Open-ended UK fund closures have provoked concerns that the property industry could once again be at the heart of the next downturn in the UK economy. Should everyone be running for the hills or are the headlines not as scary as they look?
What’s happened so far?
Last week, most open-ended UK retail real estate funds reduced the pricing of the units in their funds following the result of the EU referendum and some switched to weekly rather than monthly valuations.
This was done to try to prevent redemptions from the funds. However, this measure has not been successful, particularly for six fund managers – Standard Life, Aviva, M&G, Henderson, Threadneedle Columbia and Canada Life which have all closed their funds to redemptions.
The Bank of England has also warned in its latest financial stability report that the closures and prospective sales of assets by the funds are a risk to the UK’s economy.
It said: “Any adjustment in commercial real estate markets could potentially be amplified by the behaviour of leveraged investors and investors in open-ended commercial property funds.
“Although they have a range of measures to manage stressed levels of redemptions, these open-ended funds could be forced to sell illiquid assets to meet redemptions if conditions persist beyond funds’ notice periods.”
Why has it happened?
Following the result of the EU referendum, property shares slumped in anticipation of a hit to the UK economy and the rental prospect of companies’ properties worsening. This market sentiment was transposed across the industry, namely to open-ended funds.
Open-ended retail funds are tradable on a daily basis but valued on a monthly basis. This means that there can be a wide dislocation between the price available to redeem units in the fund and the perception of what the price will be when the new valuation is applied and there is therefore a rush to redeem units before the revaluation.
Once there is a rush on redemptions the cash reserves that the funds hold become diminished. As the sale of the units are liquid and can be sold on the day, they are mismatched with the speed at which the funds can (or it is sensible for them to) sell properties. Therefore they cannot pay redemptions and have to close for trading.
Mike Prew, managing director and analyst at Jefferies, said, “The issue you have is that you have got a model here which takes liquid cash and puts it into illiquid assets. It works well when you have inflows when you have a rising market and is a one way escalator of investment but the trouble is when the escalator goes into reverse.”
Will there be more closures?
It’s likely. Once one fund closes, investors in other funds anticipate closures of the ones they are invested in and this creates a run on withdrawals.
However, Aberdeen Asset Management has chosen to slash the pricing of its fund by 17% rather than close entirely. This could serve as an effective way of quashing redemptions whilst keeping the fund open and putting a floor in the market. It has been one of the most aggressive sellers of UK property in the past year, which will have served to bolster its cash position. The move to keep the fund open could backfire though and allow for more redemptions and put more pressure on the fund manager to sell.
By no means is any fund immune to the phenomenon, but Legal & General’s UK Property Fund is also thought to have a relatively strong cash position, which was 19.1% as of the end of May, and may be less susceptible to redemptions. Kames is also understood to be hopeful that its general focus away from London, where there is perceived to have been the most dramatic repricing and smaller lot sizes may give it some protection.
Closing funds is a natural and not entirely surprising move by fund managers to safeguard the cash of their overall investor base, particularly those that want to remain in the fund and is not necessarily a slight on the quality of the assets themselves.
John Cartwright, chief executive of the Association of Real Estate Funds, said, “Fund suspensions are designed to safeguard investors in times of uncertainty. Our members have a duty and regulatory requirement to act in the best interests of fund investors and we fully support their ability to suspend dealings when it is in the interests of protecting remaining unit holders.”
What is the link between funds closing and the price of property shares?
Rather than holding just cash reserves, open-ended funds have been holding property shares as an alternative as they provide a better returns but are also very liquid and can be sold quickly.
The problem is that this creates a vicious cycle when things go wrong.
Property shares are depressed so the investors in the funds want to withdraw from the funds and buy shares at a depressed value. The funds have to sell their shares in the listed property companies in order to pay redemptions, further weakening the price of the shares and making them even more attractive for investors in their fund which makes the investors want to withdraw all the more.
“It is no coincidence that British Land’s and Land Securities’ shares went down by 6% and 7% the day Standard Life closed its fund,” said Jefferies’ Prew.
Didn’t this happen before?
Kind of. In 2008, amidst the global financial crisis, the New Star International Property Fund, which once had £750m of assets, was closed to redemptions and remained so for 14 months. New Star was bought by Henderson in 2009 and the management of the fund was subsequently taken on by Aviva Investors in 2010.
No UK-focused retail funds closed for redemptions then, however. In isolation, arguably, that makes the current situation for the funds worse than during the crash but the broader property market is in a much healthier position given lower levels of leverage across the board and distressed sales due to excessive debt unlikely.
Did no one try to do anything about this after the last crash?
Yes. In 2012, John Forbes, then of PwC, was commissioned by the Association of Real Estate Funds to undertake a study on the behaviour and practices of its member funds, both closed and open-ended. It highlighted some of the flaws with open-ended fund structures.
The report included this analysis:
“There is a fundamental issue for open-ended funds in preserving fairness between investors in a fund and those wishing to leave or join. Suspending redemptions so that investors cannot leave is the most extreme step in setting aside the interests of investors who wish to leave to protect the position of those who want to remain. It is therefore a highly contentious area for which there is no right or wrong answer.
“The process by which the decision was reached therefore involved the fund manager taking into consideration a broad range of stakeholders, including the affected investors. There are a number of considerations to be taken into account in trying to assess how well the manager handled this, both in terms of the decision as to whether or not to suspend redemptions and the timing of the decision.”
What next for the funds that have closed?
Most are reviewing the situation formally once every 28 days.
They are faced with a serious dilemma. Do they keep the fund shut until such time when they think they can get best value for assets but do not fulfil the wishes of those that want to redeem, or do they sell up and take lesser prices when they are perceived to be forced sellers?
There is no formal determination of what fund managers must do and the onus is on them to decide what is fairest for the investors as a whole.
Forbes, who now runs his own consultancy business, John Forbes Consulting, said, “Funds must sell and strike a fair balance between those investors that want to stay and those that want to leave. Buying yourself time by blocking redemptions allows you to do a more managed disposal. There might be a couple of assets that you can sell that are really liquid but that could be distorting the portfolio for those that want to stay.”
Andy Pyle, UK head of real estate at KPMG, said: “It is likely that some investors will be making opportunistic approaches to these funds, buying a significant proportion of their assets to provide liquidity.
“While they may seek a discount for this, fund managers will need to weigh up whether that provides best value for investors versus undertaking individual disposals or from drawing down available debt facilities.”
What impact will it have on the rest of the market?
In theory, if funds have to sell properties there should be some downside pressure on values.
However, with the properties owned by the fund being largely prime, well-let properties with minimal development assets as they have to provide sustainable income to unit holders, they may well be highly attractive to overseas investors that are encouraged by the devaluation of sterling, which will help put a floor to the market.
The funds are either unleveraged or have very low gearing and the industry more broadly, is much less highly leveraged than in 2008. This decreases the prospect of high levels of distress spreading through the industry.
Nick Leslau, chairman of Prestbury, said: “The current hysteria belies the reality. Investors will soon remember that five-year money is 0.43% and 20 years 1.1% and that property may well be offering the best risk-adjusted returns of all assets classes, even with a possible recession looming and so ‘gating’ will hopefully stop investors selling too cheap and cutting their noses.
“Gating is sensible and responsible on the part of the managers and always a risk for the investor but they have had some stonking years recently and well let and run property will recalibrate and will continue to offer great returns going forwards.”
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