Blind pooled or seeded? With the industry in flux the decision process has become all the more complex, as Wendy Arntsen finds
There is something funny going on - the real estate industry appears to be in feverish matchmaking mode. Platforms are divorcing, buying out their parents, and retying the knot left right and centre. The UK Citigroup team is moving to Apollo, Internos has bought GPT Halverton's European business, Cornerstone has bought Protego, Credit Suisse is in talks to spin off part of its property business to its management team, and ING is widely known to be lining-up potential suitors for a mega-wedding. Individuals are also making moves, starting up their own businesses and moving from one ship to another.
Change can be very refreshing. New platforms can be a great hotbed for fresh thinking; for experienced individuals to work together to redesign the model and bring about progress. New teams will not have established procedures, however, and personnel may have little experience of working together. Areas such as accounting, administration, investor relations and reporting may all face teething difficulties, requiring extra vigilance from investors. New platforms can also be a means to walk away from the headaches that shackle us elsewhere and to borrow or selectively transport parts of a good track record while burying a bad one elsewhere.
Which should we buy into? Should it be the old and stable, with its well-known bumps and bruises, or the new and shiny but ultimately untested? When trading most investors aim to pick a partner to stay with over the long term. In an environment where so much is changing, they should not be afraid to volte-face if the suitor is not quite right.
There is often something sparkly about new fund managers and new fund ideas. They are more likely to integrate the latest in corporate governance standards and corporate social responsibility ideas, and to play to current market preferences, such as shorter life vehicles and NAV based fees. Managers are espousing the merits of a ‘new approach' to fund manager accountability, reporting and transparency, and are furthering their efforts in sustainable and socially responsible investing. It appears that leopards are indeed changing their spots.
As a result, there is evidence of progress in new fund terms. Certain previously hotly debated points such as longer look-back and high-watermark performance fees are now accepted common positions. The use of investor advisory boards and independent directors seems to be growing and we are also observing genuine activity rather than mere rhetoric with respect to sustainable investment programmes. We are even seeing some existing funds voluntarily revising their documents to include more investor friendly terms (particularly when they are capital raising).
As investors have emphasised financial management and reporting provisions in the wake of the credit market crisis, there has been a marked trend towards clearly defined low leverage policies in new fund marketing. This newly established caution may be short term and it certainly pays to make sure the legal documents are sufficiently tight so that a policy cannot be easily overturned as memories fade.
Whereas many have preferred low leverage opportunities, more opportunistic investors will see the stabilisation of a major property market correction as a good time to apply a higher level of leverage. Existing funds often have a higher leverage than new funds can obtain. If this debt was not ‘swapped-out' the distribution yield might be very attractive today. One of the common challenges for existing funds, however, is the level of income being eaten up in loan amortisation, higher margins and meeting swap payments or breakage costs for derivatives that have locked in old rates of interest. This increases reliance on capital growth as a contributor to returns at a time when capital growth is certainly not a given.
Will capital growth be stronger for existing or new funds? Three years ago, investors responding to INREV's annual investment intentions survey said seeded funds were their approach of choice. This preference completely reversed towards blind funds in their 2010 survey. This is not surprising given that valuations tend to lag behind capital value falls. At some point, however, this might reverse. Valuations might eventually lag behind the recovery and as competition for investment becomes fiercer those funds with seed portfolios might come back into favour. Existing funds will already have paid their acquisition and set-up costs, and will avoid the J-curve. They will also have verifiable total expense ratios, and be less reliant on further capital-raising to achieve their target diversification and economies of scale.
These considerations are, however, tactical decisions related to market timing as opposed to long-term drivers of fund selection. As INREV reported in the same annual investment intentions survey, the single biggest reason given for investing in non-listed real estate funds is "access to expert management". The critical selection criteria for a non-listed fund manager are therefore very people-orientated. Investors will be searching out concentrations of expertise - the teams that are the most knowledgeable and experienced, with the best networks and the best track record.
The last criterion is more difficult than ever to measure. Track record is ultimately a record of the achievements of a group of people who might have changed considerably over the relevant period. ‘Key man' clauses are being regularly triggered as the merry-go-round rotates and performance may have been delivered at other companies. This will mean examining results in prior incarnations, setting those records in the context of client risk appetite and exploring longer-standing personal reputations, which will take a more forensic effort from investors.
A recent Nabarro survey found that ‘incentivising and retaining key personnel' was the second greatest concern of managers (after time to market and the closing of new funds). Given that this is what concerns managers, investors should be concerned to make sure that the team they select has the dedication and staying power to stick with them - for better, for worse.
Investors will be highly focused on the strength of ‘key man' clauses and the genuine alignment of interest of the management team through personnel co-investment or carried interest. When wedlock is padlock it will certainly pay to take time in selection and make sure you know exactly who your partner is.
Wendy Arntsen is director and head of multi-manager at DTZ Investment Management