The big chill:protection for investors or fund managers?

Unlisted property trusts are freezing redemptions. It’s 1990 all over again.

We are likely to see more funds freeze, and not just unlisted property. This will remind us all, once again, how important liquidity is.

It is sometimes argued that illiquid assets bring a benefit to portfolios.

The fundamental difference between liquid and illiquid assets is that you can’t cash in the illiquid assets, whether you want to or not. It is a fantasy that this is a benefit.

Being unable to sell an asset, and therefore not knowing its price, is sometimes represented as lower volatility. As more properties are forced onto the market over the next 12 months, at lower prices, we will see whether investors are really protected from volatility.

Three justifications are commonly advanced for freezing redemptions from a fund:

• it prevents irrational decision making by investors;
• it protects underlying value; and
• it is unavoidable as assets can’t be sold quickly.

One rationale that is never presented is that it preserves funds under management (FUM) and therefore the value of the manager’s business. Closing redemptions locks in FUM while paying them out reduces it.

It is important that the financial services industry is realistic in acknowledging that managers often have a conflict of interest in assessing whether or not to freeze.

Though the desire to protect a business built up over many years is perfectly understandable, fund managers need to behave with the utmost propriety in making these decisions.

As always, financial planners need to be the representatives of investors, and not have their thinking clouded by loyalty to fund managers.

Of course, planners should be respectful of the needs of others in the industry, but this should never compromise our focus on who our client is.

We are keeping your money

What managers see as ‘our FUM’ is actually someone else’s money, which has been placed temporarily in managers’ hands. Denying investors access to their own money is a very significant action.

In my view, it is not appropriate to withhold funds on the grounds that investors are irrational to want to get their money out, as some have recently suggested.

It is not a fund promoter’s place to decide which redemptions requests are rational.

Imagine the reaction if an equity trust manager suggested suspending redemptions because it thought people were irrational to take money away at some point in the market cycle.

Indeed, in my view, unit-holders who tried to withdraw their funds from unlisted property vehicles before the likely process of downward revaluations, and prior to any need to reroll debt, may have made quite rational decisions.

I am not arguing that no fund should freeze, nor passing judgement on the actions of any particular managers; I am simply setting out factors that managers should impartially consider among their options, and which planners should raise with managers to ensure they are assessed.

If it is necessary to freeze until a property is sold, due to having no cash to meet redemptions, then a temporary delay during the sale process may be unavoidable.

However, a decision to not sell property, thus extending the freeze, because the price would cause investors a loss, is a very different matter.

The promoters of unlisted property trusts (UPT) argue that they give exposure to the real property market, unlike listed trusts where stock market forces impact returns. This being so, it must be expected that losses will occur when the property market falls.

Let’s explore whether freezing will preserve unit-holder value.

If a property has to be sold to raise funds for redemptions, it will be sold at market value. Is the suggestion that selling would reduce unit price? This can only be so if valuations are not current or are optimistic. One of the lessons from the previous UPT collapse is that, if properties are appraised at higher prices than they could actually sell for, it encourages redemptions; that is, investors take the opportunity to cash in for more than the asset is worth.

If promoters have determined not to sell to ‘protect’ investor values they must have reason to believe that, within some reasonable time frame, they will be able to return higher value to their investors. The rationale for this should be set out clearly so it doesn’t appear to be a case of, ‘Trust us, it is in your interest for us to keep your money’.

Some UPTs offered no liquidity mechanism. As long as this was clearly set out in the Product Disclosure Statement (PDS) this can be a robust structure. The situation is more complex where a PDS described a liquidity mechanism and set an expectation that there was a reasonable prospect of investors being able to withdraw funds.

Those funds that have held a portion of their assets in cash or listed property, should certainly use this to fund redemptions. Why were liquids held if it was not to meet redemptions?

The property downturn in the early 1990s was prolonged. The regulators required that every UPT suspend redemptions.

Ultimately most funds were listed to provide a liquidity mechanism.

Should this occur again, while listed trusts are trading at a discount to net tangible assets (nta), it would not protect unit-holder value.

It would be better to liquidate at nta than to trade at a discount to it (though this again raises the question of whether appraised values are realistic).

Unit-holder votes

Some funds have a periodic unit-holder vote on whether it should be wound up or its life extended, usually at five to eight-yearly periods.

The trusts deed of some of these requires a 75 per cent majority in favour of termination for the fund not to continue.

In such a case, a decision to freeze may lock up investors’ money for a very long period.

Assume such a vote is taken every six years and at the first vote only 20 per cent wish to terminate, at the next vote 40 per cent, at the next 60 per cent, and at the fourth 80 per cent vote for wind up. Thus it would be 24 years before funds are released and some investors will have been waiting 18 years.

When the odds are stacked against liquidity to this degree, to freeze is a very serious step; there is no way out. Incidentally, where the manager has co-invested it is to be hoped that they do not vote on the termination resolutions, as they represent a potential blocking vote to ever winding up.

To have to freeze an investment is unfortunate. Funds that do so should not present it as a beneficial step for unit-holders. Apologising but explaining that it is unavoidable (if indeed it is), is more appropriate.

In any case, to deny investors can have substantial consequences.

An investment could be part of an estate which, if the will precludes in specie benefits, may not be able to be wound up until the fund unfreezes.

Or the money could be desperately needed for any number of purposes. Regrettably in some, but not all, cases, investors will be locked in to a very high fee structure with high gearing.

I repeat that I am not passing judgement on the actions of any particular fund.

However, it is to be hoped that fund managers properly consider their duties to their unit-holders before making any decisions to lock up their assets.

Robert Keavney is an independent spirit, of no fixed industry address, who believes financial planning is an honourable profession.

EDIT: This column was originally submitted for publication before any mortgage trusts froze. Hence, its focus is on property trusts. Some of the issues raised will be applicable to mortgage trusts, though there is a difference with quality mortgages, which will mature for full value over time. Thus a stronger case can be made that freezing does protect value. Of course, mortgage funds with sub-prime loans are in a more vulnerable position.