Liquidity pressures are pushing investors to trade their interests in closed-ended funds. Will the current dislocation act as a catalyst for the emergence of a more organised and active secondary market? Richard Lowe investigates

When the European Association for Investors in Non-listed Real Estate Vehicles (INREV) published the results of its Liquidity Provisions earlier this year the headline figure was somewhat surprising: more than one billion euros of secondary real estate fund interests had traded over the previous six months. This was surprising because, unlike in the private equity buy-out space, the secondary market in real estate funds has largely been seen as non-existent.

Perhaps this is because the practice of selling stakes in closed-ended property funds is seen as being in direct contradiction to the hold-to-maturity mentality of the sector, where investors enter into such vehicles with a view to committing capital for several years without any option for liquidity. But this hold-to-maturity mantra had not been overly challenged during the years prior to the credit crunch when capital values rose across all markets and the majority of European investors were chasing their target allocation to real estate.

Today there are a number of reasons why investors want to exit property funds as a result of the current market dislocation. These included a need to rebalance portfolios; simply being unable to fund future capital commitments; a loss of confidence in the ability of a fund manager to be able to follow through with his strategy, or in other words ‘throwing good money after bad'.

US-based Liquid Realty Partners is the largest of only a handful of companies specialising in real estate ‘secondaries'. It is currently raising equity for its fifth commingled fund targeting opportunities in the secondary market. Founder and managing principal Scott Landress explains that, since its creation in 2001, Liquid Realty has been waiting for the time "when the market would cool and an abundance of sellers would emerge".

Jeffrey Giller, fellow managing principal at the firm, recalls the start of 2008 as a turning point, when a large number of investors quickly discovered that  they had reasons to sell fund interests, causing the secondary market to "explode almost overnight". That is not to say that widespread trades immediately began to happen but rather a sea change in investors' thinking began to occur.

"The long-held mantra has been ‘hold everything to maturity'," Landress says. Many US pension plan sponsors, for example, have since had to "shake the shackles of this mantra", he adds.

The recent market dislocation has demonstrated clearly that not all investments can be held to maturity in all eventualities and there is therefore a role for a secondary market. However, while a significant upsurge in motivated sellers has acted as a catalyst, is this a short-term anomaly?

When the dislocation subsides will the secondary market disappear with it and will the real estate funds sector return to  the status quo? Or will there remain a stable level of secondary transactions thereafter?

Delegates at INREV's liquidity provisions seminar in March at MIPIM in Cannes were hoping to hear some answers to these questions. Unfortunately, clear conclusions were lacking. More than half (62%) of respondents of the association's survey saw the emergence of an organised platform for a secondary market as unlikely.

Neil Turner, head of fund management at Schroder Property Investment Management, summed up the dilemma facing the sector. Would the industry lose sight of what it ultimately provides investors - an illiquid investment with low volatility, low correlation with other asset classes and regular income generation - and become more akin to the listed sector, he asked. "Just put EPRA here instead of INREV and you've got it," he joked, pointing to the association's logo.

That said, Landress and Giller believe the current market dislocation will leave in its wake a greater level of general activity. "Right now, the secondary market in real estate private equity is addressing the distress of the sellers, solving their denominator effect problems, solving their liquidity problems," Giller says.

Landress adds: "Going forward, the market should grow steadily as investors not only solve their immediate problems but also turn to real estate secondary sales as a portfolio management tool."

A similar view is held by Edward Casal, CIO of global real estate multi-manager at Aviva Investors, who founded Madison Harbor Capital, which merged with Aviva last year, and has several years' experience in buying secondary real estate interests.

"You are going to see a bubble of activity and then it will settle down to more of a regular flow," he says. "That flow will settle at a level higher than where it was before. Many investors have approached their real estate allocation limits and so will start to use this to balance portfolios and won't be in this perpetual struggle to keep up to their real estate allocations."

An efficient, organised secondary market would certainly be of benefit to the burgeoning fund of funds sector. Many will have come under pressure from the current market environment, perhaps unable to alter strategies that were designed before the onset of the credit crunch and requiring a more efficient secondary market to sustain investment strategies.

"It is not really an established market. There is no platform," says Volker Wiederrich, chief investment officer at fund of funds manager Swisslake Capital. "A lot of these trades take place via a secondary investment bank… or it is a direct relationship between buyer and seller."

When panellists at INREV's seminar at MIPIM were asked whether they expected to see the emergence of an organised platform there was some scepticism, particularly from Paul Vosper, chief operating officer at Morgan Stanley AIP Real Estate.

He said: "We have seen the emergence of some trading platforms, particularly in the US. [But] I am not convinced those are going to be particularly successful in providing significant amounts of liquidity."

Instead, Vosper suggested a more active secondary market could be sustained by the emergence of dedicated secondaries funds, as transpired in the private equity buy-out funds sector. There are estimates that 4% of all capital raised in the buy-out arena goes into such secondaries funds.

At present only a small number of firms specialise in secondaries, including Liquid Realty, Landmark Partners, Credit Suisse and Madison International Realty (the latter has tended to be more active in trading secondary interests in direct assets). Other players are expected to enter the market in 2009.

Secondaries products, both in private equity and real estate, have been largely pioneered in the US. Mike Clarke, head of property distribution at Schroder Property Investment Management, is keen to know whether this model will cross the Atlantic successfully and appeal to European investors.

The firm is looking to take advantage of secondary opportunities for its institutional clients, whether that is through its multi-manager business or potentially through a dedicated fund. Clarke admits that today "the jury is still out" as to which route would appeal most to investors.

