The issue of fund exits is a hot topic: over 175 funds are terminating between 2012 and 2016, with a total gross asset value (GAV) of €68.6bn. This experience is new for many fund managers and investors. Managing investor expectation throughout this process has been a challenge for some fund managers. Here we examine some of the common issues.
What do the documents say?
The fund documentation will usually set out the timescale for implementing fund exits or extensions. Most funds include a certain amount of flexibility to allow the fund manager to extend the term of the fund. This is particularly useful when market conditions are not favourable or when a particular asset is not ready for sale.
In private equity closed-ended funds, a one-year extension can usually be at the fund manager's discretion. Anything more will require investor consent.
Some funds envisage an investor vote to extend for five or more years. This is when investors have the opportunity to renegotiate fund terms with the fund manager and those not wanting to extend have an option to exit.
When some investors are exiting and others continuing, pricing is a key issue. Redemption prices are usually based on net asset value (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 that any fund forced to sell its assets can achieve the valuation. It is widely recognised in the industry that the use of NAV as a pricing on redemption may not be fair to remaining investors. There needs to be an ability for the managers to act fairly, but the ability to adjust valuations is not often provided for in the fund documentation.
Is it the right time to sell?
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.
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.
If the fund manager is looking to extend the fund, it must be clear about the purpose of any extension: is the extension to effect an orderly disposal of the assets or to enable the fund manager to continue with the implementation of an asset management strategy? Prior to an extension, the fund manager should produce a new business plan to set out the vision. All myths should be dispelled that the fund manager is extending the fund to guarantee future fee income.
Often extensions of funds will involve an element of structural change to the fund. This makes for a tricky tightrope for fund managers to walk in order to achieve the best solution for all the parties. Done well, it can cement some strong relationships, even for future funds.
Changes to funds that investors seek include the following:
- Fees and carried interest: fund managers' fees are usually reduced and based on NAV and not GAV. The performance fee or carry is rebased to give fund managers a new incentive to achieve the goals of the fund's strategy.
- Investment strategy and borrowing: tightened to be prescriptive on the level of debt, property sector, tenant exposure and location of assets, including a strategy on sales and exit.
- Closed- to open-ended: some funds when extended give liquidity windows going forward to allow redemptions.
- Advisory boards: if these do not exist, they are being established, sometimes with an independent representative.
- No-fault divorce: removal of the fund manager is being introduced on a 75 per cent vote of investors.
- Key persons: investors like to have named individuals responsible for the fund, even from the biggest fund management houses. Advisory board consent is required for their replacement.
Fund managers have reported that the process of engaging with investors can be challenging, particularly when they are faced with a divergence of investor requirements. One size generally does not fit all.
Ending the fund
If the fund is to end, after the debt and asset strategy has been implemented, there are a number of remaining issues for the fund manager to deal with:
- Ongoing liabilities: there will always be a risk of ongoing liabilities. On the sale of its assets (especially if they have been sold in corporate wrappers) avoid giving warranties beyond the life of the fund. This may mean insurance is required for the benefit of buyers of the fund assets. This is now common and easy to obtain. Other unforeseen risks could be ring-fenced in a fully funded separate vehicle that is owned by the manager but has no recourse to the investors. This is considered a risky strategy from the point of view of the manager.
- Distributions and carried interest: distributions are usually subject to clawback from investors, but limited in time and amount. Clawback will also trigger a recalculation of any carried interest. Clawback should be avoided if at all possible.
- Audit and wind-up: keeping asset holding structures in place has cost implications. Certainly, no fund manager wants to claw back distributions made to investors in order to pay for the continued maintenance of the special purpose holding vehicles.
- Regulation: winding up any UK fund vehicle is a regulated activity under the Financial Services and Markets Act 2000 and can only be done by a person authorised by the Financial Conduct Authority, which when coupled with the requirements of the Alternative Investment Fund Managers Directive will usually mean that this function is performed by the authorised fund manager.
When people embark on new projects, the end is often the last thing on their minds, but without clear provisions on how investors can exit or how the fund is to be wound up, parties will be left confused and dissatisfied.
So does "end of term" mean "end of term"? Not necessarily. It is a point in time when fund managers and investors discuss the future strategy of the fund in the light of current market conditions. They can then decide the best course of action taking into account all investors' requirements.