Seán O’Callaghan, Head of Institutional Banking at RBS International in Jersey, explains an emerging trend in the management of private equity investments in real estate
Nothing stays the same for long in the world of investment, and it is crucial for institutional investors and fund managers to tell the difference between passing fads and significant changes in markets and products.
A particularly interesting trend of recent times has been a shift in the investment vehicles of choice for institutional investors in real estate.
Over the past two or three years, there has been a distinct move towards using open-ended funds, rather than the more traditional and more rigid closed-end funds that have previously dominated the sector.
This is an intriguing development as it has chiefly been driven by a combination of investor appetite and innovation by managers, rather than regulatory reform.
Private equity real estate managers have generally tended to use closed-end structures that have a defined lifespan of typically about 10 years, perhaps with scope for two or three one-year extensions.
The investors are locked in for the life of such a closed-end fund so, when launching one, fund managers are very clear about how it will operate, with a defined investment period when it will call on investors’ capital and then look to return money to those investors prior to the maturity of the fund.
Once they have called on typically 70% of the investors’ capital, they will start looking to raise another fund – a process that has long been a staple of private equity investment in real estate.
What we have seen over the past couple of years is more managers looking for new structures as they seek to set themselves apart and produce more attractive offerings. There are many real estate funds available that may be achieving similar returns with a comparable investment focus and similar geographies, so a more flexible structure is one valuable way to differentiate a fund from others.
Open-ended structures, or ‘evergreen’ funds, have no expiry dates. They give investors more liquidity rights by allowing them to exit or increase their investment and by permitting the fund manager to raise more capital.
Such an open-ended fund can recycle capital from its realised returns and change its strategies and timelines to suit market conditions as well as the performance of its investments.
Open-ended funds aimed at institutional investors often have lock-in periods reducing the rights of investors to withdraw all or some of their capital – typically at the outset, when the fund is first raised, with the lock-in period being anywhere between three and five years.
Those lock-in periods are designed to protect the funds until they know that they have a certain amount of capital over those first formative years so they can go out and invest.
Lock-in periods provide more stability than one might see in retail-focused open-ended funds, which tend to have much lighter restrictions on withdrawals. Those retail funds can therefore face problems, such as the rush to sell holdings that followed the 2016 Brexit referendum, which forced some retail fund managers to freeze redemptions.
However, institutional investors that use these open-ended real estate fund structures have a longer-term investment horizon of 10 years or more, and thus are less likely to react to short or medium-term macroeconomic conditions.
Advantages and disadvantages
An obvious advantage of open-ended funds is that the investors have more flexibility because they can sell (or increase) their holdings when they want, subject to any restrictions, such as a lock-in period.
Importantly, the manager has the freedom to hold the assets for longer, rather than being forced to ‘flip’ them according to a pre-ordained timeline, and some investors are very keen to see longer-term annuity-type income from those assets. That is particularly attractive for pension funds and insurance companies, as well as for many other institutions.
When market conditions are not great, managers in a closed-end structure could make a time-forced purchase or sale. If a closed-end fund buys an asset in year five, for example, they typically have another five years to turn that asset around to a point where they want to sell. So if the market is not at the right point in the cycle, they can be forced either to restructure the fund or even to sell off the asset at a loss.
An open-ended structure allows them to choose their own timing for transactions. That gives them the flexibility to rethink their timing, perhaps holding on to assets for longer and implementing a new strategy that is best suited to those particular assets. The result is that with astute guidance the fund should end up holding better-managed assets.
Another attractive benefit of these longer-term funds is that they avoid the extra costs and the distraction of management attention and resources that come from constantly having to set up new funds.
The managers, and ultimately the investors, can escape the traditional costs of raising each new fund, which include marketing, structuring costs, legal advice, subscription agreements and all those other things that need to be done when a fund is being constructed.
An evergreen fund is already up and running, and that efficiency is especially attractive to institutional investors who are dealing with a long-term horizon rather than the dipping in and out that can happen in the retail space.
The downside of an open-ended fund is that the greater flexibility for investors to withdraw their capital reduces the certainty of its funding. Once any lock-in period is over, a market downturn might always create a rush for the exits and resulting liquidity pressures. This is a particularly pronounced issue in the real estate sector, where you have a liquid investment product but an illiquid underlying asset.
That greater uncertainty in turn can lead to financing becoming more expensive for fund managers after the lock-in periods, and all parties need to go into such funding arrangements with their eyes open.
Another complication is that an open-ended structure does not fit as easily with some of the traditional methods used to compensate managers and ensure they have ‘skin in the game’. Many investors want the management team to have its own stake in the fund, but that is a bigger commitment for the managers when there is an indefinite timeline.
It is also tougher to calculate managers’ performance incentives with an ongoing fund compared with simply measuring investors’ returns when a closed-end fund is dissolved. It can be complex, but banks and fund managers are keen to be innovative and are responding to this shift towards open-ended funds because the trend is clearly here to stay.
At RBS International, we have seen some clients starting to run concurrent strategies – for instance, by still running closed-end funds while also using open-ended structures for specific elements of the European real estate market.
One thing is certain: the market will keep evolving and the industry will keep tweaking its products to better serve the needs of investors.
FIND OUT MORE
For more information, please contact: Seán O’Callaghan, Head of Institutional Banking, Jersey
E: Sean.OCallaghan@rbsint.com
• This advertising feature was first published in the November 2019-January 2020 edition of Businesslife magazine