One of the reasons Vosper backed the dedicated secondaries funds route was the intensive due diligence required in valuing and trading secondary interests. Investing in new funds entails such factors as assessing manager track record and fund strategy. But secondary investing arguably necessitates a more complex range of factors and considerations, from underlying assets to the proportion of committed capital drawn down.

"Valuing the entire portfolio of a fund is a huge job," says Casal. "There are a lot of nuances when you run through an analysis of a secondary interest."

In addition to assessing the underlying real estate, investors need to understand the corporate finance aspects. "It is very easy to do the math wrong in these analyses," he continues. "You've got to really figure out where the cash is, what it is going to be used for and any reserves that you may need, because a lot of the underlying funds are going to end up calling their capital to pay down debt, and you might have been thinking they were going to call down capital to take advantage of all these great opportunities out there to buy real estate at cheap prices."

Landress and Giller question whether fund of funds managers or consultants are set up to invest in the secondary market efficiently, given that their expertise is in assessing fund management teams and constructing portfolios, not in making multi-faceted property-based investment decisions.

"Funds of funds and consultants are expected to be very good at allocating capital in accordance with asset allocation models. They are good at portfolio construction, they are good at evaluating managers in terms of their historical performance. And that is really where funds of funds can be quite strong," says Giller. "So it is hard for us to imagine how they are going to turn their core capabilities overnight into real estate due diligence and underwriting expertise."

Landress suggests that real estate consultants and fund of funds managers are following in the footsteps of their private equity counterparts, who account for a minimal portion of the private equity secondary market. The challenge they face when investing in the secondary market, he asserts, is "it is a demanding, underwritten strategy that requires the full focus and attention of a large, experienced, fully-integrated investment management team".

He adds: "One cannot approach it as a part-time job."

While the headline figure of INREV's liquidity provisions survey that €1.1bn of secondary trades had taken place over the last 12 months was surprising, panellists at MIPIM questioned how representative a figure this was.

"It doesn't feel like that and I suspect probably that's because most of those trades were redemptions or funds closing and returning equity," said Mike Cutteridge, director at DTZ Corporate Finance.

Anecdotal evidence suggests there has been a marked upsurge in secondary market interest, with potential sellers of secondary stakes putting out feelers to see what sorts of bids they might attract. But so far indications suggest there are a lot more ‘conversations' than actual trading.

But, as already stated, there are a number of factors driving investors to look to sell stakes in closed-ended funds on the secondary market, such as not being able to afford to fund future capital calls, possibly because the investor is relying on distributions from other funds that are not forthcoming. Another more controversial scenario is one where an investor no longer believes in a fund manager's strategy - or ability to execute it - because of changes in the market environment since committing to the fund.

The latter has been put forward a number of times by Paul Parker, managing director for European real estate at Landmark Partners, who moved from DTZ last year because he expeced "a big increase in the potential to do these sorts of deals" on the real estate side.

During a seminar held at MIPIM, Cannes, in March by INREV, Parker argued that there were two leading drivers for limited partners to sell: a reliance on distributions to fund capital calls and, more contentiously, a loss of confidence in the investment itself.

"There have also been investors who are looking at substantial, large unfunded commitments. I think of those situations where we have seen investors actually starting to question whether they even want to make that commitment," he said. "That is an area of potential issue for the industry."

One reason transactions have yet to arise in any great number is the current wide bid-ask spread where potential sellers of stakes - or vendors - are clinging on to potentially outdated net asset values (NAV), while bidders are asking for significant discounts to NAV to compensate for future capital value falls and uncertainty surrounding the financial health of the vehicle itself.

"The bid-ask spread is very wide right now," says Casal. "In my view it will resolve itself to the bid side as the sellers come to realise that the NAVs on these funds are coming down."

But Casal points out that the situation is exacerbated by the fact that the bidders are invariably "nervous" and are lowering their bids just as vendors are lowering their expectations. "The bidders are giving bids they are not sure they really want to close on, because they are so afraid every time they open the newspaper," he says.

While large portfolio trades are yet to surface, individual interests in funds are being bought and sold. A stake in an Invesco Real Estate fund was recently sold to existing investors in a fund, for example. The multi-manager arm of CB Richard Ellis Investors also recently bought a secondary fund interest.

However, managing director Jeremy Plummer explains that CBRE Investors has a strict set of pre-requisites for a secondary transaction - the fund is financially strong, there is value in the equity already invested, the manager is motivated, it is "cheap" - and questions how many secondary interests on the market will meet these criteria.

"We are screening a lot of secondary opportunities," he says. "We will do some, but you've got to be very selective." In fact, Plummer warns that some fund interests could even have a negative value.

At IMN's recent European Distressed Real Estate conference in London, James Burdett, partner at Baker & McKenzie, a law firm representing a number of secondary market specialists, was bullish about the potential for the sector, especially given the high level of discounts being quoted.

"I am not an economist," he said. "But if you are talking to them about 70-80% discount you can't fail to make money over the long term."

John Dwyer, head of real estate at FF&P Asset Management, said he had heard of vendors offering to pay investors to take on their fund commitments.

"You've got to be extremely careful," Plummer says. "Even if you take on the invested part for nothing and you take on the obligation to take the unfunded capital calls, that might not be a good deal."

He gives an example whereby fund assets had been purchased using a subscription line (borrowing facility secured on uncalled equity); another could be uncalled equity having been used to refinance deals with negative equity.

"Zero is not necessarily a good price," Plummer concludes.