Why UK CRE Funds Survived Brexit
‘Nothing to be done’ again for UK commercial property funds [post-Brexit]
By Alastair Sewell
Vivian Mercier famously reviewed “Waiting for Godot” as the play in which “…nothing happens, twice.” We may well have just seen the very same effect in the UK commercial property fund market. Following on from the Brexit vote in June 2016 the vast majority of UK open-end commercial property funds closed to redemption — or gated. That is, they stopped investors from being able to withdraw money. This isn’t the first time this has happened. Following the financial crisis in 2009, many such funds also closed to redemption. But then, like now, the funds seem to be emerging from a crisis relatively unscathed.
So why did the funds stop redemptions in the first place when they were essentially taking a sensible precaution? By stopping investors from redeeming money, they avoided the risk of having to sell properties at distressed prices via fire sales into stressed market. While this may well help investor’s longer-term financial health, it is no good at all if an investor needed their money back then and there. For a money market fund, such an outcome would have been disastrous given the specific investor need served by such funds.
Fast forward to today and many of the funds have re-opened already or announced their intention to re-open. How have they achieved this?
First, there really wasn’t anything fundamentally wrong with the properties the funds were holding pre-Brexit. The funds had reasonably granular portfolios with some diversification by region or sector. The largest individual property we’ve seen represented just over 5% of a fund’s portfolio. Still properties are worth GBP125–175m, a formidable range but not necessarily large compared with the total amount of assets in a fund. The valuations too were based on standard, current, methodologies. So in effect, the Brexit vote drove a gulf between sentiment and fundamentals.
Second, the funds had quite a lot of cash to start with — and it is cash which serves as the bedrock for meeting investor redemption requests. The average cash holding immediately pre-Brexit was about 14%. Interestingly enough, all of the funds with less than 14% cash gated apart from one. And that fund had one very important differentiating factor. Unlike all of the other open-end UK commercial property funds it didn’t offer daily dealing. The fact that it was small probably didn’t hurt its cause either.
Over the summer, the funds were busy selling properties trying to build their cash buffers up. Many funds have announced successful property disposals which will have helped build cash. They have also implemented a helpful tool: they can adjust the value of units in the fund to reflect the “fair value” of the properties, and to take account of transaction costs. Such a fair value adjustment can make the fund more attractive to new investors — especially non-sterling investors seeking to take advantage of the fall in the value of the pound — and put existing investors off leaving the fund. Put the combination of sales, cash and fair value adjustments together and at some point you get to the “right” mix to allow the fund to re-open. Where is that precisely? Well, at some point between the cash you have today and 100% cash. There’ll be some art and, some science, to that decision. So far, at least, it seems that funds have gotten the mix right for the second time.
“Nothing to be done” as Estragon from “Waiting for Godot” might have said; or is there? The fact that this is the second time these funds have gated shows that something isn’t right.
Put simply, illiquid assets — like properties — do not make happy bedfellows with daily dealing funds. Even though the funds had quite high cash balances and other asset- and liability-management tools at their disposal, when sentiment collapsed the funds closed their doors. It was striking that the only fund with a relatively low level of cash which did not gate was a monthly dealing fund. In contrast, closed-end funds do not offer any liquidity. As such, so they do not suffer the same asset-liability mismatch as the open-ended funds. Instead, their price simply varies depending on supply and demand. Indeed, prices did fall quite sharply post-Brexit but have since recovered. Whether investors will choose to move away from the illusory liquidity of open-ended funds or providers will start offering funds with more appropriate asset-liability matches remains to be seen.