Real Estate Investment Funds: The current trends


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Real Estate Investment Funds: The current trends

  1. 1. Indirect Investment briefing November 2009 Real Estate Investment Funds: The current trends Summary and implications Ask a question Uncertain market conditions and the demand for new equity have If you have any questions in respect of any matter raised in this briefing resulted in fund investors having the upper hand in negotiating please contact Amanda Howard, investment terms. Fund managers need to react to the changing Partner T +44 (0)20 7524 6342 circumstances. What is the impact on the indirect real estate investment market? Recent briefings As investors become more selective in where they commit funds and Alternative Investment Fund more focused on Fund operations, there is highlighted awareness of: Manager's Directive (August 2009) The recently published European • the importance of managers and investors interests being aligned; Commission proposal on regulating Alternative Investment Fund Managers • the need for a comprehensive corporate governance structure; will have an impact on funds in the real estate sector. Click here for full • increased accountability being placed on a manager’s actions; and briefing. • the requirement for specific investor friendly terms. Joint Ventures Joint venture structures in the real estate sector have become Alignment of interests increasingly topical. Joint venture parties should consider at the outset Management fees and carried interest the circumstances in which the joint venture will terminate. Click here for Investment Funds now usually adopt a private equity model for manager full briefing. remuneration, namely: The Indirect Investment team • management fee, based on a percentage of fund commitments For further information on these and (typically 1.5 to 1.75%); other briefings, the Indirect Investment team and its capabilities, • carried interest payment (essentially a performance fee) of a click here. percentage (typically 20%) of a Fund’s profits once investors have received back their equity and preferred return (typically 10 to 12%). Management fees are now commonly based on capital drawn and invested during, as well as after, the commitment period. Investors are resisting management fees being paid on uncommitted capital, which used to be the norm. The carried interest payment is increasingly being paid on a whole fund basis i.e. investors receive all their invested equity back and their preferred return before the manager receives its carried interest payment. Investors prefer this to carried interest being paid on a deal by deal basis, 1
  2. 2. Indirect Investment briefing Funds' Trends November 2009 which can result in a manager being overpaid if subsequent investments underperform, leading to the need for complicated clawback and escrow arrangements. Investors are pushing back against paying managers any catch up payment on carried interest. Instead, hard hurdles are becoming more common, with managers only receiving a proportion of profits in excess of the hurdle. Other fee related trends include: • investors resisting a manager or its affiliates receiving additional fees, such as acquisition, disposal, subscription or finance fees; • fees being based on a Fund’s net asset value as opposed to its gross asset value; • performance fees not being based on unrealised capital gains; and • fee calculations being subject to independent verification. Manager co-investment Lack of alignment of interests is now considered the main obstacle to fund investment, overtaking the issues of transparency and availability of market information. While fees can be structured Investors are keen to ensure that to help align interests, many investors consider fees alone to be insufficient. Investors are increasingly looking for co-investment Fund Managers share in the good by the fund sponsor to create alignment. Investors look for a times as well as the bad meaningful and proportionate investment at a corporate and/or individual level, with individuals involved in the Fund to be appropriately incentivised through participation in carried interest. It is now normal for this investment to be maintained throughout the life of the Fund, with transfers of co-investment (and carried interest) being prohibited. Transparency Alignment concerns apply not only between investor and manager, but also amongst investors. Investors want to know who they are investing alongside, so they can be reassured of common investment philosophies and of their partners’ ability to meet funding commitments. Managers have traditionally not encouraged disclosure of investor identity, citing confidentiality obligations, but some investors are starting to make investor disclosure a condition to their investment. Amalgamation of roles As a way of consolidating fees, functions and responsibilities, investors are starting to question whether fund management and asset management roles should be amalgamated. For European Funds, such consolidation may be necessary anyway as a consequence of the implementation of the Alternative Investment Fund Manager’s Directive, currently expected in 2011. 2
  3. 3. Indirect Investment briefing Funds' Trends November 2009 Corporate governance Investor involvement in decision making Investors are demanding a greater involvement in the decision making process, leading to more “club style” ventures. Demands include requiring: • regular written updates on strategy and on demand meetings with managers; Investors are requiring better • certain decisions (e.g. appointment of auditors and valuers communication and increased and any replacement key person) to be reserved to a vote of investors or the advisory board; and levels of transparency from managers • opt in/opt out rights on investments. Larger investors are resisting provisions requiring unanimous investor approval, so as to prevent minority investors from blocking decisions. Investors also expect managers to be disenfranchised on matters where they may be conflicted e.g. appointment of affiliate service providers, removal of manager and term extensions. Independent directors Investors are increasingly keen to monitor the key decision making process of a Fund. Some investors favour the appointment of independent board members tasked with overseeing these activities. These appointees should be truly independent (and not remunerated via the carried interest) with adequate authority and a robust framework to fulfil their role. Advisory board A Fund’s advisory board is the principal forum for interaction between investors and managers. To be attractive to investors it should: • be independent of the manager so that conflicts can be avoided; • have access to independent counsel; and • offer indemnity protection and PI cover to its members. Larger investors will make a seat on the advisory board a pre-requisite to investment. 3
