PricewaterhouseCoopers and the Economist Intelligence Unit published a survey entitled ‘Transparency versus returns: the Institutional investor view of alternative assets’ in 2008, based on a poll of institutional investors from around the world on investment in alternative asset classes, including real estate. According to the respondents, performance was, by a wide margin, the key criterion when selecting a service provider in alternatives investment asset classes. However, even then, when deselecting a service provider, performance (or lack of it) ranked equally with quality of compliance and risk management process, transparency and quality of reporting. While good performance would generally lead to a service provider being selected, failings in other areas could result in the loss of a mandate. Furthermore, institutional investors had been more tolerant of other weaknesses when returns had been strong.
Even in 2008, their tolerance was weakening along with the returns.
In the two years leading up to mid-2010, investors have had time to crystallise their views, resulting in an even greater focus on wider performance measures, better understanding of the risks of underlying investments and critical assessment of the control environment, both at the real estate manager and the underlying assets. As indirect investors return to the market, there will be a demand for stronger governance, risk and control processes and, perhaps more importantly, investors will need to see this through transparent and effective reporting. Accordingly, demonstrating a strong control environment is key.
A focus on operational reporting
As there is greater focus on managers’ operational effectiveness, investors are increasingly demanding answers to a number of important questions:
1. Are an underlying fund manager’s operating systems and processes, and those of the underlying investments, fit for purpose and providing accurate and timely reporting?
2. Is the underlying business compliant with the regulatory and governance needs of investors?
3. Is the underlying business flexible enough to remain compliant with an increasingly complex regulatory environment, with, for example, the European Union Directive on Alternative Investment Fund Managers, due to be adopted by the European Union in July 2010, succeeded by mandatory compliance within two years from the adoption date?
4. Can the business model adapt and flex quickly to changing market environments?
5. Are all the risks understood and how are they controlled and managed?
6. Can I demonstrate to others my understanding of the above?
Any fund manager should be in a position answer these questions for investors at any time through the investment cycle; and as a result of these questions actually being posed, investor expectation of the quality and timeliness of reporting is changing.
There is an acknowledgement by most investors that to make significant changes to the extent of reported information on their current investments will be difficult, not least because the information they receive is already established legally through their investment contracts. However, fund managers wishing to attract new money are likely to find that investors see this as an opportunity to affect change, bringing in new areas of reporting to ensure that appropriate governance, risk management and operational control can be demonstrated by fund managers. Many investors are also indicating a move away from a relatively passive approach to real estate investment to one that is far more active in terms of regular monitoring, periodic reviews and more robust challenges throughout the investment cycle, which would span a range of stages from the due diligence phase to final exit or realisation.
New investments, new demands
A number of investors have indicated how their needs are changing and what information they will require on future deals. There is general consensus that the increasing information requirements and focus on effective risk management will be covered by a gradual change over a period of many months or even years. However, their objectives and vision are clear, and set out below are some of the areas of focus both at the initial investment stage but also in the ongoing monitoring and assurance that investors have indicated they would like going forward.
Investment due diligence
The following list of action points highlights areas where investors believe they will need to spend significantly more time and effort to understand the underlying operations to enable them to agree that the operating model is fit for purpose:
• Overall governance structures, in particular assessment of key reporting lines, oversight of any outsourced operations, including any associated service-level agreements and mandates
• The operating model process flow, including the quality of information and ability to gather data
• The flexibility of the operating model and its ability to change to meet unexpected demands or significant market changes
• Risk management and compliance – the size, quality and depth of experience of individuals within the team, along with areas of focus, reporting lines and coverage. The quality, reliability and transparency of the reporting processes
• The activity of any internal audit-type monitoring and review function, either internally or externally sourced, including their findings and the organisation’s response to those findings
A key aspect of initial due diligence, looking at management track record, is discussed later in this chapter.
Ongoing monitoring by the investor
There is an expectation that investment managers will establish or enhance their ongoing periodic monitoring of investments, this being a historic area of weakness. Such monitoring reviews are expected to include:
• The quality and accuracy of the regular reporting provided
• Obtaining an understanding of and gaining assurance over known issues and understanding how any remedial actions or recommendations have been implemented by the management team
• Validation of the effectiveness of key ongoing control processes
Investors are also expecting to enhance their understanding of the operational risks associated with their investments. There is an expectation that ongoing information requirements may in the future cover aspects such as human resources, information technology, procurement processes, health and safety, and sustainability. This is alongside the more traditional requirements such as financial performance; however, even in this area there is an expectation of better assurance being provided to the investor over the quality and accuracy of the information and a greater understanding of the more significant risks to the business.
This partial chapter is one of 11 in The Definitive Guide to Real Estate Fundraising: Leading insight and know-how for real estate fund managers, investors and professional advisers, a new book from PEI Media.