The downturn has driven compliance with INREV's Corporate Governance Guidelines but there is still room for improvement, says Alasdair Evans

In late 2006, in an effort to provide guidance to investors and fund managers on corporate governance, the European Association of Investors in Non-Listed Real Estate Vehicles (INREV) issued its corporate governance guidelines, covering such issues as board structures, accountability, transparency and alignment of interest. The guidelines, now part of the integrated INREV Guidelines, were positively received by the industry. Three years on, INREV wanted to know the extent of compliance, so more complete data and analysis were sought.

In the financial crisis, corporate governance issues came under the spotlight. Many funds faced issues that had been caused or at least exacerbated by poor alignment of interest, little accountability and poor transparency. This has led to renewed emphasis being placed on this important area to determine how an appropriate corporate governance framework should be constructed.

This year, INREV undertook a review of the current corporate governance practices of European institutional non-listed property funds. The review, supported by the Dutch law firm Loyens & Loeff, targeted funds launched in 2007-09 and examined their documentation to understand the approach taken to corporate governance compared with the guidelines. In total, we examined 38% of the funds launched in the period on the INREV vehicles database.

Overall, the results are encouraging. Most funds have adopted many of the recommended practices and the general level of compliance is adequate. Nevertheless, the review also pointed out some surprising gaps that remain in current market practice and specific areas where board structures, accountability, transparency and alignment of interest can still be improved.

The inclusion of non-executive officers in fund management structures is a key feature of the guidelines on corporate governance. But to be effective in all circumstances, non-executive officers should be independent. The review found that although 84% of the funds reviewed have non-executive boards to monitor or exercise control over the decision-making of a fund, the directors generally are not truly independent, with non-executive officers generally investor representatives.

An example of a situation where directors need to act independently is to resolve conflict issues, such as deciding how defaulting investors should be handled and overseeing transactions with related parties. But without truly independent non-executive boards, it is difficult for the rights of other investors to be considered adequately protected.

A key indicator of accountability of managers in funds is the ability of investors to remove the manager, either with or without cause. Less than one-third of the funds reviewed provide for the no-fault removal of the manager, however. In these cases, typically three-quarters of the investors are required to take such action and the manager is compensated by up to two years of fees, along with carried interest. In practice this makes the removal of the manager extremely expensive and a less effective mechanism to hold the manager to account.

In cases where the manager can be removed for cause, which is possible in 77% of funds, the barriers are also very high, again with support from three-quarters of the investors generally required to take such action. Conduct sufficient to constitute cause for removal must sometimes wait until a final court judgment is obtained and, typically, the manager does not forfeit all their carried interest. In addition, there are few claw-back provisions if the manager is overpaid. As a result, even managers who are ultimately removed may end up being financially rewarded.

Situations where the best interests of investors would be served by removal of the manager are not difficult to imagine, yet there are high barriers to taking such action, making it more difficult for investors to hold managers accountable. This is especially important in closed-ended funds where investors do not have the ability to exit when they believe the manager is not performing.

Providing adequate information about a fund to all relevant parties in a way that is clear, fair, timely and not misleading is a principle that everyone should support. Other INREV studies show improving levels of reporting, although when considering governance aspects, we find some gaps relative to best practice. For example, barely more than half of the funds examined in the review explicitly give investors the right to inspect the books and records of the fund or the manager. Fewer still allow investors to appoint a third-party auditor to review the books and records or appoint the third-party valuer. These results do not point towards open and transparent fund operations.

A note of caution about the results should be sounded though. It is important to realise that a lack of compliance evidence may only prove that some corporate governance measures were not effectively explained in fund documentation and so not identified in this review, and not that they would not be encouraged in practice. Even so, explicitly disclosing good corporate governance measures is best practice and gives greatest assurance to investors.

Other identified gaps in transparency include the limited ability of investors in funds to call investor meetings. In addition, side letters are only disclosed in a small minority of funds, pointing to an area where much improvement could be made. Funds should take note that the EU Alternative Investment Fund Managers (AIFM) draft directive would require greater disclosure, including side letters, in particular.

Co-investment by managers is often seen as the best indicator of alignment of interest between investors and fund managers. Nevertheless, not all funds reviewed have co-investment by either the fund manager or the sponsor, and only a small minority provide for co-investment by the management team. More surprising still, nearly half of funds may not preserve the initial alignment of interest, allowing managers to transfer their interests in the fund, thereby allowing them to reduce their alignment with investors after the fund is established.

Conflicts of interest can also arise in situations where a manager runs other funds with overlapping strategies. We found that funds generally have only limited controls to prevent such conflicts from arising or for them even to be fully disclosed.

Another key indicator of alignment with investors is a performance fee or carried interest structure that rewards managers who have delivered good performance to investors. Some commonly used fee structures do not always align interests, however. For example, in most cases, base management fees are calculated as a percentage of gross assets, potentially encouraging managers to accumulate assets rather than maximise performance for investors. In addition, the majority of performance fee mechanisms are based on absolute geared performance, which can reward market movements and financial engineering as well as the manager's skill. Only one in four performance fee mechanisms is based on relative ungeared performance.

Although aimed at hedge funds and private equity funds, the AIFM directive also applies to non-listed real estate funds. It seeks to hold fund managers fully accountable for investment and risk management. It requires funds to use an external custodian, currently the practice in only one-third of property funds, and requires greater transparency. Funds must be aware of the directive's consequences on their corporate governance structures and practices.

The financial downturn of the past two years has turned the spotlight on many corporate governance issues. While poor corporate governance cannot be blamed for disappointing financial results, it has exacerbated them. Although the review revealed that, in general, non-listed property funds launched since the release of the guidelines have good corporate governance, the gaps identified in board structures, accountability, transparency and alignment of interest should be addressed by
the industry.

Encouragingly, anecdotal evidence points to a trend toward more investor-friendly corporate governance practice in more recently launched funds. Nevertheless, both established and newly launched funds should use this review to identify specific areas where they can make improvements.

A full copy of the INREV Guidelines is available at the INREV website,

Alasdair Evans is COO of UK fund manager Hermes Real Estate, chairman of the INREV corporate governance committee, chairman of the leisure asset manager, X-Leisure Ltd, and a director of IPD, Argent and MEPC