Growing pains

Looking out from the floor-to-ceiling windows of a Macfarlanes’ conference room in the heart of London last month, the evidence of Europe’s real estate boom was undeniable. Construction cranes dotted the skyline, and a towering office building was being constructed just across the street, bringing clangs of progress into the room where pfm had gathered five European private equity real estate experts.

For many in the room, the construction scene served as a reminder to what real estate as an asset class has always been about – the assets. Back in the early 2000s, when the private equity real estate industry was first emerging, managers were primarily concerned with the buildings themselves, and fund administration was a secondary issue. Now, however, with the increased complexity in the industry and the pressure of regulations like the ever-encroaching Alternative Investment Fund Management Directive (AIFMD), the everyday concerns of the European private equity real estate manager have changed.

“It would be great if running a real estate fund were as simple as it used to be: just doing real estate deals and collecting rent and returning investors capital. However, for the current fund manager, the remit now includes significant work with legislation, regulation, compliance and reporting,” says Stuart Jenkin, director of fund management at UK real estate fund manager Frogmore Real Estate Partners.

Jenkin’s comment receives a murmur of agreement from around the table, as his fellow real estate experts wax nostalgic for the good old days. But for better or for worse, the new days of AIFMD, complex tax regimes, customized investment structures and increased investor demands are here to stay.

To better understand how the industry is handling this onslaught of new developments, pfm invited Jenkin and fellow fund manager, Sangeet Dhanani, finance director at AGC Equity Partners, along with real estate fund administrator Simon Burgess of Bedell Fund Services, Macfarlanes fund formation lawyer Jagdip Singh Gujral and Jersey Finance deputy chief executive Richard Corrigan to discuss the changes they are all witnessing in their businesses today.
Despite their varied backgrounds and unique individual perspectives on European real estate, all of the participants agreed that as the private equity real estate industry hits its teenage years, it is experiencing many of the typical growing pains that come with it – a certain sense of being misunderstood by the powers that be, married with an unmatched hopefulness for the future.

Finally caught

For years, private real estate fund managers have had the luxury of a “quirky existence” outside of a financial monitoring regime, observes Jenkin. As AIFMD and other regulations have settled in, however, they are now firmly caught within its grasp. Much of the fund admin work for a European real estate manager in the past few years has been determining how the directive applies to their business, and how they can manage the excess workload that its compliance prescribes.

“You spend much of your time working out what legislation and data returns apply to your real estate company, and then you realize most of it doesn’t apply, as the regulators’ approach is ‘one-size-fits-all.’ But you still need to submit a return,” Jenkin says.

Regulation is also impacting investment strategies, notes Burgess, and separate account activity has increased in real estate partly because of AIFMD, which layers additional compliance requirements such as a depositary for firms that manage leveraged funds in excess of €100 million or unleveraged funds in excess of €500 million. “As a result, some managers are choosing to partner with just a small number of individual clients on a deal-by-deal basis.”

Gujral argues that single investor vehicles are not purely used to circumvent AIFMD, as many large institutional managers who are offering them are still full scope AIFMs. But for smaller managers (who may classify as sub-threshold AIFMs and are subject to some regulatory oversight), the increased demand for managed accounts from sovereign wealth funds and pension/insurance institutions has meant that the directive is certainly playing a part in their decisions of whether to focus on single investor managed accounts or to raise blind pool funds.

Both Jenkin and Dhanani agree that the reporting obligations under the directive are actually not as burdensome as the industry once feared, but the effects of AIFMD on the mindsets of their investors, and the lasting confusion over what’s expected for real estate managers is impacting their day-to-day.

Take for example, says Dhanani, custodial services. “Until now, we’d had very little mention of custody services in real estate. Yes, in our private equity and hedge fund products, but never from a real estate perspective.”

This past year, facing regulatory pressures and increased governance standards, investors have begun asking about custodial services, despite the fact that AIFMD does not require GPs to appoint a depositary for products like a single asset special purpose vehicle. Moreover, investors often miss the important point that appointing a custodian would not add much value for that type of structure.. 

“What services will a custodian actually provide? How are they ever going to be able to value a particular building?” Dhanani asks.

Indeed, Burgess chimes in that depositary requirements are top-of-mind for his real estate fund clients as they adjust to this new regulated reality. All relevant AIFMs must appoint a depositary to provide a general “oversight” function, including monitoring compliance with a fund’s investment policy (for example, investment diversification limits).

Currently, Bedell provides depositary services in the UK and Jersey to approximately 20 funds. Burgess stresses all the managers he has worked with want the same things from their depositary: the lowest cost possible with the least amount of interference into investment decisions. But selecting the right depositary is also a delicate process. There are some who conduct their stress testing post-investment, which may speed up the investment process, but investors are unlikely to be happy with that approach. Bedell’s platform, in contrast, evaluates information pre-deal with “a quick turnaround time.”

