At our Funds First seminar earlier this week we shared lessons we have learnt on ‘alternative asset’ or ‘sector specialist’ funds for each of investors, fund managers/sponsors and property and asset managers. We were delighted to see so many of you there. This briefing sets out some of the highlights of the issues discussed, which we hope will also be of interest to those who could not attend the seminar itself.
Sector specialist real estate funds are commonly thought of as those focussed on real assets which do not fit into the standard sector definitions (i.e. office, retail and industrial/ logistics). They are pooled investment vehicles designed for more specific and diversified market segments: for example, student accommodation, the private rented sector (PRS), as well as care homes, social housing, medical centres, cinema parks, purpose built car parks, marinas, woodlands, call centres and open structures such as theme parks.
Although data on the real estate sector specialist funds is less prolific compared to that of commercial real estate generally, UK allocations to non-traditional real estate have increased and appetite for this sector continues to grow. For instance, CoStar reported earlier this week that in 2015 £4.3bn was invested in student accommodation, more than double the level invested in 2014 and the strongest year on record. The INREV Investor Intentions Survey 2015 found 21% of investors in European real estate markets indicated a desire to gain exposure to alternative real estate in 2016. Recent press announcements paint a similar picture: from the likes of JLL that they will be expanding their alternative asset capabilities and confirmations from Glenbrook and Grainger that they will be pursuing PRS strategies.
In our seminar we discussed some specific issues and characteristics that influence the shape and detail of sector specialist real estate funds. Our headline observations, based on our recent experience in this area, are:
- A specialist asset manager or underlying operating partner is key to the success of a fund of a non-traditional asset class. It is therefore essential to work out what are the bespoke services required for the relevant asset class, who is going to provide them, and for what duration. Tied to this is how to ensure continued strong alignment between the fund and operational management. The asset manager or operator may simply be looking for an exit for assets that it has been developing rather than a long-term asset management role.
- Given the limited pool of experts, the key executives retained by the asset manager are often in a strong position as their expertise is fundamental to ongoing performance as well as sourcing assets. As a consequence, delegation of certain roles may be restricted and fund documents may have stronger termination provisions in a scenario where a specialist manager is no longer appointed.
- Conflict management is a key area of concern to investors and must be dealt with robustly. For instance, where the operator is providing multiple service lines from its wider business to the fund. It is also worth considering whether or not default by one service provider which justifies termination of that service agreement should trigger cross-default on all the others.
- Often specialist non-executive directors are appointed to a manager’s board, to ensure independent oversight and to augment the role of the fund’s advisory committee.
- Closed-ended fixed life fund structures are most prevalent for sector specific real estate investment strategies, although some sponsors have put in place hybrid models for more liquid structures, where investors are offered the opportunity to exit during limited liquidity windows. Open-ended structures are more prevalent in the specialist asset classes with more liquidity, such as student accommodation and PRS.
- Investors prefer a shorter commitment period than that typical for traditional asset classes.
- We have seen managers facing challenges in demonstrating a strength of pipeline/ stock for niche assets, which may result in the fund having to look at buying assets on a forward funding/forward commitment basis.
- Where assets are seeded, issues arise around three principal areas. Firstly, addressing conflicts again is of crucial importance, for example where the operator is developing and on-selling assets to the fund. Secondly, valuation, which can be a more nebulous process for less common assets, in particular where assets are not fully stabilised or developed. And thirdly, price negotiation, given the lack of obvious comparables and a dearth of expert valuers in the field.
- Heighted reputational risk for some specific assets, along with any consequent negative media coverage, means there may be more sensitivity in terms of asset management and its potential downsides. Also, in some emerging sectors, unanticipated changes in the regulatory or legal environment may cause problems that delay or negate fund launch.
- At the end of the life of the fund, transparency on pricing is key, as third parties will want access to information available to the managers and other interested parties, so that they can assess market value of the ‘alternative’ assets.
Much will depend on any general social, economic and regulatory developments that take place, but it appears that alternative real estate as an asset class for indirect investment will become increasingly important as investors seek more diversity, different risk profiles and an ability to have bespoke solutions tied to their own needs and requirements.
We see some sector specialist funds becoming more mainstream despite their asset-specific issues, namely student accommodation and PRS, both in terms of their perception and the technical and market issues affecting them. In addition, traditional balanced funds will increasingly look to invest in specialist areas for diversification purposes. Alongside this, and whilst experience and expertise grows, we expect to see a new breed of ‘super-specialist’ sector funds: for instance, housing for second and third year university students, rather than purpose-built halls-of-residence.
So the lessons learnt on the current stable of sector specialist funds should remain pertinent.