Stable, capable and credible: the crisis has not changed investor demands on fund managers significantly. Funds are upping the ante - newcomers will have to fight for a share of the cash. Shayla Walmsley reports

If the economic crisis has affected the way pension schemes select fund managers, it has been a change of emphasis rather than the wholesale abandonment of the old selection principles for a new set.

“To be honest, we haven’t really changed the way we select managers,” says Michael Nielsen, managing director at ATP Ejendomme, the real estate subsidiary of the €54bn Danish labour market supplementary pension scheme. “We’ve always had a deep and structured way of selecting managers. We do our due diligence very carefully.”

It largely comes down to cash: whether the fund manager has put in his or her own money, how much cash they have invested, remuneration - how, how much, whom - and fees. And Douglas Crawshaw, a senior investment consultant at Watson Wyatt, claims that many fund managers have not charged fees “the best way they should for their clients”. Instead, charging on gross assets - both equity and debt - has encouraged risk-taking on debt.

The pressure for more transparent fee structures has come from pension funds demanding evidence of value for money. “We weren’t talking about the distinction between NAV and GAV five years ago,” says Crawshaw. “Before, when real estate was delivering higher returns, even if you weren’t good value, when returns are 20-35%, the problem got diluted because you were doing so well in the first place. It’s more visible in a crisis.”

And in addition to fees, pension funds and consultants are concerned about performance. According to the most recent Prupim future intentions survey,* UK pension funds and consultants are concerned with three criteria: a clear investment process, good operational risk controls and track record. If the expectation of returns is lower - only a third of the 200 investors polled were after absolute returns - the expectation that managers will meet these three criteria remains high.

Specifically, pension funds want fund managers who know how to weather a downturn. Hermann Aukamp, chief investment officer for real estate at the €8.8bn North Rhein Doctors’ Pension Fund (NAEV), says: “The main issue is whether the manager is able to be proactive, and whether they have been in the past. We want to know whether they protected their assets and funds, and how they communicate in a downturn. In a downturn you can see what they’re about better than you can in an upturn. You can see how people behave very differently. On transparency, we wanted to know whether they had been transparent. On fee structures, we wanted to know whether they could work with the fee structure that works in both downturns and upturns.”

The October closing of Sparinvest Property Fund (SPF) II, a three-year fund of funds targeting returns of 10-13%, with €100m raised from investors including Danish pension fund PenSam, amounted to a vote of confidence in the fund manager’s ability to perform in a downturn. Sparinvest managing partner Bo Jensen claims that the first global fund of funds, launched back in 2005, proved the manager’s conservative investment style to be correct.

“In the past few years everyone has lost money and we’ve had disappointing returns but I’m optimistic about the future,” he says. “Investors can count on the hands-on experience of local managers for both funds.” The fund of funds targets funds operated by managers who understand asset management and who are locally connected - two factors cited by PenSam chief investment officer Benny Buchardt Andersen for investing in it. A third is what Jensen describes as “total alignment” with the fund’s investors. “We were the first fund of funds manager to invest our own money. Now that’s the trend,” says Jensen.

The issue of track record is one of the factors putting new entrants into real estate fund management at a relative disadvantage. Kirstin Irvine, European real estate researcher at Mercer, points out that more pension funds are screening out those funds least likely to succeed. Of the offerings crossing her desk daily, she says, many will never launch.

Nielsen’s Danish pension fund is looking for a combination of experience and performance. “We’ve been through a period of significant downturn in the market and we’re only interested in dealing with managers who have a long presence in the market - those with experience through market upturns and downturns,” he says. “Most of our managers are larger and have been in the market for several years. We’re not in favour of upcoming managers - those who’ve just set up. A pension fund needs to be cautious about the people it selects.”

Claude Angeloz, co-head of the private real estate team at Partners Group, claims to be seeing increased demand for global real estate portfolios even from usually conservative investors. The difference now is that investors have shifted their focus from products to expertise. “Now investors are looking to a fund management house rather than simply selecting a China fund or an India fund. They’re looking to someone who takes care of their money in China, not just someone who runs a China fund,” he says.

This demand for local management is important, especially for investment in the secondary real estate market, which Angeloz claims has “exploded” in recent years. Partners Group’s secondary deal flow totalled $3.6bn (€2.4bn) in 2008. Year-to-date, however, it has sourced more than 300 secondary opportunities involving existing fund interests representing $11.5bn of deal flow.

“In simple terms, when you invest in a newly launched fund you’re effectively underwriting the fund manager, trusting he’ll deliver the promised returns. In a secondary fund, however, you also need to underwrite the existing portfolio. You need your own local people on the ground to do the due diligence. Otherwise it’s a pure bet and that’s the last thing you want as an investor. It means underwriting each asset individually and to do that you need real estate investment experts. This is sticks-and-bricks territory - it has nothing to do with financial engineering. Understanding the true value of the properties in the portfolio is a challenge.”

