The defining quality of a crisis is change. But there is little analysis on the interpretation of this phenomenon in light of its possible outcome: what changes will the current crisis bring? The scenarios are examined by Xavier Jongen
What will the post-crisis property industry look like? How will the property industry operate? Who will be winners, who will be losers? To this end, the concept of semiotics is applied. Semiotics is a qualitative analysis tool defining, through opposing polarities, the field of possible post-crisis outcomes by analysing already observed changes brought about by the crisis. In this case, we apply the polarities of ‘Continuity and Discontinuity (x-axis)' and ‘Mutability and Immutability (y-axis)'. This enables us to define four simple quadrants (A,B,C,D).
Then, by combining the concepts of ‘Continuity, Discontinuity' on the x-axis with the concepts of ‘Mutability, Immutability' on the y-axis, we identify four quadrants A,B,C,D which each define a possible post-crisis system outcome. We can now apply this semiotic framework to the property industry by allocating semiotic signs, ie, observed events unfolding in reality, to each of the four defined quadrants. Importantly, it is only against this background that the true meaning of the AIFM Directive can be identified.
We will now subsequently review each of the quadrants which are named: A: back to business, B: adapt and move forward, C: change yes we can, and D: check your premises.
Quadrant A: back to business
This post-crisis outcome holds that after the dust has settled, we will discover that the crisis was, in fact, a giant misnomer: it was not a crisis, but a failure. Consequently, the crisis will ultimately bring the system back to its initial pre-crisis state. Importantly, the magnitude and intensity of the failure do not alter the fundamental analysis and, therefore, its outcome: the crisis was fundamentally an outlier, and the system will ultimately circle back to its initial state.
This post-crisis outcome, furthermore, holds that outliers are a natural phenomenon in modern economies. Indeed, they should be accepted rather than fought against as a deeper evil cause, because they are actually a part of progress. Consequently, only the symptoms of the crisis can and should be remedied. In this world, all measures should focus on stopping the crisis as quickly as possible in order to revert to the normal situation. We identify this variant as ‘back to business'.
For the property industry, the main focus is to remedy the symptoms of the financial crisis. The first priority is to restructure investment vehicles that suffer serious covenant breaches. In cases where shareholders have no prospect of regaining positive equity, investment managers will ultimately unwind vehicles.
Secondly, cost cutting is a main priority, too, as investment managers have become less profitable or unprofitable and are struggling to survive. Some companies do not have the appropriate skills or financial backbone to overcome the debt crisis, leading to a market shake-out of financially weaker investment managers and consolidation in the market.
After an initial inward-looking period, driven by solving the debt crisis and bringing costs down, investment managers strengthen their sales and customer care departments in order to survive as the size of the investment market shall have shrunk severely due to de-gearing. The immediate concern after the initial crisis management is to raise equity. New product offerings will initially be more income-oriented and ‘core', like residential or high street retail, but as the reversion to the pre-crisis status slowly takes hold, so will product offerings revert to a more traditional product offering of ‘core' ‘value added' and ‘opportunistic' investment styles.
At company level, senior management is focusing on short-term actions such as negotiations with investors, property lenders and their mother company in order to find a financial solution enabling them to work their way out of the debt crisis, as well as on various cost-cutting measures that bring short-term results. The focus of senior management is also to maintain the same strategic skill set in the company. Their analysis is that the exact same skill-set will be needed again, once the crisis is over. There is no need to think long term or check fundamental business premises in this world. Survival depends on one's ability to react quickly to immediate needs: the victorious archetype investor is the pragmatist.
Quadrant B: adapt and move forward
The crisis ends in a reversion to the initial system but, crucially, the system alters as it is forced to adapt itself in its struggle to survive. This adaptation can be profound or incidental, durable or short lived, the essence is that the system manages to position itself as the actor of transformation by its capacity to integrate new facts, propelled by the crisis. Consequently, the system wakes up in a new context it can claim to have forged from within. In time, it could also reverse-engineer back to its initial pre-crisis state. We identify this variant as ‘adapt and move forward'.
Because there was something structurally wrong with the way the property industry was run, there is a more ambitious need for reform than dealing only with the debt crisis and cost cutting. Importantly, change comes from within the system. The property industry will increasingly develop and implement better ‘standards' that can easily be measured and monitored by customers, new rating agencies and advisers. These take the form of ‘best practices', ‘industry guidelines' and ‘white papers', all falling under the broad concept of ‘auto-regulation'.
Under these new professional standards, the main concept that will be strengthened is that of ‘governance'. One reason for this is that the ‘governance gap' is identified as the true underlying driver to the crisis and, on the other hand, because some senior managers see this as a huge opportunity to develop their organisations into front-runners reshaping the customer-centricity of their organisations. Front-runners will increasingly be competitive cross-border, driven by the standards they have themselves developed and already integrated into their business philosophy and operations.
Organisations that cannot command the necessary leadership need to change their senior management, or they will disappear. On the product side, the key feature will be to broadly revert to the same pre-crisis product line, but to ‘make them better' - ie, more customer responsive. There is a need for a new win-win based on rational trade between seller and buyer: the victorious archetype investor is the entrepreneur.
