As investor clubs have become larger their original benefits of control and adaptability no longer hold true, says Julian Schiller

During the height of the financial crisis, investors in real estate funds questioned the validity of the real estate funds investment model, probing key areas such as alignment of interests, governance structures, liquidity and risk management. Some high-profile investors even suggested that the traditional funds model was broken.

This radical view has largely subsided, with most market participants believing it was an over-reaction in a pressured and volatile environment. Investing indirectly remains a viable route to real estate markets, but it is recognised that change and evolution to the present funds model is required.

As markets have started to stabilise, industry participants have entered a period of reflection. The unlisted funds market is entering a transitional phase, as typical fund structures and indirect investment routes are being redefined as both investors and managers draw on the lessons learnt over the past two turbulent years.

One size doesn't fit all
Smaller investors considering real estate markets continue to appreciate the benefits from investing via the commingled multi-investor funds route, whether it is due to capital constraints limiting access via the direct market, diversification benefits, or access to the expertise of established fund managers.

This investor group, despite the recent market turbulence, has rarely questioned the applicability of the traditional fund model but has voiced concerns around alignment of interests between investor and manager, current fee structures, corporate governance and the role of leverage.

The greatest call for change is emerging from the larger, sophisticated investors with significant pools of capital, resources and consequently more options for gaining real estate exposure.

These larger investors have traditionally been more demanding of managers, utilising the negotiating power of larger commitment volumes. However, in the buoyant markets of 2005-07, many investors (particularly larger ones) felt pressured to deploy significant real estate allocations, and the demands on managers were less pronounced.

In the current market, this urgency to invest has subsided. Consequently, investors with significant volumes of capital to commit are pursuing a more pro-active and tailored approach to their indirect investment programmes, while still demanding the same access to management expertise that a traditional multi-investor fund offers.

The main options for larger investors requiring a tailored route to implementing their real estate investment strategies include separate accounts, joint ventures, co-investment and ‘club funds'.

The club fund is an important means to accessing real estate markets and current market feedback has identified this route as one of the preferred options. But the structure of these club vehicles is changing.

Return of the ‘true' club fund model
The original arguments behind implementing a true club fund approach to investing remain valid.

Over the past few years, the ‘club fund' route to investing drew much attention as a preferable avenue for many of the larger, sophisticated indirect investors, but there also emerged much interest and desire from the medium-sized investors that also wished to be ‘part of the club'.

As the number of investors seeking a club fund-like structure increased, the definition of a club fund was distorted as the number of investors in a typical structure grew from two to three to as many as eight to 10. The structure had moved closer to the traditional multi-investor fund model that investors taking the club fund route were seeking to avoid. This shift implied that the original merits of the club fund no longer held true.

Club funds have always provided an attractive level of control and adaptability versus the traditional multi-investor commingled fund (prior to the emergence of the ‘distorted' version). However, the new generation of true club funds that will be launched will be structured to emphasise investor control and adaptability to an even greater extent.
We also expect changes around other areas of the club fund structure, such as fees and leverage, and some of these are likely to filter into the traditional multi-investor fund model.

Investor control
From the investor's perspective, having a more significant role in decision-making provides additional comfort in an uncertain environment. The true club fund structure provides investors access to an investment framework that affords improved transparency, a greater level of control throughout the investment period, and clarity/certainty around exit options.

By having significant influence in areas such as exit provisions, extensions to the vehicle life and transfer/redemption options, the issues associated with liquidity constraints can be controlled more effectively.

Although the day-to-day management and implementation of the investment strategy will stay with the manager, investors will have more influence on decisions related to areas such as debt management and asset disposals/acquisitions, to a greater extent than offered in the traditional commingled fund structure.

Investors are seeking a more active dialogue with managers, and the club fund can accommodate this requirement well due to the smaller number of investors that the manager must communicate with. Through regular discussions, investors can be provided with a clear insight into market conditions, and therefore identify early on any changes that might have an impact on the fund's investment strategy.

By having a more flexible framework and involvement from a smaller number of investors, the club fund structure can react quickly to changing conditions.

A current example of how adaptability is important in changing markets is the recent fall from favour of high leverage. While investors generally appreciate the use of leverage, more moderately geared funds are attractive to investors as they have become averse to the volatility associated with high gearing. We expect a number of club funds to be launched with a specific provision to allow a vote on increasing leverage if market conditions are deemed appropriate.

Joining the club
Investors have become increasingly sensitive to investing partners because of investor disagreements. The club fund structure allows investors to be more selective about the investors they invest alongside.and are therefore invited into ‘the club', ensuring greater alignment of investment philosophy and horizon.

The structure of club funds will change, but, these are not going to be revolutionary. The focus now is firmly on investors having greater influence in the decision making process (particularly around leverage and exit), adaptability and ensuring that the right club is created.