“We put in place a platform that allows managers to interact with their depositary in such a way that it does not interrupt their business, which is the most important thing,” says Burgess.

As their fund structure does not require a depositary, AGC is currently not looking to appoint one. Frogmore has not appointed one yet either, but likely will soon, says Jenkin. 

Domiciles of choice

The conversation shifts as the room agrees that one of the reasons why investors may be struggling with the concept of custodial services is because the language around fund administration changes depending on where you are in the world. Different terms have different meanings from jurisdiction to jurisdiction, a problem only made worse by the “minefield” of various worldwide accounting standards, Jenkin notes. From US GAAP to the new UK GAAP FRS 102 to Luxembourg GAAP, GPs are having to produce multiple sets of books to accommodate different investors.

That’s where choosing the right fund jurisdiction can make all the difference, notes Corrigan. For UK-based real estate managers, Jersey has long been the offshore domicile of choice for the past 10 to 15 years, Burgess agrees.
“This complexity that you’re dealing with as asset managers is good for us in Jersey as a jurisdiction because we have nearly 13,000 people across different services – custodianship, fund administration, tax – working to deal with that complexity,” Corrigan says.

For managers dealing with the challenges of AIFMD Annex IV transparency reporting, the Base Erosion and Profit Shifting (BEPS) project, UK Foreign Account Tax Compliance Act (FATCA) or the upcoming OECD Common Reporting Standard, having all of those services available in one tax-friendly domicile is increasingly important. Jersey was made even more attractive when the European Securities and Markets Authority (EMSA) issued an opinion last July suggesting a pan-EU marketing passport be offered to the Channel Islands.

Indeed, Gujral notes that at Macfarlanes, while he is consistently setting up English limited partnership structures, joint Jersey limited partnerships are “the preferred vehicle of choice when it comes to the joint venture,” a play growing in popularity in the real estate sector as investors push for more specialized, individualized investment strategies.

“With the rise of those types of structures, fund administration has become simpler in one respect because you’re having to tailor your administrative services to whatever that one investor wants. The complexities arise because those investors are also becoming more sophisticated – they want more data and they want more real time access,” says Gujral.

Transparency demands

“You’ve hit upon what is one of our major issues, and that is reporting,” Jenkin interjects.

All real estate managers are bearing the burden of increased investor demands when it comes to reporting. “And there is, especially in joint ventures, an expectation for much more sharing of information at a much earlier stage,” adds Gujral.

LPs are particularly clamoring for more data on valuations, wanting to know what properties are worth as frequently as a daily basis, whether they’re investing through a fund or more directly in separate accounts or joint ventures. This is a significant departure from the prior status quo, especially in the value add or opportunistic spaces, where property valuations operate on the J curve.

“The message from investors is that the approach for a fund to be just focused on the out turn and not the journey is not what they require. They need to know where they’re at, at any point in time, using their own spreadsheets and data systems. This requires managers to change their mindset and their systems to cope with that,” says Jenkin.

It comes as no surprise that, aside from valuations, investors are also demanding greater transparency on fees in European real estate. Jenkin says Frogmore LPs did not raise the issue of reduced fees during the firm’s most recent fundraise (Frogmore Real Estate Partners III, which closed last July), rather, he feels the discussion has shifted to an issue of transparency rather than necessarily moving any one term. Corrigan, on the other hand, notes that some managers he works with are receiving pushback to reduce fees.

“Investors want to pay less,” he states. “There are slightly more intrusive investors who want slightly greater servicing from the managers and other administrators around the fund structure but the pressure on fees continues as well.”

AGC is currently fundraising for a Western Europe-focused vehicle, and Dhanani finds that investors are also asking about the fund’s structure in a much more granular way, requesting assurance that the fund’s legal and tax set up will not compromise them in any way. 

“From our point of view, it’s great because we now have better informed investors who know exactly what they’re coming into. They can’t come to us in a year’s time and say we didn’t know you were using XYZ structure and we’re uncomfortable with it for whatever reason,” he says.

Dhanani and Jenkin both say that investors are also taking much more interest in who their fellow investors are. At AGC, investors want to know more regarding the firm’s Know Your Client screening practices.

To outsource or not to outsource

The new regulatory requirements and extra reporting expectations from investors are leaving many smaller real estate managers overwhelmed in the back office, which brings the table discussion to outsourcing. Traditionally, many real estate fund managers have only outsourced property management services, but the winds of change are blowing.

