InvestmentsJul 30 2020

Challenges facing investors in gated funds

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Challenges facing investors in gated funds

Many investors will be aware, through bitter experience, that open-ended property funds are currently gated, or closed to redemptions and new investment.

So, what does this experience mean for the future, what can we learn and what is the risk of gating in other investment areas?

The concept of gating, with respect to open-ended investment companies and unit trusts, first came into focus during the credit crunch in 2008.

At the time of the Lehman Brothers’ collapse, there was a sudden stampede for the door as cash became king and those funds invested in illiquid assets, such as commercial property, quickly ran out of cash.

The authorised corporate directors, who oversee the transactional activity, implemented their suspension clauses to protect remaining unit holders, which subsequently stopped all further transactional activity.

Key points

  • Many property funds are gated
  • Covid-19 has prompted many big companies to rethink their office space
  • The more exotic an asset is, the less liquid it is likely to be

For many investors it was a big wake-up call. As the credit crunch thawed, the funds re-opened and investors realised that the attractions of commercial property remained as a recovery play and the demand for redemptions quickly dissipated.

Consequently, nothing changed, while investors had another wake-up call when the Brexit vote returned a ‘leave’ result on June 23 2016.

Investors concluded that commercial property would be one sector particularly affected and many rushed for the door. Round two of fund suspensions occurred once more.

There was widespread condemnation within the media from marooned investors, with many complaining that nothing had changed since the credit crunch, despite the obvious conflict between having daily dealing within funds that have predominantly illiquid underlying assets.

This remains the case today. There is no distinction in place for an investor with regard to the liquidity of the underlying assets within one retail open-ended, daily dealing Oeic/unit trust and another.

There is no requirement for the promoter, ACD or fund manager to make the investor aware when this could be the case and no requirement to declare that there is a risk that, during a major market set-back, an investor may end up holding a suspended investment where they cannot get their money back on demand.

Covid-19 has cruelly exposed this conflict once more where most bricks and mortar commercial property funds are currently suspended and there is no certainty as to when they may reopen.

What is worse this time around is that the asset class is unlikely to experience the usual recovery in tandem with economic conditions.

The virus has brought about a huge change in corporate thinking with regard to remote working and the need to occupy expensive offices in city centres.

This means that when these property funds do reopen, there is likely to be a significant mark down in the value of the assets, whenever the valuers can be assured of what the value is, given the likelihood of reduced demand and a probable reduction in development expenditure.

It could be some months before this becomes clearer.

There needs to be a change.

Maybe that comes as a change in the risk declarations, or possibly it could be something more fundamental. This is not unique to property but relevant to any fund that has illiquid underlying assets but needs to provide daily dealing for retail investors.

Perhaps the way forward is to restrict such assets to investment trust structures, which is why renewable infrastructure funds are all investment trusts. The market for wind turbines and solar farms is not particularly liquid and abundant with buyers.

Another idea could be to introduce a liquidity measure such that when a fund gets to a certain size and has significant stakes in unquoted businesses, which would be difficult to sell (think Woodford), then daily dealing is removed, subject to some sort of calculation.

This would affect a lot of funds, but clearly there needs to be a change.

Open-ended property funds have existed for many years and were intended to give smaller investors the ability to pool assets together so they could invest in assets of considerable value that would not be ordinarily available to an individual with say, £10,000 to invest.

They work well from that perspective, but unsurprisingly, the higher the value of each individual asset, the more illiquid it is going to be.

This is probably the key and should perhaps be extended to private equity funds, AIM funds and some smaller company funds where the underlying assets can be very illiquid.

There were other examples around the time of the credit crisis that invested in forestry and agricultural land. 

Not surprisingly they ran into difficulty, were suspended and put into liquidation over time.

While the suspension is implemented to protect existing unit holders, unfortunately the fund liquidators are forced sellers and so it is difficult to believe that the best price for the assets will be obtained.

So, our guidance would be, when investing in any daily dealing open-ended fund, always consider the liquidity of the underlying assets, not just today, but historically at times of market stress.

It could prevent some nasty surprises and orphaned assets in the future. As a general rule of thumb, the more exotic, unusual and niche the underlying asset, the more illiquid it will be when markets are in fear mode and investors want their money back.

Guy Stephens is technical investment director at Rowan Dartington