Fund terminations loom large, with implications for the range of strategic and tactical investor requirements. Against this backdrop the secondary market provides an opening. Michael Clarke reports
Terminations of unlisted funds in Europe are due to peak in the coming years. In 2010, in terms of gross assets, approximately €26.9bn are due to be liquidated and, in 2011, it is estimated that the number of funds that will be terminated will peak at 34 (source: INREV). In termination situations, investors, who have different strategies, can have a variety of expectations. Satisfying their diverse requirements is not without its challenge but solutions that meet the needs of all can be achieved.
Sector or single-country fund investors can usually be identified as
having either a strategic or tactical investment strategy.
The strategic investors are seeking a longer-term exposure to the
market with a manager that they have judged will outperform the wider market. While they may choose to increase or decrease their weighting to the specific sector, they are unlikely ever to withdraw from the sector or country in full, due to the perceived diversification benefits over the longer term.
The tactical investors are more focused on maximising returns for a given amount of risk. They look to move their capital between sectors and countries in line with their views on relative future returns, and are willing to exclude markets that they believe will underperform regardless of any diversification benefits.
Fund duration is important to both types of investors for slightly different reasons. While the strategic investor is willing to have a long-term exposure to the chosen market, they need a degree of liquidity either through liquidation or redemption rights during the fund's life to allow them to adjust their allocations or to escape a manager that has failed to perform or strayed from their original strategy.
The tactical investor is seeking to deploy their capital for a specified period in the hope of exploiting a market upswing. Once the capital is returned, it can be recycled into the next ‘best idea'.
Economists rarely forecast beyond one or two years, and property forecasters are reluctant to forecast beyond three to five years. Therefore, tactical investors with interests in funds, which typically have seven to 10-year life cycles, must either focus on managers whose alignment of interests encourage them to terminate early, if market conditions start to weaken, or use secondary market liquidity.
On continental Europe, early liquidation is quite common among value-add and opportunity funds. Reinvestment of sale proceeds is often discouraged in favour of returning capital to investors. Furthermore, as the performance fee, a substantial part of the manager's overall remuneration, is often only payable on the completion of the sale of the final asset, the manager is incentivised to liquidate at the time that maximises total returns.
In the UK, many core and value-add funds have been structured more like investment trusts, rather than the private equity model used on the continent. While they have a fixed life, the manager is able to retain the capital and reinvest it throughout the fund's life to achieve the investment objective. Therefore, the tactical investor does not have the luxury of an ongoing return of capital as assets are sold. For the tactical investor, the secondary market is therefore becoming increasingly important.
Secondary transfers rely on three key things:
Liquidity cannot be guaranteed in all circumstances but ultimately it is usually achievable if sellers are willing to be flexible on price. In falling markets, this means offering discounts and in rising markets purchasers need to accept paying premiums. Investor confidence in future movements in value is a key factor.
Values in the UK have fallen by approximately 15-20% over the last nine months and closed-ended funds are now trading at a NAV of 10-15%, in some circumstances more. As a result, the UK now looks more attractive relative to many other European markets. The weakness of sterling also helps in attracting international capital. With discounts still on offer in many closed-ended funds, it could be an interesting time to enter the market.
Schroders recently gained investor approval to extend the lives of its UK sector-specific funds from 2010-11 to 2020-21. Extending the life of these funds, which have a total AUM of €4.8bn, satisfied many of the strategic investors who wanted to retain exposure to sectors and the assets. Furthermore, extension of the term of the funds allowed tactical investors to optimise the marketability of the units in the short term. However, tactical investors wishing to create flexibility for the future required liquidity mechanisms to cover the extended period. By incorporating periodic redemption rights, we ensured that investors secured windows when they knew they could exit based on NAV, which should protect them from discounts widening too far in periods of weakness.
The advantages of creating longer-term funds with periodic, rather than ongoing, redemption windows is that it gives stability of equity to the manager to optimise performance over the long term. It also improves the environment for secondary markets to thrive while ensuring pricing migrates towards NAV on a periodic basis. A win-win for managers, strategic and tactical investors.
The views and opinions contained herein are those of Michael Clarke, head of property distribution, and do not necessarily represent Schroder Property Investment Management Ltd's in-house view
Michael Clarke is head of property distribution at Schroder PIM