Frogmore currently does not outsource any fund administration activities, but Jenkin says that the firm is looking more critically at accounting and reporting functions and considering whether outsourcing those elements would be a more efficient use of firm time and energy, mainly so that a focus remains on investor returns.

Dhanani is at a similar crossroads with the plethora of investor and regulatory reporting that lies ahead, and the speed at which AGC needs to accomplish it. “Do we go ahead and develop these systems in house, or should we go to companies who specialize in this and have spent millions on their own investor reporting systems? Those questions are driving our thought process as we look at outsourcing going forward.”

Jurisdiction also plays an important role in the outsourcing decisions confronting real estate GPs. Most of AGC’s funds are based in Cayman and have underlying structures in the locality where the investment is made, so if an administrator can cover Cayman, Jersey and Luxembourg reporting in one go, that would be “a great situation for us,” says Dhanani.

That was one of the reasons Bedell made the strategic choice to become jurisdictionally agnostic, Burgess notes, and this move has proved popular amongst clients. One of the firm’s latest clients is an international real estate investment manager with funds based in BVI with more than 100 special purpose vehicles around the world, who needed Bedell to take the administrative strain. Bedell takes on their reporting headache, as well as the general challenge of looking after all the SPVs, no matter where they are based.

“The trend has also brought quite a bit of scale into Jersey with service providers able to cover multiple jurisdictions on behalf of their clients. It’s been a real change in our industry, from one that was much more fragmented in the past to one that’s consolidating but actually providing greater expertise,” adds Corrigan.

But what do investors think? Overall, they are on board with real estate managers who choose to outsource some of their back office responsibilities, says Gujral, as long as the GP’s fees reflect that change.

“No one asks if outsourced costs will be borne by the fund or the fund manager. There’s an expectation of intrinsic trust that managers won’t overinflate the costs,” he notes. “But if you’re outsourcing, there might be an expectation that your fees would be slightly lower than a competitor who is not outsourcing. You shouldn’t have your cake and eat it too.”

As real estate managers assess the costs and benefits of outsourcing, the demands of real estate fund administration will continue to change and increasingly require an international mindset.

“Real estate is center stage for us right now. We have growing teams serving our clients in Europe, Asia, Middle East and the US and particularly expect more pan-European real estate work on the horizon,” says Burgess.

And that help will be welcome as real estate managers take on new challenges. 2016 promises to bring updates on the roll out of ESMA passporting, for which Jersey it currently readying itself, Corrigan says. Around the table, everyone hopes that AIFMD II (due in 2017) will bring some changes to benefit the asset class and relieve some regulatory pressure.

“But that’s really only going to happen if all the major European bodies come together, like Invest Europe and the BVCA, to say ‘This is what we think has worked, this hasn’t worked,’” says Gujral. “AIFMD II can make it clear that real estate, private equity and hedge funds require different rules.”

All are hopeful that greater resources and better technology will help lighten the load as the real estate industry grows into its new regulated role, so they can all get back to focusing on the buildings. Growing pains, after all, are a temporary discomfort towards further improvement.

Or as Jenkin puts it: “There are some clouds on the horizon regarding regulation and tax changes. We have to be mindful of what kind of governmental attention real estate is receiving as an industry. But when all is said and done, we just need to front up, put our case forward and get on with it.”

Around the table

Simon Burgess is a managing director at Bedell Fund Services, specializing in the establishment of multi-jurisdictional real estate, infrastructure and private equity funds. Burgess is a chartered surveyor with 30 years’ real estate experience including many years establishing both funds and property investment companies globally and acting as a director across key jurisdictions.

Richard Corrigan is deputy chief executive at Jersey Finance, the promotional agency for the island’s finance industry. Corrigan helps to support member firms in international growth markets and foster close working relationships with a wide group of industry stakeholders.

Sangeet Dhanani is a director of finance at global alternative asset investment firm AGC Equity Partners, which invests in real estate, private equity, secondaries and hedge funds with a particular focus on European and North American assets. Dhanani is a chartered accountant with more than 18 years of experience in finance.

Jagdip Singh Gujral is a senior solicitor in the Investment Management Group in Macfarlanes’ London office. Gujral advises both investors on their investments in funds as well as fund managers on the structuring and commercial terms of private funds and managed accounts, with expertise in private equity, real estate, debt and life sciences funds.

Stuart Jenkin is the director of fund management at UK real estate fund manager Frogmore Real Estate Partners. Since joining the firm in 1997, Jenkin has been actively involved in the sourcing and acquisition of investments, asset management and the set up and monitoring of joint ventures. He also worked on the fund formation for the firm’s three discretionary private equity real estate commingled funds.