Pension funds were recently accused of making such excessive demands on fund managers that they effectively talked themselves to the back of the queue. Should they be bargaining at all - and, if they should, is it every scheme for itself? Shayla Walmsley finds out

Are pension funds taking their cash-backed negotiating clout too far? That's the claim made recently by a US property fund of funds manager who claimed some smaller European schemes were taking advantage of capital constraints to demand special investment terms in return for early commitment.

The problem for fund managers is that these schemes are overplaying their early-investor advantage, pushing their demands to such an extent that they are damaging a relationship putatively  based on trust. It could also become a problem for the schemes because they risk getting shunted to the back of the queue by irate fund managers. What has provoked the emergence of these demands is a shift in the balance of power between pension funds and the funds they invest in. In the US, research from fund-of-funds manager Clerestory, which observed the trend, shows a continuing proliferation of funds pursuing higher-return investment strategies faced with declining capital-raising momentum. The net result is increased competition among funds for capital.

Does it matter? Yes, according to the fund manager, because it risks weakening real estate fund structures and endangers trust in the investor - manager relationship that is "the linchpin of the market".

So what are these terms investors are demanding? They come in two categories: governance and practical. Real estate investors may simply ask for clarity on the legal terms of investment - effectively, due diligence. They may, as large funds such as PGGM and public pension funds do, ask for disclosure and reporting in a form they can use. 

In some cases, they may even seek to influence who's on the advisory committee. Some pension funds - including APG, the investment arm of the €218bn ABP pension scheme, have strict rules that prevent them exploiting potential advantage from governance terms. APG's July acquisition of a 5.77% shareholding in Altarea, the French shopping centre developer, came with the offer of an appointee on its supervisory board. Although Altarea had approached APG as a strategic (rather than a financial) shareholder, the scheme's governance rules prevent managers taking a seat on the board and it will have to substitute "someone close to ABP", according to Altarea.

Yet other pension schemes' willingness to take advisory roles in return for capital commitment could present a problem both because the exchange of capital for wisdom is rarely equal and because it limits the fund manager's scope for decision-making.

"If you limit it, you're limiting the opportunity toolkit and you don't want to limit what they'll be doing. You don't want only people with the most capital to be on the advisory committee - you want people with the greatest competency," says Steven Grahame, a senior investment consultant at Watson Wyatt. "General partners only want to work with good people."

For Calum Mackenzie, a senior investment analyst with consultancy AON, if pension funds are bargaining - and he sees little evidence of the trend -  they're unlikely to succeed.  Rather than demanding lower fees of fund managers for a specific fund, they might more productively negotiate terms with an investor looking to divest.
"If you're looking for specific terms, you might offer to be the first investor to make a commitment in return for a preferential fee arrangement, a seat on the advisory committee or extra voting rights. But there's no evidence that this is being heeded," says Mackenzie.

"In the current market, the opportunities are there to negotiate not preferential terms but secondary trades with an investor looking to come out of closed-end funds at a slightly reduced price to net asset value. The real opportunity is in selling out and selling in, with pension funds looking to invest in a specific market or region. That's the opportunistic side."

He points out that some fund managers are participating in the trend with opportunistic funds for secondary units at discounted prices, with secondary trading increasing market transparency. Property is following the trend set by private equity, which has had a well-functioning secondary market for several years, minimising the J-curve effect by investing in funds as seed investors, with later closing. (The J-curve plots returns against time, with - usually - an initial negative return because of the payment of management fees and costs.)

So are fund managers justified in complaining about investor demands for special treatment? After all, they would say that, wouldn't they?
Clerestory cites against "the practical reasons" why larger investors seek better the terms  the principle of "equality of terms" among investors - a principle that putatively results in "a more efficient management process, a better product, a higher-quality investor base and, ultimately, better performance".

But why would pension funds not lever their potential advantage as early committers of capital to a fund? To pass up the opportunity would not make sense, according to Lisette van Doorn, CEO of the European Association for Investors in Non-listed Real Estate Vehicles (INREV). One reason not to treat investors as if they were the same, she says, is because they aren't.

"Some investors provide seed capital - which is a reason for them to have specific terms," she says. "If you're investing €75m, you're in a different position than if you're investing €2m. Once standard terms are agreed, you can focus on the complicated issues."