An example of the intensified focus on management of property assets comes from PGGM Investments, manager of the €75bn Dutch healthcare scheme PfZW, which in July extended the application of environmental, social and governance (ESG) principles to its real estate portfolio. Governance is becoming more important not only to investors but to tenants, argues Mathieu Elshout, senior investment manager for European real estate. “For us, that has always been the case. Governance is very important - we’ve never invested in funds we don’t get information from. We ask our managers to be fully transparent. We’ll keep on demanding transparency, including transparency on the environmental performance of assets.”

Sustainability credentials dropped one place (to fifth) as a criterion for fund manager selection in the UK Prupim survey. But Elshout says it often emerges as the determining factor in practice - not least because it offers a proxy for the manager’s approach. Although there is no specific percentage weighting on ESG in the fund manager selection process, “if a manager won’t give us the information, we would find it very difficult to invest in that fund. If we’re comparing like-for-like funds, better ESG performance will make the difference.”

If there has been increased scrutiny at the portfolio level, corporate scrutiny has been at the level of the fund management firm rather than at the level of the individual fund manager. In spite of mooted demand from pension funds for ‘key man’ clauses, this does not seem to have emerged as a significant selection factor.

According to Jenny Buck, head of property multi-manager funds at Schroder Property, the key man issue has been overplayed. “They have always been a focus, but I would argue they only give investors a negative tool. I’d be nervous of investing in a fund for one person. Our focus is on teams. In the downturn, fund managers have walked away but I’m not sure people have thought through what happens if a person goes. Perversely, fund managers can sometimes become a Maradona within a financial house.”

Alex Jeffrey, European CEO at real estate investment advisers MGPA, forecasts that, although fewer fund managers will claim a larger share of pension funds’ real estate allocation, the business will not go to new houses set up by fund managers from larger firms. “An individual track record is not the same as that of a stable team and many of these will find it hard to gain traction with investors,” says Jeffrey.

No one seems to think consolidation will necessarily be a bad thing either for fund managers with a track record or for investors - despite the threat of reduction in fund choice. Jensen says: “It’s good for us and good for investors because it offers them a better risk-return profile. If you look back to 2005 and 2006, it was too easy for fund managers to raise money and invest it. They took too many risks.”

The challenge for institutional investors is to stay on top of developments, to know which are surviving, which are going out of business and which are reconstituting themselves, says Angeloz. Or, as seems likely, they will not bother. Instead, they will go with what they know. Although take-up of offerings from spin-outs is unlikely to come substantially from pension funds, consolidation will see the emergence of new business models based around stability and financial strength.

Among the new models, Buck cites one adopted by Palmer Capital, which offers “big brother support” for multiple operations with operational skills but without the overarching risk and management skills. The venture capital firm-cum-fund manager provides developers’ start-ups with management nous in return for equity in their firms.

“When suddenly fund managers are not making any money, viability matters,” says Buck. “It will be difficult for others that don’t have a strong financial balance sheet and risk systems in place. Pension funds are focusing on risk management systems, and two- or three-man mandates will find it difficult. But we’ve had a retrenchment. As the money flows again, the criteria may fall off.”

Yet it isn’t just business models that matter here. The economic downturn threw up three kinds of real estate fund manager. First were those who “didn’t need to do much”, with a solid business model in which the interests of the investor and the fund manager were aligned and communication was transparent. These were in a minority, according to Crawshaw. Second were those affected by the credit crunch but who recognised the issues and have shown themselves willing to deal with them. A third category “are those in a state of denial and who have been forced into acting. Those fund managers in denial have closed their eyes and ears. They’ve been waiting for others to sort out the mess.” Stubbornness has implications for how their businesses are run - as an indication of how they are thinking.

Even if fund managers claim to be listening, pension schemes want evidence. “Not one of our fund managers so far said they won’t work with us on ESG,” says Elshout. “For commercial reasons they wouldn’t. But it isn’t enough to say they agree: we’re looking for proof. We’re asking fund managers to state what their policy is in their annual accounts. We want real figures. That will enable us to monitor improvement, and to engage with fund managers - where there are problems.”

Some fund managers, initially slow to react to the rebalancing of power, are getting the message - but still not all. “Now the industry needs to look at itself - to find out how it broke and to prevent it breaking again,” says Crawshaw, pointing to diversity of effort between and among fund managers.

And, as Angeloz says: “There is a big difference between the good, the bad and the ugly - and there’s a lot of ugly out there.”

*What’s on the horizon? Real estate investment for UK pension funds 2009