Investors have learnt it's just as important to know and be aligned with fellow LPs as it is with the GP of a fund. Richard Lowe reports

A consensus appears to be forming in risk management circles: what you don't know is just as important as what you do. Nassim Taleb, the author of The Black Swan, has
long criticised the vulnerability of the global financial system for not adequately incorporating unexpected outlier events into its risk management processes, inadvertently encouraging banks to take on more risk in the process. It is interesting to note that today Taleb has many more readers than he did before the downturn.

Similarly, pension funds and other institutional investors are now much more focused on managing their risks, not least when it comes to indirect real estate investments. The difficult capital-raising environment for real estate funds today, when compared with the preceding years when investors seemed to rush to allocate capital to vehicles, is arguably a direct result of a widespread re-examination of risk on the part of investors everywhere.

But investors in unlisted real estate funds seem to have been hit with a double-whammy. The underlying real estate investments themselves may, in hindsight, look more risky than previously thought, particularly where gearing levels are concerned. But in addition to this, pension funds have learnt very quickly and dramatically that due diligence should encompass the financial health and motivations of fellow investors in a fund, not just the fund manager and its ability to execute a strategy, and so on.

The inability of some limited partners (LPs) to pay their capital commitments, for instance, sent shockwaves through the industry in 2008. Furthermore, alignment of interest has been a mantra championed by investors and fund managers in recent years, but it is only in recent months that models have really been put to the test. For some investors it became clear that regardless of their alignment with their general partner (GP), the interests between different LPs could quite easily diverge when markets dislocate.

It is of no surprise, then, that large institutional investors with enough critical mass in themselves are looking to move away from commingled funds that have large numbers of diversified - sometimes anonymous - fellow investors in favour of club deals with a smaller number of like-minded investors. Taking this approach removes much of the risk associated with investing alongside other parties whose financial health, motivations - or simply their identities - are less certain or varied.

The sentiment that smaller club deals are more attractive today than larger commingled funds was echoed both at the INREV annual conference in Athens and IPE Real Estate's annual Investor Forum in Amsterdam by the likes of APG Investments, ATP Real Estate and TIAA CREF.

"What we are spending time on is partnering up with like-minded investors," said Roderick Munsters, the outgoing CIO for APG, in Athens in April. "Not too many and not your usual 10 or 20 in a club deal, but two, three, four like-minded… institutions with a similar perspective."

Speaking a month later in Amsterdam, Hermann Aukamp, managing director at German pension fund Nordrheinische Aerzteversorgung (NAEV), said that larger pension funds "will focus in the future very much on smaller funds and on funds which are very like club funds and will emphasise alignment of interest between investors."

ATP Real Estate, the property manager for Denmark's largest pension fund, has also indicated its preference for club deals in today's financial climate.

Speaking separately to IPE Real Estate Michael Nielsen, head of real estate at ATP, says: "We prefer to work on club-type investments right now. It is so important these days to know who are the other partners in a fund. We don't want to step into a fund where you could end up being together with 30 different investors. We prefer smaller clubs, with perhaps up to five, six or seven investors."

This is not necessarily a departure in strategy for ATP; Nielsen points out that the pension fund's indirect property portfolio already includes a number of club-style deals; it is just that in the current environment the focus has shifted to such opportunities.

The main motivation, nonetheless, is "to make sure that we are like-minded with the investor partners in the fund - we have the same view," he says, and "the same power to meet the commitments".

If like-minded investors increasingly gravitate towards each other, there are implications for real estate fund managers that in recent years have sought to diversify their investor bases. Having underlying investors with different outlooks, liquidity needs and domiciles in a single fund can be appealing to managers, because it lowers the risk that they will all experience similar pressures or changes in strategy at the same time, thereby reducing the likelihood of investors exiting en masse at any given time.

This issue was raised by Tim Hoeppner, managing director at the McArthur Foundation, in April in Athens. He said: "You have a bit of a conflict of interest here in the sense that GPs are rightly trying to diversify their LP base, because they do not know which LP group will have difficulties in the future. At the same time the LP group is maybe trying to become more clubbish and more similar. It will be interesting to see how that plays out."

Of course, any preference for club deals over commingled funds is a luxury that can only be entertained by the larger breed of investors. For small and medium-sized pension funds the former is unlikely to be a feasible prospect.

