Brexit’s first casualty? Property investment funds: what you need to know

The London Market will be keenly following the impact of Brexit. The suspension of redemptions from six property funds this week may signify the first casualty.

What’s happened?

There has been an increase in redemption requests from investors in property investment funds causing a drop in liquidity resulting in the suspension of redemptions. Since the start of the year there has been an uptick in redemptions but this has accelerated since the vote for Brexit.

There are about 50 UK property funds. Suspensions have so far been announced from six with assets of £15 billion. The suspended funds to date are those managed by Standard Life, M&G, Aviva, Henderson, Columbia Threadneedle and Canada Life. Those funds are now effectively frozen and according to analysts it will likely be at least six months before the suspensions are lifted. In the meantime, the funds must raise funds to meet the redemptions and the fear is that more funds might follow as the forced sale of assets could lead to a “vicious circle of value destruction”.

This downward pressure on property funds is most keenly felt by open-ended funds. Such funds trade directly with investors. If someone wants to leave the fund, he or she simply withdraws the investment (although in present market conditions it is hard to value what that investment is worth). By contrast, a close-ended fund has a fixed level of capital and issues a fixed number of shares: if an investor wants out, he or she sells their shares on the secondary market.

These open-ended funds own commercial property. Commercial property is an illiquid class of asset – it takes time to sell any property, even longer when it is, say, a large office block. An inherent tension arises in managing a fund that holds illiquid assets but where investors can instantly redeem their investment. To manage this, property funds hold a cash buffer. This might be between 5% and 20% of assets. That cash buffer may not be sufficient where there is a significant demand for redemptions and so redemptions are suspended (or a “gate” is imposed) to allow the managers to sell properties in the fund’s portfolio.

This leads to another problem. The fund manager needs to sell properties fast to raise cash to pay redeeming investors. The easiest properties to sell will be the best ones in the portfolio leaving the funds with a weaker pool of assets. And where everyone is looking to sell assets within a defined period, the prices achieved will inevitably be depressed in the fire sale.

Cause for concern?

The current situation presents echoes of the claims we dealt with following the 2008/9 crash. However, the situation is thought unlikely to be as bad. Banks hold more capital than they did before and so can afford to keep lending and typical fund leverage is less than before. And this is presently an issue localised in Britain rather than one affecting the whole globe and it seems restricted – for now – to the property fund sector

What claims?

While conditions may not be as bad as 2008-2009, claims will follow. The Financial Ombudsman Service has already reported receiving complaints and expressions of customer concern. The Financial Conduct Authority (FCA) is looking at open-ended property funds “from the point of view of conduct and systemic stability”.

Who might receive complaints?

• Those involved in running the fund: fund managers/D&Os/sponsors. Did they describe the funds properly? Were fund suspensions explained sufficiently? Are sufficient cash buffers held? Was the suspension imposed quickly enough? Should the suspension have been imposed at all? Have investors been treated equally and fairly?
• Those recommending investments in the funds: discretionary fund managers/asset managers/IFAs. Where investors have put money in these funds, was there proper disclosure of the potential for fund suspensions? Was the asset class suitable for each investor? This is not just confined to retail investors - many institutional investors such as local authorities and trusts will have liquidity restrictions on their investment class.
• Surveyors and valuers. Were the fund assets properly valued? How do you value the assets during a period of such instability?
• Auditors and lawyers. Are accounts fair and was all fund documentation in order?

With the FCA’s interest piqued, regulatory investigations may also follow.

What should insurers do?

What should you do? Ask questions of your insureds. The questions to ask will depend on the nature of the insured:

Do they envisage claims and, if so, why? What property funds are they involved in, whether as manager, director, asset manager or valuer? What are the values involved? Are suspensions likely to be imposed? Do they consider suspensions happened in time? Were cash buffers sufficient? What other fund assets are illiquid and might be exposed should contagion spread? Were investment recommendations suitable for the particular investor?

John Bruce and Jenny Boldon are partners in Kennedys’ FI and D&O team. They work alongside fellow partners, Philip Hartley and David MacLoughlin. Much of their work in recent years has been in dealing with issues arising from the 2008-2009 Market crash and subsequent mis-selling scandals both in a defence and coverage capacity.

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