Funds of real estate funds: Practical challenges
Property EU
June 2011
By Michael Hornsby
Recent years have seen a proliferation of funds with indirect exposures to real estate through investments in direct real estate funds which offer investors a distinct investment opportunity in terms of increased diversification and access. A common misconception is that the administration of such funds is straightforward - there are, in fact, a number of practical challenges which need to be considered when setting up and running a fund of real estate funds (“FoREF”); promoters, service providers and investors alike need to be aware of them. I briefly outline the key challenges.
Fund launch and structuring
The above process chart defines the typical steps in launching any fund product. The rationale is that firstly the commercial design of the fund is determined. The key elements of this are as follows:
- Investment strategy
- Targeted investors
- Investor liquidity and the related framework for managing fund liquidity
- Fee structure
- Reporting framework including fund pricing methodology
The optimal fund structure is designed taking into account the above and relevant legal, regulatory and tax considerations. Critical to this process is the embedding of the FoREF’s commercial design within its governing documents (partnership agreement, prospectus or similar). We have identified the following key areas which should be considered carefully at set-up and in drafting the FoREF’s governing documents:
- Sufficient restrictions on redemptions are put in place to prevent the FoREF suffering from liquidity issues at a later date. Problems can occur, for example, when liquidity offered to investors is not matched by that of the FoREF’s investment portfolio
- The governing documents allow for the net asset value (“NAV”) or redemptions to be suspended in times where valuation uncertainty in respect of the FoREF’s portfolio is high – this is an important feature to ensure fairness between the FoREF’s investors
- The NAV calculation methodology of the FoREF is clear so as to avoid difficulties after launch when the NAV has to be determined for actual reporting and pricing purposes
- The valuation methodology defined by the governing documents is neither too prescriptive, and thus does not cover all potential investments of the fund, nor is too generic leading to confusion as to how fair values of the FoREF’s investments should be determined
- Management and performance fees are clearly described in order that any interpretation of the governing documents are minimised when these have to be calculated in practice
Next the FoREF’s platform is built: the operational processes and controls are determined as well as those for reporting including valuation (typically referred to as the back office function) which we will discuss in more detail. Finally, the overall governance structure, which sits above the operational and reporting functions, is determined. With regards to governance, we note that it is becoming increasingly common for such funds to have a formalised structure including such bodies as valuation committees, investment committees, audit committees and investor committees.
Due diligence and key processes and controls
As noted above, management must put in place adequate processes and controls covering all of the FoREF’s key activities. A number of these will be common to many alternative fund structures such as cash and credit facility management, tax and legal compliance and capital transactions (such as subscriptions, redemptions and distributions). It is crucial, however, that those processes which are product specific are carefully designed in order to ensure take into account the nature of the fund vehicle - we have seen through practical experience, for example, that neither the processes for direct real estate funds nor for other fund products, such as traditional equity funds, provide a suitable “template” for the management and administration of alternative real estate products - special care must be taken when establishing procedures for the following processes:
- Investment selection and due diligence process
- Investment valuation process including ongoing monitoring of investments
- Financial reporting and NAV calculation process
As for any indirect fund product, the due diligence process is absolutely critical for a fund FoREF - this evaluation process is both the key skill from a performance perspective (i.e. the investment selection process) as well as being by far the main element of a FoREF’s risk management framework. In fact, it can be argued the challenge facing FoREF managers in performing adequate diligence procedures with respect to their investments is more complex and judgmental than for those investing direct in real estate assets. Guidance in this area is available from the European Association for Investors in Non-Listed Real Estate Funds (INREV) who provide best practice guidelines in respect of information requests from potential investors in direct funds – this can serve as a useful starting point for any FoREF manager’s due diligence process.
The investment valuation process is closely linked to the initial investment selection and due diligence process. The usual monitoring procedures linked to valuation will include detailed analysis of reporting from the FoREF’s investments including addition information provided through side letter arrangements where feasible and regular monitoring calls with the managers of the investments. It is important that all of this ongoing diligence and monitoring actually feeds into the investment valuation process – not that is becomes a separate function of the front office, with those tasked with preparing investment valuations and the FoREF NAV having access only to limited information.
Finally, it is crucial that the roles of all participants in the financial reporting and NAV calculation process are clearly defined. This is especially true where significant portions of this function are outsourced to one or more service providers.
Valuation of investments
The major component of the FoREF’s NAV calculation process will be the valuation of its investments made in target funds. The valuation will, in large part, be based on the NAVs reported by the investments but it is likely that these will not be available for all of the FoREF’s portfolio and thus the valuation will have to utilise the latest available NAV for many investments, adjusted for material valuation events that have occurred in the intervening period such as subsequent drawdowns or redemptions of capital. Other material valuation events at the underlying fund level should also be taken into account including revaluations of the property portfolio, disposals at values significantly different to those previously reported and gains/losses on re-financing transactions. These events will be identified through the ongoing investment monitoring process described above.
In addition to the date of the latest available NAV reported from investments consideration needs to be given to the quality of the underlying NAVs including the following key factors:
- Whether the NAV is audited or unaudited
- How up-to-date last appraisal of underlying property portfolio is and whether this is management estimate of has been performed by an independent appraiser
- The target fund managements’ historical accuracy with regards to actual vs. estimate NAVs reported
- Appropriateness of GAAP used/NAV calculation methodology as a proxy for fair value
- Quality of reporting from target funds’ reporting – e.g. transparency, disclosure, additional information to aid user
These factors should be considered as part of the initial due diligence process around acquisition and hence the valuation process for reporting purposes will follow on from this with all of the above considerations addressed/documented at each NAV calculation date of the fund of fund.
Conclusion
The above issues represent only a brief summary of the key considerations regarding set-up, processes and valuations for fund of real estate funds. We would urge managers launching such products not to underestimate their potential complexity and to ensure the fund structure as well as the operation processes controls are appropriate and, crucially, specific to product type.
By Michael Hornsby, Real Estate Leader, Ernst & Young, Luxembourg
+ 352 42 124 8549