In any case, Jeroen Winkelman, portfolio manager for European indirect investments at BPF Bouwinvest - the real estate investment manager for the €24.2bn Dutch building industry pension fund BPF Bouw - believes that diversifying the investor base is not just in the interests of the fund manager.

"Alignment between LPs is key, no question," he says. "We have good experiences with both club deals and joint ventures and will probably continue to work on that base going forward. But also consider that the advantage of having a diversified investors base is that you pool relevant experiences and look at issues from different angles with all the investors you are investing with in a particular fund."

Indeed, a hypothetical fund with, say, eight investors, each with 20 other indirect real estate investments would have the opportunity to share knowledge and experience of up to 160 different funds.

"For the sake of getting a lot of experience and information to make it more transparent, a diversified investor base is definitely an advantage," Winkelman says. "Naturally, alignment within that group of investors is most important."

International institutional investors commonly share knowledge and experience among themselves for the greater benefit of the investor community. Winkelman says this fact is paying off now, "because we capitalise on our existing relationships when dealing with issues within funds".

Therefore, converging with smaller groups of like-minded investors is not necessarily the only way of seeking to reduce risks associated with fellow investors. Perhaps another is for LPs in funds to communicate among themselves fully and frequently.

There are potential obstacles to this, however. At a conference in London at the beginning of the year, John Dywer, head of real estate at FF&P Asset Management, who manages fund of funds accounts, revealed he had been invested in a fund whose manager stated that all LPs had signed confidentiality agreements.

"All those LPs, he told me, wanted confidentiality; their names were not to be known to other investors," he said. "I have come across that more often, but basically I do not invest in any fund where I do not know who the LPs are. If they can't share their conditions with me, I am not going to invest with them."

Speaking separately to IPE Real Estate, Dwyer says that LP confidentiality agreements are nothing new and if a GP is invoking them this could be construed as evidence of the manager having something to hide.

There may also be an element of wariness on the part of GPs over sharing the identities of LPs, particularly if they were to club together in a way that precluded the GP from discussions. Anecdotal evidence suggests that in the current environment many managers organise meetings to bring all LPs together to discuss issues.

BPF Bouwinvest has on several occasions, especially before entering into a fund, asked the GP to disclose the identities of fellow LPs. Where BPF Bouwinvest has come up against reluctance on the part of GPs to do this - that is, managers saying that LPs do not want their identities disclosed - BPF Bouwinvest had to decide whether it should not invest, or to insist on getting full disclosure. "In all situations where we considered it to be crucial to know the other investors we got full disclosure," Winkelman says.

He adds: "The way things have developed recently, we now see that alignment of interest between LPs can be crucial in dealing with challenges, so therefore going forward you will probably see that investors will include the examination of other LPs in their due diligence."

Allan Mikkelsen, partner at ATP Real Estate, agrees that one of the lessons to be learnt from the current crisis is the importance of carrying out due diligence on fellow investors."We would put a bit more emphasis on understanding who the other LPs are, because if we can do some due diligence on that at an early stage we would reduce risk," he says.

But Mikkelsen is concerned about how investors can carry out the necessary due diligence on other LPs before entering into a fund when there are often multiple closings, each introducing new investors into the pool.

At the INREV conference in Athens, Mikkelsen was forthright. "There is no doubt that our due diligence going forward will also include knowing who our fellow investors are in commingled funds," he said. "But how will you know your investors in the eighth close if you came in during the first close?"

He added: "I think we can dare to provoke the audience a bit today and say: if you need to go to an eighth close to have sufficient capital, maybe that product shouldn't be raised."

Speaking separately to IPE Real Estate, Mikkelsen reiterates the dilemma that fund raisings with multiple closes poses for ATP.

"We have seen funds raised with multiple closings: six, seven, eight," he says. "If it takes that many to close a fund, I wonder if that fund should ever have grown that big. Because clearly if you sign up as one of the first investors, how can you control who is coming in later on?"

Issues like these need to be addressed by real estate fund managers and investors alike. One positive ramification of the current crisis, if solutions for such issues are sought, could be a greater transparency and communication between investors and managers, and between LPs themselves - thereby reducing dangerous unknowns and, consequently, risk.