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Open-ended Real Estate Funds

Insight 9 July 2021

Open-ended Real Estate Funds

In recent months, we have seen an increase in enquiries to establish open-ended funds to invest into underlying real estate assets. Open-ended real estate funds are extremely topical, with industry consultations ongoing as well as new fund products set to be launched. This briefing examines the latest industry developments for open-ended funds as well as answering some of the most common practical questions we see from Managers whom are appraising whether their next fund might be open-ended.

The Financial Conduct Authority (“FCA”) has recently published two important papers on open-ended funds:

  • a proposal for a new authorised fund regime for investing in long term assets, the Long-term Asset Fund (“LTAF”); and
  • a consultation paper on liquidity mismatch in authorised open-ended funds (“mismatch consultation”). The European Association for Investors in Non-Listed Real Estate Vehicles (“INREV”) and The Association of Real Estate Funds (“AREF”) also recently concluded on the second phase of the open-ended fund pricing consultation project, details of which are discussed later in this paper.

The proposed LTAF is designed to enable authorised funds to invest efficiently in long-term illiquid assets such as venture capital, private equity, private debt, real estate and infrastructure. The LTAF will provide a useful alternative investment opportunity to potential investors interested in open-ended fund structures. The legislation regarding the LTAF is expected in late 2021 and the LTAF is likely to prove popular with investors seeking long-term returns, such as defined contribution pension investors. The FCA sought feedback on the LTAF consultation with submissions required by 25 June 2021.

The mismatch consultation is seeking to conclude on ways to reduce the potential investor harm that arises from the liquidity mismatch.  This mismatch exists where the frequency of dealing in units of some property funds (especially the property funds with daily dealings or frequent dealings), is not aligned with the time it takes to transact the underlying properties in which the funds invest. The principal outcome of this consultation was a recommendation that the property funds should have a notice period before an investment holding can be redeemed, and that the notice periods be between 90 and 180 days.

Open-ended funds are by their nature long term and typically seek to return stable cash flows and income returns to investors. Assets are typically held for a longer time than those acquired by closed-ended funds and this profile compliments most sub-classes of real estate and infrastructure investment.

Investors into open-ended funds will also have a longer-term strategy, targeting income returns. This profile proves popular with pension Fund Managers whom have regular and long-term obligations to pension beneficiaries.

It is perhaps not surprising that in the current macro environment and with yields in core markets compressed, many Fund Managers are focusing on income returns. Open-ended fund structures offer the perfect platform for this investment strategy. The advantage of an open-ended fund is that the Fund Managers can buy and sell assets at times that they deem right. By contrast, a closed-ended Fund Manager is constrained by investment periods and the fund-term.

Redemption and subscription mechanisms

The main challenge for a Fund Manager of an open-ended real estate fund is finding the balance between the liquidity needs of the investors and the illiquid nature of the underlying real estate assets. Fund Managers don’t want to be forced to sell at a particular time simply to fund redemption requests. The liquidity challenge is most typically managed though the use of lock-up periods at the launch of the fund and the appropriate notice periods for redemption requests.

For open-ended funds investing in real estate there exists the challenge of an illiquid asset with regular liquidity dates for investors. Fund Managers employ a number of liquidity and cash management tools to manage this challenge:

An open-ended fund operating a quarterly dealing date for redemption maintains a significant percentage of underlying investment in liquid assets at which a NAV is struck. In this scenario, there is no need for notice periods for redemptions. The percentage that needs to be maintained in liquid assets for this option to work effectively is generally accepted to be a minimum of 25%. In this example, there is a trade-off in that capital is not wholly invested into the target assets, in exchange for the absence of notice periods and thus this mechanism does have an impact on the target fund returns/IRRs.

Perhaps seen more often, is that notice periods are used and provide the Fund Manager sufficient time to realise funds from underlying assets in order to meet redeeming investor requests. To illustrate, where a fund operates a calendar quarterly dealing date and requires a six-month redemption notice, the dealing date of a redemption request received from an investor on 10 November is 30 June the following year. The dealing date for the redeeming investor is the one at the end of the notice period and thus they take an element of price risk (as they deal at a future NAV), but this is considered fairer than other investors having to bear the price risk for a redeeming investor. This approach also aligns with the recommendations of the mismatch consultation paper discussed earlier. There is no need for notice periods for subscriptions.

