Exit this way No.1: closed-ended fund exits

United Kingdom

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

The issue of fund exits is currently a hot topic. 176 funds are terminating between 2012 and 2016, with a total GAV of €68.6bn (from INREV (European Association for Investors in Non Listed Real Estate Vehicles): Fund Trends Survey 2013). This is a new area for many fund managers and investors to experience. Managing investor expectation throughout this process has been a challenge for some fund managers. 

This is the first in a series of three briefings. This briefing covers the typical issues for exiting a closed ended fund. Briefing 2 will look at open ended funds. Briefing 3 touches on some more general issues applicable to all types of funds.

Timings

Closed-ended funds have a fixed end date. The term of a closed-ended fund will be set to tie in with the investment strategy of the fund. As part of the investment strategy, a fund manager will have a plan as to how it intends to create returns from the assets of the funds and when those assets should be sold to achieve those returns. Generally, a private equity real estate fund has a fixed life of between seven and 10 years. 

However, most closed-ended funds include a certain amount of flexibility in their fund documentation to allow the fund manager to extend the term of the fund to ensure that the best returns can be achieved, particularly when market conditions are not favourable or when a particular asset has not matured, contrary to the plans set out in the initial investment strategy. Some investors and fund managers may take the view that the planned end date is a point to take stock and decide what is the best course of action, rather than to automatically wind up. 

Fund documents often include a one year extension at the fund manager's discretion. Any subsequent extension will often require investor consent (for example, a further year's extension may be permitted with advisory committee consent). In the UK, some funds provide for a longer extension period (for example, five years). If voted for, it is usual to allow investors to exit the fund at this point if they no longer wish to participate. In these situations, the fund manager must pay particular attention to the terms of the fund documentation, particularly on timing and procedure. We will look more closely at some of the issues that arise during this process in the third briefing.

Secondary trading

Secondary trading is the sale of units or shares in a fund so an investor can exit, in whole or in part. 

Transfers of fund interests are governed by the fund documentation. Often fund documentation permits the transfer of fund interests to certain group companies of an investor (or perhaps other named persons that have been specifically requested by an investor and set out in, say, a side letter). Sometimes there will be restrictions to prevent a competitor of the fund manager holding interests in the fund or to prevent investment by those who may have an adverse effect on the fund due to their regulatory requirements (for example, US ERISA investors). INREV Guidelines 2014 state that the transfer of interests in non-listed funds should be without unreasonable restrictions as long as it does not prejudice the manager or other investors.

Otherwise transfers tend to require the consent of the general partner or fund manager. Usually consent cannot be unreasonably withheld or delayed but there may be conditions associated with it. For example, the transferring investor may be required to pay the fund's legal fees to prepare the transfer documents and the transferor will always be required to provide satisfactory KYC information before the transfer is permitted. 

Overall transfers can be simply effected. Fund managers must remember to ensure that any changes to limited partners in a limited partnership structure are registered at Companies House and published in the London Gazette. Investor details should also be updated in the fund's records to ensure that a transferee receives all fund reports and information.   

A tricky balance to achieve is between maintaining confidentiality over fund terms and documents and ensuring that such confidentiality does not impinge an efficient secondary transfer market. INREV Guidelines 2014 suggest that potential new investors should have access to the same information as existing investors, subject to signing a non-disclosure agreement. A fund manager must also pay careful attention to any restrictions on confidentiality contained in any investor side letter before divulging the identity of existing investors in a fund to potential transferees.

The price at which interests are sold will, for all funds, reflect the sentiments of the market. In a rising market pricing could be above NAV to reflect anticipated growth. In a falling market, trades are usually at a discount. It is unusual that the transfer of an interest in a fund would attract transfer tax.

There are very few venues for secondary trading of property fund interests. The trading and settlement of property fund interests is well behind its counterparts in the equities market and there is faltering impetus to develop the sector. Perhaps with the success of property authorised investment funds, more providers may be willing to provide more venues to enable secondary trading in closed-ended fund interests.

Implications of debt

In normal markets real estate funds can provide reasonable liquidity but the 2009 global financial crisis showed what can happen in a downturn. The fall in property prices meant many funds were in breach of their debt agreements. This was particularly an issue for closed-ended funds which tended to be more highly geared than open-ended funds and often were outside the investment period so had no scope to raise additional commitments or draw down funds, without investor consent.

The issues with external debt are looked at in more detail in subsequent briefings but the market consensus is that banks are not necessarily forcing managers to sell assets but are willing to extend facilities for a higher margin. There are also new players in the finance market, such as insurance companies, which makes it more competitive. 

"For fund managers and investors alike the decision to terminate or exit a fund is driven mainly by the current market conditions.

Commercial drivers

In the most recent INREV fund termination study, 70 per cent of respondents listed current market conditions as an issue affecting their decision to terminate a fund.  This was way ahead of the second most popular consideration of quality of the portfolio. 

In the same study, the termination options that are set out in the fund documentation was the third most popular consideration followed closely by an individual investor's liquidity requirements. This illustrates the importance of setting out clear provisions on fund terminations and redemptions in the fund documentation as well as knowing your investors and their internal drivers. 

For funds where the market conditions have changed dramatically during the life of the fund there can often be a divergence of objectives at the scheduled fund termination. Fund managers will have a fiduciary duty to achieve the best returns for the investors as a whole but must analyse how to achieve this in light of investors who wish to exit. Investors may also disagree with a fund manager’s proposed investment strategy during any period of extension and it is important to maintain an open and productive dialogue with investors to seek a workable solution. Often extensions of funds will involve an element of structural change to the fund, including changes to fees, leverage reductions or fund governance. This makes for a tricky tightrope for fund managers to walk to achieve the best solution for all the parties. Done well, it can cement some strong relationships, even for future investments. 

"Remaining and exiting investors will inherently have conflicting requirements."

Case study

A property fund held a partnership extension meeting in accordance with the terms and timescales set out in the fund documentation. At the meeting, the manager proposed extending the life of the fund, knowing that those who dissented had the right to exit. The manager reasoned that in the current market there was no prospect of the investors realising their investments as this could not be achieved without a sale of assets which would be at a substantially lower price than would be anticipated in future years. The manager accompanied its proposal with a new investment strategy for the fund and its assets.

The majority of investors considered the manager's proposal and agreed to the extension with the proviso that new review dates and a stronger role of the advisory committee were included in the amended fund terms. 

There was one dissenting investor, however, who held a 10 per cent interest and wished to retire from the fund. There were no other large investors who could take up the slack of the exiting investor. The issue for the manager was how to pay for the exiting investor's units. The exiting investor pushed for an early disposal of the best assets to allow its interests to be redeemed. But this was not in the best interests of the remaining investors. The manager looked into taking out further bank debt to cover the cost but this was not cost effective. The manager eventually managed to agree a disposal strategy that worked for everyone and allowed the remaining investors to benefit from a longer period of holding the assets until a better opportunity was available to sell, while at the same time realising enough cash to pay out the exiting investor. 

Next time

In the second briefing, we will examine exit methods for open-ended funds.