Refinancing raises a number of concerns for investors but these are not always in the best interest of the fund, as Deborah Lloyd explains

Real estate funds in breach of their banking covenants are part of the funds' landscape today and 20% of real estate funds face refinancing in the next 12 months.

It may be the case that without restructuring and new equity, banks will call in their loans and investors will face the loss of their investments. Where new equity is required, this inevitably involves restructuring funds.

While fund managers should seek to put the interest of the investors first, there are occasionally conflicting views with minority investors as to what is the best course of action. Investor concerns will focus around the following areas:
 

New equity and dilution - the price of new equity is at a staggering discount. The figures on recent transactions in the UK seem to range from 45-80% discounted to NAV. This has a big effect on existing investors' equity which is heavily diluted. However, only 20% of existing investors agreed to commit to new funding according to the INREV debt study published in April 2009. Many investors believe that they may be throwing good money after bad. Those who will not or cannot increase their equity stake have often objected to the harsh dilution effect. The position is often dilution versus equity wipe-out. So it is usually in the best interest of the fund to accept expensive new equity to preserve its existence. Alignment and fees - investors want to ensure fund managers' fees are aligned with the fund. Fee adjustments may be appropriate where the fund manager has no prospect of earning a performance fee but it cannot be all upside for the fund manager. Investors will want to see some areas of reduction. The most popular proposal seems to be the reduction in the management fee and a rebasing of the performance fee. While managers may not like the former, rebasing the performance fee helps to incentivise the fund manager and its staff. Management consolidation - this happened in the well-publicised equity injection into The Junction by AREA Property Partners. The revised structure reduced fees overall and consolidated all management into one new management company, rather than a separate fund manager and asset manager. This benefited all investors because costs were reduced. Corporate governance - investors are seeking more control on key decisions if they are asked to consent to major changes to the fund. This may be through more matters being referred to the advisory committee and/or greater reporting requirements. We have started to see some funds bring in independent directors to oversee investors' interests but this is still relatively uncommon despite the encouragement through INREV's guidelines. Term - fund extensions are popular where the fund is due to expire in the next two years. While it seems sensible to exit in a better market in 2013/14, some investors have good reason to want out now and do not support an extension. Renegotiating debt - banks are reluctant to declare faults. This appears to be for a variety of reasons, including an inability to manage assets taken over, a poor market in which to sell and crystallising losses in their loan books. Fund managers are understandably dismayed by bank fee demands to waive LTV breaches but it is a brave fund manager who ignores the bank and hopes that it will take no action for the breach. Some investors question whether fund managers have conceded to bank demands too fast when the bank may have no realistic hope of improving its position by enforcing following a default.

So while some investors may not agree with fund manager proposals, many of the changes go to the heart of the constitution of the fund and require the consent of investors.

Unless a fund manager is confident that all the investors will back the proposed changes, its first port of call will be to examine the fund documentation to decide how to manage the proposed changes and any dissenting investors. There are three matters to which fund managers should be alive:
 

What consents (unanimous or otherwise) are required to make the proposed changes to carry out the restructuring? Frequently fund documentation provides that investor consent is needed from all of those who may be adversely affected by the changes. However, it can be argued that investors are not suffering any adversity where the alternative is the fund's potential ruin. In this situation unanimous consent may not be strictly required to make the changes; For funds structured as limited partnerships with offshore unit trust feeder funds, there is often the ability for the trustee to step in and vote contrary to the wishes of its investors when determining how to exercise its voting rights as a limited partner if, in its reasonable opinion, to do otherwise is likely to prejudice the fund. Again, this provision may be activated when there are minority investors whose vote could threaten the future existence of a fund; Is there a mutual covenant of good faith between investors in the fund documentation? It could be argued that an investor that contests proposed changes in the hope of achieving a favourable arrangement over others and not for legitimate investment reasons, may be acting inconsistently with this contractual duty, and could be challenged by its fellow investors. However, suing on such a covenant could be a risky proposition.

Fund managers have a tough time dealing with the banks where the lack of debt over the next two years means there will be increasing competition for it and some funds will struggle on refinancing. Raising new equity is a tough call for fund managers and funds lucky enough to secure it, to save themselves from liquidation or bank enforcement, pay a high price.

The fund manager then has to manage investors' expectations. Investors may have different views on the proposed course of action. In the end, the manager should put the investors' interests first, take a firm course of action, keep investors informed and talk to banks early.

Deborah Lloyd is partner at law firm Nabarro