C quadrant: change, yes we can
Overcoming the crisis requires radical changes that go beyond the system's intrinsic capacity to accommodate a workable response to the crisis. Consequently, the reorganisation of the system is not originated from within, but from outside the system. Here, the system loses control of the transformation process. As a result, it is profoundly changed and these changes cannot be reverse engineered. This post-crisis outcome holds that the deeper cause of the crisis is not confined to the economic world, but driven by how it interacts - or better: does not interact- with the political world. A global economic crisis needs a global political response. Consequently, a rethink of the system's structure is necessary by focusing on how regulatory authorities can limit negative externalities from the financial world, or bring about positive change through new regulation.
The uniquely new feature is that the new regulatory impulse originates at a coordinated international level, like the new solvency requirements or bonus systems under the impulse of the G8. In particular the EU, which is the only post-national legislative authority with binding implementation powers and a regulatory track record of almost 50 years, enters into the new regulatory field of private equity as is the case for the proposed AIFM Directive. This coordinated regulatory push transgresses investment markets. It also affects business models through anti-trust legislation. Indeed, investment managers that are linked to investment bankers, or banking and insurance companies that are ‘too big to fail' will be restructured by law. Politicians also push through an environmental agenda. Clearly, in this world, regulators rather than the industry are following a globalisation strategy. We identify this variant as ‘Change, yes we can'.
The crucial turning point in this post-crisis outcome is that the property industry faces a fundamental rebalancing from a largely market and shareholder-driven accountability towards a regulatory and politician-driven accountability. Consequently, the industry focuses more inwardly on transforming products and business processes to new regulatory requirements and, outwardly, influencing the decision makers in the political networks around Brussels, Washington and elsewhere.
On the product side, traditional investment strategies are eco-enhanced. In the beginning, mostly to fit a political mainstream agenda but, in time, entirely new responsible products like farm funds, microfinance property funds, and green Africa funds will take hold, especially where these are kick-started with the aid of state subsidies. Importantly, in this world view stability of cash-flows is preferred over return level of cash-flow. Consequently, investment vehicles will generate lower return levels than in the past.
Companies already operating in a highly regulated environment, such as German or French companies, might have a competitive edge because of familiarity with that business model. Ironically, this does not make them necessarily more competitive internationally, as they face prevailing cultural differences between nation-states, as well as still-applicable fiscal hurdles. Also, sovereign wealth funds - a ‘new kid on the block' - being closer to political power centres than economic hubs, become a main actor in the market.
In addition, fear for protectionism pushes investment managers to relocate from their current main offshore hubs, to new onshore and infra trade block hubs like, for instance, Malta. Similar blocks are likely to appear in bigger geo-political centres such as the US, China, Russia, and Brazil.
In order to keep up with the new regulatory requirements, and influence them better, senior management positions in the industry are increasingly held by managers that move upwards from back-office positions in legal, risk, compliance, accounting or audit departments. These managers focus on new ways of sharing back offices in order to reduce the additional cost triggered by new regulations, leading to new forms of back-office platform JV co-operation in the industry, similar to Master KAGs of Master OPCIs. In this scenario the victorious archetype investor is the Weberian bureaucrat.
D quadrant: check your premises
The initial system does not survive the crisis and ends in a radically different model, or in chaos. This is, however, such a fundamental change that it is to be identified as a shift in paradigm, also widely affecting other systems beyond the property industry. Here, it is the mixed economy's incapacity to deal with capitalism that is the fundamental cause of the crisis. The system is therefore under attack from two angles: there is either too much free market, or too little free market. Either way, the current crisis leads to an uncoupling of the 20th century marriage between capitalism and the mixed economy. This post-crisis outcome is driven in essence by philosophy: it holds either that individual selfishness is at the root of all evil, or that it is the fountainhead of all progress. Consequently, the new paradigm can go two ways. We identify this post crisis system outcome as ‘check your premises'.
First, a swing to the philosophical left. Its fundamental basis is that capitalism leads to an unfair society which even the democratically installed welfare state can apparently not handle anymore. Consequently, the regulatory push will go beyond investment market regulation, antitrust legislation and eco-legislation in order to define an entirely new socio-economic system where the free space of the market is largely contained.
Stability will be sacrificed for justice. The investment manager will not survive this fundamental shift. This young actor developed as an entirely market-driven unregulated response to professionalising property investment requirements. It will now be reverse-engineered by regulation to the benefit of pension funds and sovereign wealth funds which enjoy higher democratic legitimacy and accountability.
Second, a swing to the philosophical right is also possible. Here the world will, on the contrary, evolve towards an entirely free market. Facts reveal that the crisis originated in the most highly regulated US market, namely the residential markets and the residential mortgage and mortgage backed securities markets. These markets know a myriad of government-sponsored entities, most notably Fanny Mae and Freddy Mac, which have been pursuing a political agenda of enforcing home ownership even on those who could not afford it. Moreover, these secondary market products were rated by government-sponsored rating agencies, and propelled forward by government-led interest rates which even went into negative rates of return as part of the ‘great moderation'.
It is, therefore, a pre-Copernican mistake to blame the lack of regulation as the cause of the crisis. Quite to the contrary: regulation failed and it is, therefore, total deregulation that is needed. In this world, government-linked companies will disappear in their current form, including sovereign wealth funds and pension funds, and a myriad of new fully market-oriented investment managers will expand beyond property into real assets, including health care, education, cable networks, road infrastructure and space industries.
To conclude, observe how a simple framework like semiotics can shed first lights into the world we could discover at the end of the tunnel. I hold that the four semiotic options that were possible outcomes for the property industry before the Lehmann collapse have already been reduced to two, and that this will be made official through a vote in Brussels this autumn.
Xavier Jongen is a fund director, Bouwfonds European Residential Fund