What are the most important areas of risk that investors need to assess and manage, and has this changed since the onset of the financial crisis? Richard Lowe asked six commentators and found a wide array of issues for investors to consider

Timo Löyttyniemi
State Pension fund of Finland

Key risk for indirect investors is exposure to leverage in funds
Dedicating more time and resources to monitoring existing funds
Targeting lower leverage in new fund investments

Valtion Eläkerhasto (VER), the state pension fund of Finland, began investing in real estate for the first time in 2004 and set about building up an indirect exposure through non-listed funds, predominantly in Europe with a small exposure through a fund of funds vehicle to Asia. For this reason, managing risk in its real estate portfolio is a more straightforward and less wide-ranging task than if it had a blend of direct and indirect investments.

"Our model is based on investing into funds. That puts a specific angle on it and so risk management as such is an easier task from our perspective as we are a portfolio investor," says Timo Löyttyniemi, managing director at VER.

The €12.9bn pension fund has 4.3% of its total assets invested in alternatives (that is, not equities or fixed income), of which 42.2% is allocated to real estate.

VER has a long-term strategic target of 5% for real estate, which shows the pension fund has a large capacity for new investments. But Löyttyniemi explains that much of the attention is on existing investments.

"The key monitoring task from our side has been to look at the leverage ratios and the use of leverage by the managers," he says. "We expect the managers to report how they sit in terms of the loans against their covenants."

This has caused more time and resources to be allocated to managing risk in this area. "But there are only a few funds where we have been digging more deeply. We are happy with what most of the managers are doing at the moment," he adds.

This focus on leverage has also had repercussions when investing in new funds. VER now has a lower appetite for leverage in funds, although it has always pursued a modest level of debt exposure in funds.

"We are targeting lower leverage in the new funds. Of course, we were not extremely high leveraged either to start with, but we are looking for lower leveraged products, especially an amount of leverage that is suitable to the chosen target," Löyttyniemi says.

Henrik Kolind

Vacancy risk is the chief concern for direct portfolio
Main risks for funds concern loan maturities, liquidity and fellow investors
New regulations developing for EU is another major risk for all alternatives

The principal risks for Sampension's real estate investments differ depending on whether they are in relation to the Danish pension fund investor's direct or indirect portfolio.

For the sizeable direct Danish portfolio the main risks concern the employment situation in the country and the consequences this will have on vacancy rates. "We focus on our own direct portfolio to get as high a letting rate as possible. It takes a lot of effort," says Henrik Kolind, head of property investments at Sampension.

As for Sampension's international indirect portfolio, the main risks are those associated with the debt markets and the maturities of loans held by funds in which Sampension is invested. But there are other risks associated with fund investments that need thinking about, including liquidity and fellow limited partners.

"That is something that we have met in the past couple of years. It has been more and more evident that you need to know who you are investing with," Kolind says. "In the future there will be a lot of talk about extensions to the life of funds. We will need to enter into, hopefully, good discussions with other investors and fund managers. There is a lot to think and talk about in the future."

Sampension may seek to invest in funds with shorter timeframes and fewer investors as a result of the experience of the past few years. "Club deals could make sense and we could also perhaps look into joint venture possibilities with other big investors," Kolind says.

Another area of risk on the radar for Sampension is the potential impacts of new EU regulations on real estate investments.

This is something the pension fund investor is monitoring for all its assets classes, most notably the Alternative Investment Fund Managers (AIFM) directive, which could have repercussions for a number of alternative asset classes, including real estate, but also timber, private equity and hedge funds. "We need to do a lot of research. But that is an ongoing process at our company," Kolind says.

Mike Hardwick
West Midlands Pension Fund

The risks in the direct portfolio are regularly evaluated
lThere are different risk parameters for the global indirect portfolio
The crisis has only highlighted the importance of due diligence and risk analysis

The West Midlands Pension Fund has a large directly held portfolio in the UK. Investment manager Mike Hardwick explains that risk management in this area makes reference to the market index, but other key risk factors are taken into account when constructing the portfolio, including tenant spread, geographical and sectoral exposure, lease length and break clauses. "All properties will undergo regular re-evaluation in order to justify their place in the portfolio," Hardwick says.

West Midland's indirect global portfolio mainly comprises private equity-like real estate funds and is intended to deliver higher returns. "Risk parameters differ slightly based around return expectations, inherent manager risk from the investment and exposure to different economic conditions associated with the geography," he says.

"We would expect the manager to monitor and assess the same risks outlined above for direct investing in the delivery of their strategy and we continue monitoring these factors in the underlying portfolio throughout the life of the investment."

The financial crisis has not materially changed the way in which the fund manages risk. "The importance of the due diligence process is the same throughout all economic cycles but going through a crisis does re-emphasise the importance of rigorous due diligence. In times of prosperity investors can overlook the importance of this process but it has to be remembered that the process is not a theoretical exercise, it is a tool for the protection of capital," he says.

"Having been invested in private equity for over 30 years the fund is comfortable with it and benefits from the illiquidity premium. Probably one of the most surprising outcomes of the crisis has been the exposure of other limited partnerships to their funding obligations. However, in most situations there has been a solution through secondary sales. Liquidity is always a consideration when investing in private equity styled vehicles and investors should be fully aware of this factor before making such investments."

