In the post-pandemic investment universe, investors in private alternative funds, such as real estate, private equity, infrastructure and debt funds will need to keep an eye not just on liquidity and manager engagement but also the recent acceleration of governance and environmental trends.
Transfers and redemptions
Volatile global markets mean that many investors will need to consider their allocations to alternative funds. Investment levels in private equity, real estate, infrastructure and debt funds have historically suffered as investors have sought to rebalance their portfolios following falls in the value of their public market holdings. While alternative funds often have strong investment theses in dislocated markets, some investors will want to consider whether they can transfer their holdings, redeem positions in open-ended funds or look to make strategic exits on a secondary basis.
Since the global financial crisis most private alternative funds offer liquidity options, but rights of first offer, gating provisions, manager consents and redemption suspensions can frustrate attempts to find liquidity. Investors considering liquidating their interests in these funds should review the fund documentation before making any decision to ensure that they are not caught unawares by liquidity restrictions and do not fall foul of notice periods and other procedural requirements imposed on them.
Some investors may also wish to curtail their commitments to private funds that have not been fully drawn. Although investor default provisions are usually tightly drawn and punitive, the remedies available to managers vary from fund to fund and investors will need to carefully review the range of sanctions that may be invoked. In many cases, a discussion with the fund manager and fellow investors may facilitate a matched bargain transfer or the operation of an excuse provision which is likely to be more favourable to an investor than a default (where the investor may risk losing a substantial proportion of its investment value).
Across all asset classes, valuations have been significantly affected by the pandemic. While this can be an issue for open-ended fund pricing, it can also be a challenge for investors in close-ended funds seeking liquidity. If values are impaired or valuation reports delayed, it can be difficult to establish a true price between a buyer and a seller. This can be exacerbated if managers are nervous that reliance has been placed on fund reports and valuations, and they have, consequently, sought "hold harmless" letters from the buyer and seller before providing consent to a transfer.
Where private alternative funds offer redemption mechanics, many have suspended these because units cannot be accurately priced. As lockdown eases and valuation impairments are removed, suspending on this basis may no longer be valid or may be time limited. As these funds open up again, investors should be wary of increased bid/offer spreads that are driven by actual or anticipated increased transactional costs in less liquid markets. Similarly, investors who are looking to redeem their interests need to be alive to the implications of a second wave of Covid-19 and wider macroeconomic pressures on valuations, with the risk that they may be submitting redemption requests with little or no certainty as to their exit value.
Fund manager reputations are often made (or tarnished) during financial crises. Those managers who engaged with and communicated honestly and clearly to their investors during the global financial crisis tended to fare better than those who did not. Equally, investors should be talking to managers, trying to understand pressures facing the fund and working with managers to minimise the immediate and longer term effects of the pandemic. Where managers are not engaging with investors, this should set alarm bells ringing.
Although face-to-face meetings with managers may not be possible, most funds permit investor and advisory committee meetings to be held electronically and investors may wish to be pushing for these on a more regular basis.
Many fund managers rely on third-party service providers to provide important elements of a fund's operational architecture. Fund managers should already have tested the resilience of those service providers during Covid-19 and should now be communicating to investors the impact of that review. If they are not doing so, investors should be asking about the impact of Covid-19 on service provision, particularly if service providers have reduced or intend to reduce staff numbers. Similar questions should also be raised in relation to the manager itself.
As investors look to maximise liquidity, many managers will be seeking to preserve cash within the fund. Where the income flow to a fund is being restricted – for instance, because dividends, rental income or loan interest payments are delayed or reduced – managers will need to ensure that the fund has sufficient resources to cover its running costs. This can be a particular issue in funds whose tax treatment requires them to distribute income to investors, preventing them from retaining cash to cover future operating costs.
All fund managers are likely to be considering more difficult economic conditions and what those might mean for the fund's financial model. Some funds will be able to delay making distributions, if their constitutional documents allow, whereas others might have the ability to create a dividend re-investment plan. For investors who have their own income distribution pressures, an early understanding of the manager's intentions and the options permitted under the fund's legal documents will be important.
Investment periods and fund life
Impaired valuations, market volatility and the physical constraints of lockdown have meant that relatively few transactions have been taking place. Funds with "dry powder" will be seeking to extend their investment periods, while those coming towards the end of their lives may need longer to realise assets and may wish to embark on manager-led restructurings.
These extensions will often require the consent of fund advisory committees (where they exist) and investors. For many investors this is a sensible course of action. For those investors seeking to limit their draw down obligations or to increase liquidity, however, this may be less appealing, and they may wish to consider exits to fellow investors or via a secondary trade. Where a manager's remuneration is linked to an internal rate of return (IRR) calculation, investors will also need to be alive to the impact of extended investment periods (and potentially the fund life) on that calculation and how managers may seek to address that effect on the IRR.
Fund raising periods
Where funds are in their fund-raising period, managers are typically looking to extend final closing dates and should be speaking to investors about the practicalities of conducting closings. And, of course, some investors may no longer wish to make investments when faced with significant economic uncertainty. Investors who have made commitments to funds that have not been drawn may wish to investigate whether those commitments remain binding (in most close-ended funds they will be) or whether they expire if they have not been drawn (as is often the case in open-ended funds).
Environmental, social and governance issues were at the forefront of investors' and fund managers' minds before Covid-19 struck and this trend is set to continue. Indeed, with more and more investors considering the social impact of the funds in which they invest, it is likely that the pandemic will accelerate the focus on non-financial returns.
It is possible that the pandemic may result in a shift in political sentiment away from globalisation and an increased focus on the importance of key workers and community action. The consensus amongst the investment community is that fund investors and beneficiaries are increasingly interested in how their money is being deployed and whether it is having a wider social good. Over time this interest is likely to become more vocal and investors and managers will need to react to it. Those who do so, and are seen to be doing so, may well have a competitive edge.
For private funds and their investors, the pandemic will present challenges, but it will also offer up investment opportunities for existing funds and a likely post lockdown surge in new fund raisings. With some investors seeking liquidity, those who continue to invest are likely to be able to benefit from a more investor-friendly environment than has been seen for the last decade.
While this may give investors the opportunity to improve fund terms and better align their interests, it could also be used as a platform for investors to continue to push ESG and social impact issues in a world where, as a result of Covid-19, many of their underlying investors and beneficiaries are looking at more than financial metrics.
For advice on any of the issues discussed above, contact details are provided below, or please speak to any member of the Osborne Clarke Pensions and Funds teams.