This is the second in a series of three briefings examining the hot topic of fund exits.
In our first briefing we looked at the exit methods for closed-ended funds. In this briefing we will look at issues and trends for open-ended funds and how they differ from closed-ended funds.
Whilst open-ended funds may have a fixed end date, it is usually considerably longer than for closed-ended funds and often an open-ended fund will continue for an infinite period. Most significantly, open-ended funds allow investors to exit the fund during the term by way of redemption. In 2010 to 2013 we saw an increase in the number of new open-ended funds launched. This trend reflected investors' appetite for more liquidity in their investments. This is now changing as the market improves.
Open-ended funds can have a variety of redemption mechanisms. Often there is a lock-in period for the first two to five years, for example. This provides the fund manager with a period of certainty to build an asset base and make investments for the fund. During a lock in period, an investor cannot redeem its interest.
Redemption mechanisms vary from fund to fund. A typical example would include the following terms:
- Redemption notice: Following a lock-in period, an investor may give notice to the fund manager of its intention to redeem all or some of its interest in the fund. There are usually provisions in the fund documentation on the timing of service and acceptance of the redemption notice.
- Redemption period: The fund manager will have a specific period, set out in the fund documentation, in which to redeem an investor's interest. The fund agreement may also provide for "matched bargaining", where the fund manager can match the redemption request of an existing investor with a new investor at an agreed price.
- Satisfaction of redemption request: Matched bargaining does not affect the assets under management so it is usually a fund manager's preferred option. In a normal redemption scenario, however, the fund manager will have the option to use cash reserves, a sale of assets, raising debt or new equity to satisfy any redemption request.
- Redemption caps: In some open-ended funds, there will be a cap on the amount of redemptions that can be redeemed in a certain period – for example, redemptions that equal 10 per cent of NAV in any given quarter. Such restrictions help ensure the value of the fund is not harmed by forced sale of assets. Often redemption notices will be accepted by the fund manager in a specific order (for example, pro rata or first come, first served basis). All of these requirements restrict the liquidity of an open-ended fund which may be helpful to the fund manager but means that an investor's interest is not as liquid as it might otherwise be.
- Redemption price: The price paid to a redeeming investor will be based on the NAV of the fund less a percentage of the cost (or hypothetical cost) of liquidating part of the assets. We discuss the issues on pricing in the third briefing.
INREV Guidelines 2014 suggest that fund constitutional documents should include a liquidity protocol explaining how investors will be treated on different liquidity events, including new equity issues, redemptions, secondary market transfers and exit. Such a document would certainly give existing and prospective investors clarity.
The process and procedure for redemption will be carefully set out in the fund documentation to allow fund managers an element of control over the process. Consequently, an investor's interest in an open-ended fund – whilst being more liquid than an interest in a closed-ended fund – still does not offer the same level of liquidity as, say, equities. The fund manager must balance the interests of investors who wish to leave with those of investors who wish to remain.
Redemptions work well in normal market conditions but in adverse markets the idea is flawed as we saw during the global financial crisis in 2009. Fund managers will therefore try to ensure that there is provision in the fund documentation for redemptions to be suspended during economical, political or environmental turmoil. Most fund documentation allows the fund manager to suspend redemptions if it is not in the interest of the investors as a whole (for example, during extraordinary market conditions). This can often be a contentious issue for investors due to the subjectivity of the test.
Real estate is an illiquid asset and putting it in a wrapper with debt can make it even more illiquid. Key risks to liquidity in real estate funds were highlighted in the global financial crisis. These include the following:
Pricing on redemption
Open-ended funds tend to use redemption prices based on NAV less an amount representing a percentage of the costs of a hypothetical disposal of the assets. The problem here is that it is unlikely for any fund that was forced to sell its assets to achieve the estimated book value at that time. Indeed, it is widely recognised in the industry that the use of NAV as a pricing or valuation mechanism can distort (by inflating) the reporting of pricing. A sale of an asset, particularly when forced or together with a flood of assets to the market, is likely to result in a far lower price than that which it is valued at.
This means that a redeeming investor is actually getting a better deal than what reality would reflect were the assets to be sold at that time. The question for fund managers is how to fix the problem and ensure that they are acting in the best interests of all investors, when there is clearly bias in this commonly used mechanism. For some it is a case of how the costs are estimated, sometimes reflecting a higher anticipated charge than may turn out to be the case.
Effect of debt
The effect of external debt on the portfolio can be catastrophic for fund NAV in a falling market. Not only does a fund manager need to keep an eye on investors' exit requirements, it must also balance this with the term of and restrictions in bank debt secured over the fund's assets. During and since the global financial crisis, banks have got stricter with their terms of lending. Many bank loans include provisions that prohibit the return of equity to investors prior to the repayment of the bank loan.
This puts fund managers particularly of open-ended funds in a pickle; previously more bank debt was often the answer to repaying an exiting investor's share. Under the provisions of these new bank loans, fund managers must either find the cash to pay out the investor and the bank or find a new investor to take over the exiting investor's interest so that the fund does not breach its banking covenants.
Such strict lending requirements severely narrow the options available to the fund manager to use proceeds from assets sales. The fund documentation should make it clear that the fund manager's powers to pay a redeeming investor are subject to any restrictions set out in the external finance arrangements.
Often the restrictions contained in the bank financing can lead fund managers to have conversations with investors about the proposed strategy going forward, whether that would be calling for more money from investors or renegotiating fees with external lenders. Where a fund is underwater, it is more likely that the bank is the main driver in the continued (or discontinued) strategy to be followed by the fund. Indeed, where this occurs often the investors' power is significantly diluted as effectively the bank takes over the running of the fund. For this reason, many investors are looking for more input via the advisory committee on the terms of external financing before the fund enters it.
An open-ended fund had very clear redemption provisions in its fund documentation. But as the commercial real estate market nosedived, its investors – many large pension funds and other institutions – looked for a way to liquidate their holdings and exiting their positions in open-ended funds was a relatively easy route to take.
So instead of the regular drip of redemption requests, the manager saw almost a third of the fund's investors submit redemption requests in a half-year period. It was a good thing that the fund documents had a clearly defined queuing system that meant that there could not be a run on the fund.
The manager sought legal advice on whether it could declare that redemptions were suspended. The manager certainly had a legal right to suspend redemptions at times of extraordinary political, social, financial or economic circumstances but it also had to consider whether doing so was in the best interests of the investors as a whole, taking into account whether the adverse market conditions were forcing a sale of assets to fund redemptions at a significant loss.
In the manager's opinion the state of the market was in such turmoil that suspending the redemptions was necessary. During the period of suspension, the manager worked hard to establish a new investment strategy (including proposed disposals of certain assets to enable redemption requests to be satisfied) which it communicated clearly to the investors so that on resuming normal service after the end of the suspension some investors decided to withdraw their redemption requests and remain invested in the fund. This meant that the manager could proceed with a disposal of some of the fund assets and continue to pursue the revised investment strategy of the fund. Indeed, as a result of this change in strategy and use of suspension new investors were interested in investing in the fund which meant that they could be paired with exiting investors in a matched bargain and fewer underlying assets needed to be sold.
In the third and final briefing, we will examine some general issues for fund exits.