Jan-Willem Dijkhuis
Lymos Real Estate Capital Advisors

l Dutch regulator seeking to overhaul risk management of pension funds
l Existing real estate risk management not sufficient
l Dutch pension funds will move away from leveraged funds

Dutch pensions regulator De Nederlandsche Bank (DNB) is planning to overhaul risk management of Dutch pension funds following the conclusion of a study that showed current provisions and procedures were not sufficient.

"We are not where we should be in regard of risk management and real estate," says Jan-Willem Dijkhuis, managing director at Lymos. "We don't have the systems. Many risk managers still don't understanding the underlying business model of real estate and that makes it difficult to implement risk management systems in pension funds and at the Dutch central bank.

"Understanding both procedures and what is really happening in real estate funds is important. That knowledge base should be improved within the investors and also within the central bank and other authorities in Europe."

The biggest point of contention at the moment for managing real estate risk in pension funds is leverage. Funds are not allowed to leverage their investments, but many are exposed to leverage indirectly by gearing used by their real estate fund managers.
"Should that be allowed?" Dijkhuis asks. "There are some thoughts that the leverage should be decreased in funds and that will be one of the main items for the review of risk management of pension funds within the central bank."

Dijkhuis believes that a systematic change in attitude is taking place towards opportunistic real estate funds that use leverage and focus on capital appreciation over income generation. "Cash generating assets will become more popular than the illiquid, non-cash generating assets," he says. "These assets are very hard to analyse. For pension funds with limited staff many of these assets are too complex to monitor."
For this reason, Dijkhuis expects core, income-producing real estate investment to remain the preferred strategy for Dutch pension funds for the foreseeable future - perhaps five to 10 years while memories of the crisis are fresh.

Martyn McCarthy
Valad Europe

Major areas of risk for investors are debt and manager capability
Investors want to understand risks pertaining to specific assets in funds today
Some managers are unable to meet these reporting requirements

Two main areas of risk for investors today are debt and manager capability, says Martyn McCarthy, chief executive at Valad Europe. "Debt is the biggest risk because it isn't as readily available as before," he explains. Lenders are carrying out in-depth due diligence on managers today, which means they will only lend to a fund that has quality and depth of management. They won't even start the conversation unless you can demonstrate a fully integrated service."

Manager capability falls into two categories: asset management and fund management. "Asset management deals with the tenant customer and funds management deals with the financial structures - accounting, tax, governance and reporting," he says
There will be a number of funds that fall into the camp of having managers without the appropriate capability and that are unable to access new sources of financing, says McCarthy. This will apply especially to those funds that pursued cross-border strategies without local presence and expertise in the markets.

Such funds are also liable to provide investors with insufficient information on their existing investments. "Prudent investors demand managers with high-quality systems and processes that result in high-quality information," he says. "Investors need timely and accurate reporting on their investments."

This scenario will apply to a significant minority of funds. INREV therefore plays a very important role, he argues, in ensuring transparency and fund reporting is improved across the industry. "If I sit down with investors in meetings today they actually want to spend time understanding the portfolio risks. They want to know what is happening with Tenant X - which might be an important tenant to the portfolio - and what we are doing about it," he adds.

"There is much more interest today in the factors that may influence the outcomes of their investment, because previously the market was taking care of everyone. Nowadays it requires a combination of strong asset management and skilled capital management to generate the best returns."

Rob Bingen
Schroders' multi-manager risk analysis process has not changed fundamentally
But some risks such as environmental concerns have become more pronounced
Risks posed by ambiguous fund documentation have also been highlighted

Schroders' property multi-manager business has a risk analysis and due diligence process in place which has not changed materially since the financial crisis. "We constantly look at it and refine it, but the basics of the areas we look at and the rigour of the due diligence have not really changed," says Rob Bingen, head of European property multi-manager.

The emphasis placed on the various different risk categories has changed, though. Environmental risk has become more prominent, especially as tenants increasingly seek sustainable buildings. When assessing funds with existing portfolios, Schroders considers the level of sustainability and energy efficiency, but for blind pool funds with no existing assets it is all about ensuring the manager considers sustainability in future investments.

Another area of risk that has become more pronounced is terms and conditions in funds. Ambiguous wording in documentation has led to uncertainty and debates between managers and investors over whether rules have been adhered to or broken.

"Provisions such as exit arrangements, breaches, investment criteria, fees, all those types of things," Bingen says. "In some cases while they were in the documentation the legal wording might not always have been as firm." This extends to leverage; investors need to check how firm leverage caps are in documentation. "Are they intentions or caps."

Governance is another important area, especially as some investors are seeking to exert more control over how their funds are run. "We understand why that is," he says. "At the same time we are always trying to find the balance between the investor and the fund manager. You do actually underwrite the manager and put your confidence and faith in them. You have to be cautious that control of the fund does not end up in the hands of the investors."

Bingen says this is important in terms of being able to hold the manager accountable. "You have to give him discretion to do that. So we see there is debate on governance items. We haven't particularly changed our approach to it, but we do think it needs to be balanced carefully."