The compulsion to take a wrecking ball to these old-style, open-ended funds and to innovate our way out of the problem has never been greater at a time when private equity real estate continues to attract significant capital.
Close to €1trn of sovereign bonds issued during the European debt crisis at 3% plus coupons, with 10-year maturity dates are due to pay out over the next three years. Reinvesting that capital at negative nominal yields is not a viable option for those seeking to reduce their funding shortfall.
This money needs to find a more productive, higher-yielding home and real estate looks like an appealing alternative.
It is up to the European real estate industry to rise to the challenge by instituting a new generation of fit-for-purpose products capable of accommodating the demand for real estate from investors globally.
The European Odyssey
There are some major parallels today with the changes we saw when we founded our business in 1999.
We could see that clients wanted their capital managed in a different way and we innovated to meet this need, helping to establish a ‘European core-plus asset class’; our unofficial motto back then was ‘wrecking the real estate fund business one investor at a time’.
We saw a similar opportunity to ‘bring out the wrecking ball’ when we took the decision to convert our long-standing CCP core-plus fund series into a perpetual fund in 2017.
We spent several years looking carefully at the open-ended ODCE fund structures in the US and speaking to clients and prospects about the features that they would like included in such products before we launched CCP 5 Long-Life.
Although the US ODCE system was seen as having very high standards of governance and a functional redemption mechanism, it was still clear to us that limited partners (LPs) wanted some added options.
This ultimately took the form of an LP-controlled mechanism to tackle the challenges they had faced in other people’s underperforming open-ended structures.
We adopted this feature and our mechanism allows CCP 5 Long-Life clients a periodic vote and the option to shift the fund into a closed-ended structure.
Given that such mechanisms require a high level of performance, trust and understanding between LP and general partner (GP), this is not something you can build on-the-hoof or without the support of a highly collaborative client group.
However, we believe that an ‘orderly liquidation trigger’ is a great tool for aligning us with our clients. We are told that CCP 5 Long-Life is the only ODCE-style fund in Europe or the US to offer this feature.
It was once said that distress is a cradle for innovation. Our view is that the industry should embrace this opportunity because the formative nature of the ODCE universe in Europe presents a significant window to improve the alignment between GPs and LPs.
“It is up to the European real estate industry to rise to the challenge by instituting a new generation of fit-for- purpose products, capable of accommodating the demand for real estate from investors globally”
A fully-fledged European version of the US ODCE market that raises the bar on the trickiest areas of LP/GP governance will then improve access and scalability for us all: the INREV ODCE index is today pushing €21bn in assets and contains 12 funds, but is small compared with the$200bn of assets under management covered by the NCREIF NFI-ODCE index.
There is a critical role for INREV to play in this process. INREV is all about creating forums for innovation and debate and it is already pushing us as an industry to homogenise and improve the European fund market place.
Its role in defining standards for ODCE will be even more critical, particularly as the industry needs firm leadership since some of its recognised names are reeling.
The stakes for all of us in the European real estate industry remain high. This is a persistent problem and we need to fix it.
Let’s collectively do away with the false promise of daily liquidity once and for all, get the format right and work with our clients to embrace a new generation of open-ended real estate fund structures.
If we do, the piece of the pie that we, as an industry, are allocated, increases exponentially. If we do not, our failure to cooperate and co-create a best-in-class offering will mean the regulator will inevitably come calling.
Simon Martin is senior partner, head of investment strategy and research at Tristan Capital Partners
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