It is common to see the use of initial lock in periods/terms where investors are not allowed to redeem their interests for a certain period usually following the launch of the fund, to allow the fund time to implement its investment mandates and allow the investments to start maturing/grow to support redemption requests and returns. The typical lock in period will usually be around 3 years.

Subject to the constitutional documents of the fund allowing it, an open-ended fund may establish a new borrowing facility or utilise an overdraft type facility where required by a significant quantity and amount of investor redemptions. Such borrowings are typically temporary and must not exceed a certain percentage of the fund’s NAV.

Frequently asked questions

Both 90 day and 180 day notice periods are being used and the length of time is driven by realistic consideration of the underlying assets and also the expected trading activity (since there will be some opportunity to fund redemptions with subscriptions).

Contractually investors should not be able to force the Fund Manager/General Partner/Trustees/Directors, depending on fund structure (“controlling parties”) to sell assets, but in practice investors will of course be able to make their feelings known to the controlling parties. The use of the notice period is to allow for time when best efforts can be made. If the controlling party is not able to meet a redemption request, then they would typically request an extension of time from the redeeming investors. One reasonable example is that an asset was under offer, but the sale fell through and now they are engaging with other buyers. It seems reasonable in such a scenario that the investors would grant the extension. Should the controlling party be clearly failing in their obligations then there will be clauses in the Prospectus whereby the removal of the controlling party can be petitioned.

Ordinarily, open-ended funds are not a ‘carried-interest’ scheme comparable to the closed-ended funds. Of course, there is a means of rewarding performance and that is through Performance Fees. These will accrue when a NAV-based performance metric exceeds a high-watermark (e.g. the performance fee might accrue when NAV exceeds 110).

Performance fees in open-ended funds are usually based on unrealised profits. The mechanics of the performance fee calculation is often tailored and can vary from one open-ended fund to another. In contrast, rewards based on performance in closed-ended funds are generally structured as carried interest and are paid on realised profits. The calculation of carried interest follow a typically standard distribution waterfall.

A traditional carried interest scheme may apply to open-ended funds when the structuring of the fund is more on a deal-by-deal basis. This would see investors grouped against each deal and thus a carried interest mechanism could be the performance basis used on each deal. If such a fund were being established, then we would expect that fund structure to include cells or compartments.

The real estate valuation challenge

Open-ended funds will trade at a prevailing NAV, which will be driven by underlying valuations of the assets held. The valuation challenge is mitigated through the use of a consistent professional third party valuer and typically a well-diversified portfolio, however, a degree of volatility in the estimated values has to be accepted by investors and wider-macro events will contribute to the level of pricing volatility in a particular market

The open-end pricing debate

There are two pricing policies/valuation methods traditionally used in Europe for open end funds.  These are the classic dual pricing policy (“dual pricing”), which is advocated by AREF and preferred by UK Fund Managers and investors and the capitalisation and amortisation policy (“Cap & Am”), which is advocated by INREV and preferred by European and overseas Fund Managers and investors.

Long-term investors receive relatively similar returns under either method.  Notwithstanding this, consultations were held to see how the two methods could be aligned, as there was a need from investors to reconcile the pricing for both UK and non-UK investors, whom invest in funds with both pricing methods.

The key difference between these two pricing policies is how the acquisition/set up costs (“costs”) are allocated:

This method allocates the costs only to the new investors through the inclusion of a subscription surcharge on its subscription price and also cuts a separate redemption price with a redemption surcharge to reflect a share of the costs for the redeeming investors.

This method allocates the costs across all investors by amortising the costs on the NAV, traditionally over 5 years and including the notional assets in the pricing, and having a single price for subscription and redemption.

The key issues with the two methods are as follows:

Some investors need more certainty on the pricing and the use of dual pricing does not provide them with this price certainty. To overcome this funds typically use the swinging NAV/Price-‘the single pricing model’, which provides investors with a single price/value that they can subscribe and redeem at, without adjustments for surcharges. The swinging NAV/price will include an element of price volatility, but will give the investor a single price they can trade at. The dual pricing method costs also traditionally exclude debt costs.