  4. 4. Indirect Investment briefing Funds' Trends November 2009 Key persons In difficult times and when top personnel may be on the move, increased importance is placed on the individuals managing a Fund. Having relied on their track record when making an investment, Investors will require investors want the right to influence the consequences if these key individuals cease to be directly involved in the Fund. These consequences to flow if key consequences can include: individuals cease to be directly • suspending the investment period until a suitable and involved in the Fund investor approved replacement is appointed; • terminating obligations to make future contributions; and • terminating the Fund or replacing the manager if a suitable replacement is not found, with an impact on any carried interest earned and manager co-investment. Debt and financial management Some investors are now, understandably, wary of debt and the impact it can have on returns and are seeking reassurance from fund managers that they really understand how to manage debt. These investors are seeking lower debt levels and insisting on greater reporting on debt management by fund managers. Investors are placing greater emphasis on a Fund’s financial management, accounting and reporting processes, wanting reassurance that a competent financial controller has clear responsibility for Fund accounting. Accountability Investor default Typical consequences of default Investor default, such as failure to advance committed equity or Investor default insolvency, is an emerging issue for fund managers and investors. Failure of an investor to fund is typically a breach of contract which may entitle • Loss of voting rights the manager to recover damages for the loss suffered. Whilst there may • Suspension of distributions be a range of remedies available to the manager if an investor is in • Investor’s interest temporarily default (see table), the manager may opt to try to help the investor cure suspended or transferred at a the breach. This could impact on non-defaulting investors who may be discount forced to advance funds sooner than expected to fund the shortfall. • Investor responsibility for Fund’s Managers must tread carefully when considering their course of action costs arising from default as they have an overall duty to the Fund in exercising their rights. Manager default • Removal of the manager • Termination and winding up of the Fund • Loss of or reduction in entitlement to carried interest • Fund restructuring 4
  5. 5. Indirect Investment briefing Funds' Trends November 2009 Manager removal Investors are increasingly seeking provisions allowing for termination of a manager’s appointment. Manager removal can arise in two circumstances: • “for cause” arising from the manager’s fraud, unremedied material breach, negligence and insolvency; and • “without cause” or “no fault divorce”, when investors, by sanction of say a 66 or 75% vote, decide to remove the manager. Fund managers have resisted attempts to make a change in their control a “cause” event on the basis that in such circumstances investors should rely on the protection afforded by key person provisions. However, with the increased likelihood of manager being the subject of mergers and takeovers, investors are starting to require this term. It is becoming increasingly difficult for a manager to resist “no fault divorce” provisions, but it may seek to limit its effect e.g. preventing its application in the first two years of the Fund and As the likelihood of by requiring the payment of an additional 12 months of mergers/takeovers of managers management fees. increases, so will pressure for If removed “without cause”, the manager should be entitled to change of control of a manager its carried interest, based on then current valuations, perhaps to be a default event with an additional catch up sum based on actual gains at the end of the Fund term for investments made before its removal. The manager will also seek the right, at its option, to either require its co-investment interest in the Fund to be redeemed at value or to remain as an investor in the Fund with the same rights, including for voting, as other investors. With “for cause” removals, investors will expect the amount of the manager’s carried interest entitlement on removal to be heavily discounted or extinguished. Investor friendly terms Limits on commitment and contribution levels As the possibility of investor default on funding can be reality, investors are looking for ways to cap their exposure in a Fund. Investors can seek to limit their percentage commitments to a Fund on top of capping their commitments at specific amounts. Some investors are also concerned to extend this limit to cap their percentage contributions, so that another investor’s funding default does not increase their proportionate interest in the Fund. 5
  6. 6. Indirect Investment briefing Funds' Trends November 2009 Manager conflict of interests Managers are expected to have adequate conflict of interest procedures in place and to undertake: • not to sponsor, market or close another fund with similar investment parameters during the Fund’s investment period or until the Fund is largely invested; and • to ensure that the manager and its affiliates offer the Fund first refusal on all investment opportunities suitable to the Fund. Investors are increasingly scrutinising manager’s internal conflict policies and procedures to ensure they are robust. Strategic alliances As part of a general trend of investor consolidation, investors are looking to forge strong relationships with a smaller number of managers rather than having their investment portfolio spread across numerous managers, often in multiple jurisdictions. In doing so, investors are seeking improved communications and understanding between principals as well as preferential terms across a number of different funds. London Sheffield Brussels Lacon House, 1 South Quay, 209A Avenue Louise, 84 Theobald’s Road, Victoria Quays, 1050 Brussels, Belgium London WC1X 8RW Sheffield S2 5SY T +32 2 626 0740 T +44 (0)20 7524 6000 T +44 (0)114 279 4000 F +32 2 626 0749 F +44 (0)20 7524 6524 F +44 (0)114 278 6123 Alliance firms France Germany Italy August & Debouzy GSK Stockmann + Kollegen Nunziante Magrone Gilles August Rainer Stockmann Gianmatteo Nunziante T +33 (0)1 45 61 51 80 T +49 (30) 20 39 07 - 0 T +39 06 695181 Nabarro LLP Registered office: Lacon House, 84 Theobald’s Road, London, WC1X 8RW. Nabarro LLP is a limited liability partnership registered in England and Wales (registered number OC334031) and is regulated by the Solicitors Regulation Authority. A list of members of Nabarro LLP is open to inspection at the registered office. The term partner is used to refer to a member of Nabarro LLP. Disclaimer Detailed specialist advice should be obtained before taking or refraining from any action as a result of the comments made in this publication, which are only intended as a brief introduction to the particular subject. This information is correct on the date of publication. Nabarro is not responsible for the operation or content of any external website or hyperlink referred to in this publication. © Nabarro LLP 2009 6