It comes down to a test of strength. In the end, she says, investment from a pension fund in a fund is the result of negotiation. The terms depend on the strength of the manager and the fund manager, and on market conditions.

If the idea of a relationship between pension funds and fund managers that stands outside the market falls wide of the reality, there is room to improve, if not the terms themselves, the transparency of the negotiations that produce them. The problem is that neither pension funds nor fund managers are especially keen to open up.

"It isn't always clear what fund managers are doing - whether they have a policy on distributing information," says van Doorn. "Investors have something to gain, except they fear their negotiating position will be used by others once the work of negotiating is done.

"It's a discussion we're having with investors at the moment. Given the lack of knowledge of the subject, resistance is the logical first reaction. But if you think it through, all investors will benefit. If you have more transparency, it adds to the comfort of others currently fearful to enter the industry. Lack of communication adds to the opacity of the market."

In any case, she acknowledges that transparency would be a more attractive proposition if it were clearer what investors and fund managers should be transparent about. A set of integrated transparency guidelines will go to the INREV board for approval in November. And until then?

"A big part of the responsibility lies with fund managers but investors need to be equally transparent," says van Doorn. "In the end, investors profit most from information so they're easiest to convince of the necessity of transparency. But they're also fund managers' clients and they're already putting pressure on fund managers. If your client can't convince you to be transparent, I don't know who can."

Clerestory principal Joanne Douvas in an earlier interview with IPE Real Estate claimed that large pension funds were the least likely to negotiate unfair terms. For one thing, they have a size issue - that is, more capital to commit than the fund manager wants from a single investor. For another, they're more likely to be investing directly in real estate. 

A July 2008 IPE/Invesco study of 115 investors, most of them pension funds, found medium-sized to large investors had a larger appetite for real estate, with an average allocation of 10% compared with 4% among small investors. Yet large European schemes  are following the trend set by their North American counterparts. Many of the Canadian schemes invest via subsidiaries set up for the purpose, such as Borealis, the real estate and infrastructure subsidiary of Canada's CA$47.9bn (€31bn) OMERS pension fund.

It is these - the ones that don't depend on funds of funds for their allocations, rather than small, say, public sector pension funds with limited in-house expertise - that potentially have most room to bargain."If it's happening, it would be the largest pension funds with in-house property management and research teams," says Mackenzie. "The kind of funds it might apply to would be specialist, closed-end, limited-life vehicles.

"Smaller pension funds are more likely to gain exposure through funds of funds, and they tend to rely on investment managers to negotiate on behalf of all investors in the funds of funds.

"When we rate funds of funds, we question what deals they've managed to agree with the underlying funds," he adds. "Smaller pension funds aren't in these negotiations, though. Those would be with the underlying funds."

Pension funds could strengthen their position by cooperating with each other to ensure equitable investment terms for all investors in a fund. "Pension funds and other large investors can be collectively more demanding than they have been," says Grahame. "They could group together. There have been cases where they have but you could put a question mark over whether the idea will grow. It would seem to have some potential and merit.

"Why don't limited partners get together? It comes down to resources - which vary - interest, competence and the willingness of general partners to listen. General partners are running a business. If they don't need to compromise, why would they? Inevitably, it will be linked to their ability to raise capital."

Yet to make it work you have to assume that all investors have the same interests and governance, and believe in the improbable prospect that partners in fund management firms will want it to happen. This diversity of expertise points to a second assumption - that many pension funds assume due diligence has been done on, for instance, legal and accounting issues in their speed to invest.

"Often investors assume others have done the work. It comes down to competency - earlier decisions versus good decisions," says Grahame. "We'd advise that investors do manager research and due diligence, and that they take legal advice, and work with the general partner to make the right decisions."

Instead, he advises, they should take their time. Likewise, van Doorn claims that investors are telling her they‘re getting more time to make investment decisions after coming under fund manager pressure in recent years. "Now there's more flexibility, more time.

It's a signal to them that fewer other investors are willing to invest," she says. "Fund managers had all the power because there were enough investors eager to invest. Now it's a different market situation - one that's getting easier for investors."
But when it comes to negotiating terms, thinking-time is somewhat beside the point.

"Investors have a simple decision to make - whether to invest in a fund or not. That's the starting point," says Grahame. "If they decide to invest but they don't like the key terms, they have limited ability to change them. Do they want to invest? If the terms are that tough, they won't."