Although the NAV provides as single trading price, the key weakness is that redeeming investors are not allocated a portion of the remaining unamortised costs (notional asset) upon redemption, thus disadvantaging the remaining investors who bear the remaining notional asset.

In April 2021, INREV published its open-end fund pricing consultation paper, which culminated from the industry wide project (“project”) conducted in collaboration with AREF.  The project was a follow up to a previous industry consultation in July 2018 and recommended some best practice guidelines for open-end valuation. The full consultation paper, click here.

The INREV guidelines from the project were issued in two phases as noted below:

The first phase of the open-end fund pricing project in July 2018 was to promote a better understanding of the effectiveness of two common pricing mechanisms, classic dual price and the Cap & Am, and examine whether their methods of calculations provided different outcomes for investors. The conclusion was that while the two mechanisms produced slightly different outcomes for investors, both were effective in minimising dilution;

The second phase of the project explored the research carried out by the expert group appointed by INREV and AREF, to consider how the operation and governance of pricing could be enhanced. Current practices were noted and practical recommendations were made that can be adopted in setting pricing policies both under normal market conditions and during exceptional circumstances.

AREF is yet to publish its new open-end pricing guidelines following the project, as it awaits the outcome of its members’ consultations, expected to be concluded on 25 June 2021. The proposed new guidelines, click here. 

A summary of the key recommendations/guidelines from the project for each method are:

The pricing shall include any debt incurred on acquisition. In addition, funds using this pricing shall incorporate a 3 year look back of the prices to check for any differences arising from future rates of transaction costs

The amortisation of the costs shall be over the period of asset holding rather than the traditional 5-year period. As an example, evergreen vehicles were recommended to adopt the amortisation period of 10 years. Further, to address the key issue on redemptions, the Cap & Am NAV shall be adjusted by adding back the notional asset to the NAV before redemptions. Consequently, the redemption NAV shall incorporate the investor’s share of the remaining notional asset

The project also addressed the corporate governance issues facing open-end funds. There was a notable difference on corporate governance of unlisted funds vs listed funds.  It is important that this gap be addressed. Following on from the consultations, INREV will be refreshing their corporate governance codes/themes in late 2021/2022 and AREF are considering the recommendation and will prepare a Q&A paper for its members on the governance themes.

Several jurisdictions are launching new investment products which can be used by Fund Managers to operate their open-ended funds. Notable new products are The Collective Asset-management Vehicles Act (ICAV) in Ireland and the Variable Capital Company (VCC) in Singapore. As mentioned above, the UK FCA is also looking to launch the LTAF later this year.

In today’s environment where capital appreciation is proving harder to deliver, stable income returns are increasingly being targeted. Underlying real estate offers the potential for capital appreciation too, even if this is not the primary strategy. The open-ended real estate fund can provide the desired platform for Fund Managers to meet these investor objectives.

There are opportunities to set up and use evergreen funds (“Evergreens”) in this environment as new open-end regimes are being introduced. Evergreens are open-end fund structures with no termination date. They permit investors liquidity rights to exit their investment and for the Fund Manager to raise more capital. They are permitted to recycle capital from realised returns, hence the term.

With investors and managers making pledges to become carbon-neutral and adopt sustainable policies, ESG-focused funds are proving popular.  Such funds often fall under the real assets umbrella, including environmental projects such as renewable energy and social projects such as regeneration and social housing.  ESG projects inherently have a profile that is longer-term and typically more illiquid than real estate investment.  Where open-ended funds invest into ESG projects it would be sensible to assume that redemption provisions will be at the longer end of the range.

How can Sanne help?

Sanne’s international Real Assets team has vast experience supporting clients in acquiring, developing, financing, leasing, operating, managing and selling real assets covering all major asset sub-sectors. We combine the capability, cross-sector insight and global track record of our real estate, infrastructure and renewable energy professionals, so you can act and invest with speed and confidence.

If you would like to learn more on how Sanne can assist you, contact Charles or Von directly.

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Real Assets
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Charles Kilela Director, Alternative Asset Services - Jersey
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Von Atamosa Associate Director - Jersey
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