Back to basics: open-ended property funds and liquidity

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

There was a great deal of press coverage, in the aftermath of the Brexit vote, of the decision of several leading fund managers to suspend investor withdrawals (redemptions) from their open-ended retail real estate funds.

Which got us thinking – to what extent do open-ended funds really offer liquidity to investors? And is there appetite for change in the real estate funds industry?

What is an open-ended fund?

In simplistic terms, it comes down to fund term and liquidity. Open-ended funds are defined firstly by their indefinite lifespan, and secondly by the ability of investors to unilaterally subscribe for or redeem their investments at regular intervals (although investors are generally also free to transfer their interest on the secondary market). Contrast this with closed-ended funds. These typically have a finite duration, with subscriptions confined to a limited initial marketing period, and generally no option for investors to withdraw their investment until the fund's assets are sold.

As always, the reality is more complicated. The detailed mechanics of open-ended funds can vary significantly. They are influenced by factors such as the investment strategy, jurisdiction of establishment and investor base, particularly whether the fund is targeted at retail (general public) or non-retail (institutional) investors.

However, liquidity remains arguably the central characteristic of open-ended funds. This is the case both for investors looking for ready access to their cash (particularly where the fund or market is not performing) and managers, whose remuneration is often linked to the size of the fund (and who have a duty to protect the fund and investors as a whole from high levels of redemptions).

Are open-ended funds truly liquid?

In a real estate context, at least, the answer is "not really". It takes time (and considerable expense) to sell an office block or retail park for example and, for that reason, property is a relatively illiquid asset class.

In an unstable property market where investors are anxious to reallocate capital to other asset classes, it might be impossible to sell the fund's property assets quickly enough to meet all investors' redemption requests without selling at a substantial discount. This kind of "fire sale" of assets at a loss harms the remaining investors and the manager.

Safeguards have therefore evolved to restrict outflows of cash from the fund when necessary. The obvious solution is to suspend redemptions altogether. However, there may be reputational consequences for managers in enforcing a suspension. This is therefore usually kept as a last resort, for exceptional market circumstances like those that followed the collapse of Lehman Brothers and the UK's Brexit vote.

So, other means of restricting or controlling redemptions have been developed, including:

• Lock-in – no redemptions during a fixed period after subscription (e.g. two years).
• Notice period – no redemptions without a fixed period of notice (e.g. quarterly).
• Redemption "gate" – no redemptions in any given period above a fixed proportion of the fund's total value (e.g. 10%).
• Pro rata redemption basis – redemptions may be honoured pro rata per redemption period, rather than on a first-come, first-served basis. The aim is to dissuade investors from making redemption requests merely in order to be "at the front of the queue".
• Ban on revoking redemption requests – if redemption requests are irrevocable, periodic redemption requests to reserve a place in the redemption queue are less likely.

These restrictions may seem to undermine the purpose of open-ended funds by moving away from the unilateral redemption rights that distinguish them from closed-ended funds. However, there is increasing industry recognition of the crucial role these limits on liquidity play in protecting the fund (and the market) from collapsing under a stampede of investors rushing for the exit during market downturns.

It is worth noting that US open-ended fund managers often retain much greater discretion over the timing of redemptions, and can satisfy redemptions in an orderly manner without any obligation to force sales of assets. However, European investors prefer greater certainty over when their capital will be returned. Deferral rights in Europe therefore are unlikely to exceed 24 months, after which the manager will often be required to sell assets to meet any outstanding redemptions, if sufficient liquidity cannot be found elsewhere (e.g. through secondary market trades).

Are the models converging?

The restrictions that limit liquidity in open-ended funds, combined with the inflexibility of the finite term of closed-ended funds, has led inevitably to talk of hybrid or "evergreen" products. Although there is no uniform definition, these vehicles typically combine elements of both models. For example, rights of redemption could be granted to investors at certain defined windows during an indefinite term. Alternatively, a fixed-life vehicle with an option to roll over could allow individual investors to either redeem or to continue their investment at the expiry the fund's term.

However, it remains to be seen to what extent managers have the appetite to stray from tried and tested routes, particularly in a challenging fundraising environment.