Article written by Sylvie PROIA, Associate Director, Unik Capital Solutions - AGEFI Luxembourg - February 2021
The end of the year was rich in regulatory developments for investment companies. In line with ESMA's recommendations of December 18, 2020 concerning all aspects of outsourcing and the cloud in particular, and CSSF Circular 20/758 of December 7, 2020, governance is at the heart of concerns. There is a strong willingness to focus on strong governance, in particular for the oversight of all delegated functions, by extending the provisions of CSSF Circular 18/698 relating to management companies to all investment companies. Unik Capital Solutions, a specialist in professional real estate investment vehicles, explains from a very operational point of view these best-practices of a governance system applied to professional real estate investments.
These regulatory changes were anticipated by some companies specializing in real estate investment in the French market. In fact, many of them claim a level of excellence in terms of governance, which is essential in the management of real estate assets. In the world of alternative real estate investment funds, the attraction of "deregulation" is nevertheless still making followers. This explains, since their advent in 2016 in Luxembourg, the success of RAIFs (reserved alternative investment funds), unregulated investment vehicles managed by an AIFM (alternative investment fund management company). Attractive because of their apparent simplicity for the developer, they are often chosen when structuring real estate investment vehicles.
CACIK Fund, one of the vehicles marketed by UNIK CAPITAL Solutions, on the other hand, has chosen to transform itself into a SICAV-SIF, in order to offer investors the double protection of a two-tier prudential supervision, on the AIFM of the fund and the SIF (specialized investment fund) itself.
Confidence & experience
More than thirty years of experience in professional real estate investments show that surrounding investment vehicles with the best governance is always a winning choice for all the players in the life of the fund. Indeed, quality and risk control fuel the virtuous circle of trust. The trust of partners, and investors in particular, is unavoidable since they are the ones who, in turn, provide the fund with the liquidity it needs to carry out its active management.
An 8-pillar governance system
The regulations in force detail governance around a certain number of guiding principles. In concrete terms, how do the eight pillars of this solid internal governance system fit together?Integrity is the first pillar. It covers both sound management of conflicts of interest, whatever they may be, and the security dimension of processes and investments. This is where the choice of a SICAV-SIF structure, under the management of an IAMF specialized in real estate investment funds, is decisive. The structuring in SIF requires an approval of the fund by the CSSF. In addition, periodic regulatory reporting (which does not exist in the framework of a RAIF) reinforces this prudential supervision, in the interest of investors. The AIFM, the guarantor of the fund's governance, refutes or validates the investment advisor's proposals after an independent and careful study of every aspect of the file. The know-how, experience and impartiality of the IAMF's experts are major assets for the fund, for risk management and for investment management throughout the portfolio's life cycle.
Particularly dynamic active management
The second pillar, robustness, is the foundation of business continuity. It is ensured on the one hand by the continuity capacity of the operational processes carried out by the management company, the custodian and the administrative and accounting functions. On the other hand, it depends on the capacity of the players in the investment chain to adapt. This aspect is particularly crucial in the case of a fund like Cacik which, at the dawn of the health crisis linked to COVID-19 and the first containment, was in the ascending phase of its investment period! One can only note how active management has never been so dynamic! It is almost Darwinian, this current trend to push professionals in the sector to endlessly adapt to changing market conditions. Here we realize how important it is to have experienced and visionary profiles within the team.
In concrete terms, the most significant impact of this health crisis for real estate investment funds such as Cacik is the delays in setting up bank loans, linked to the efficiency constraints of banks in a context of distance working. This may require a massive review of the organization of the kinematics of transactions, to solicit a greater number of credit institutions in each country targeted for investment, to broaden the study of future projects to anticipate future financing needs, and to adapt cash management. The example of Cacik illustrates this: careful and effective work on all of these contingencies ultimately makes it possible to benefit from the expected bank leverage and to obtain all financing under the conditions initially planned.
Special attention to valuation and liquidity
This leads to an analysis of the third pillar, efficiency, which covers all risk management and control. The most obvious one, market risk, is also the one that is first questioned during any crisis episode. The present health episode is no exception. From this point of view, the choice of a SIF structure provides an additional guarantee to the investor since, unlike the RAIF, the SIF imposes asset diversification rules, which are crucial in the context of market risk management. In addition, the control system put in place around the structure to cover it may include the use of risk calculation providers specializing in the real estate field, to accompany, in an optimal complementarity, the controls put in place by the AIFM.
In addition, among all the risks covered within the control and governance system, we would like to focus on two of them, which are undoubtedly the most affected in the context of a health crisis. These are valuation risk and liquidity risk. For the first, serene governance requires systematic recourse to external valuers, not only to carry out periodic portfolio valuations, but also upstream of any acquisition or disposal transaction. The choice of an independent external valuation partner is crucial.
For an investment fund focused on geographic and sector asset diversification, it is first and foremost important to select an internationally renowned valuation firm rather than a local independent. In addition, in addition to the essential MRICS (Royal Institution of Chartered Surveyors - Chartered Member) certification, its proven experience in the markets concerned, its financial solidity in order to sum up the financial risk, in the event that their responsibility is called into question with regard to their professional evaluations, are the essential elements of this valuation risk management system.
Liquidity risk is less in the case of funds during the investment period. Provided that a residual cash cost is maintained through meticulous management, liabilities are only positively impacted by the funds collected from investors. Here again, "Trust is the invisible cement that leads a team to win" (Bud Wilkinson). Social distancing has not prevented proximity in exchanges, maintaining the dynamism of subscriptions and investments. Thus, in spite of preparatory meetings that had to be held at a distance and by videoconference, institutional confidence is there. With the dry powder(1) reserve allowing it, the collection objectives have been met.
Finally, with regard to assets, a real estate fund such as Cacik, whose policy is to invest in sectors that are sought after for their proven resilience, even in a context of crisis, can expect interesting resale conditions in the long term. Here again, both the expertise of the IAMF managers, who analyze and decide on the implementation of the projects proposed by the investment advisor, and external experts such as risk management specialists and external valuers play a key role in the effectiveness of the fund's governance.
Consistency, completeness and adequacy
We can therefore speak of the coherence of the governance mechanism, since it forms a whole, as well as of completeness, which are pillars 4 and 5 of the analysis. In fact, all risks are covered by this group of players in the life of the fund, who contribute their expertise and never hesitate to challenge any areas of risk. It is this constant vigilance that makes up the completeness of the internal control system. Each element of the system is precisely calibrated to cover the specific features of the real estate investment vehicle, its characteristics and its needs according to its life cycle. This adequacy, the sixth pillar, is implemented and adapted, in agile mode, to the changing market context. This can only be achieved through excellent coordination between the investment advisor, the AIFM, the custodian, the third-party marketer who runs the distribution network, and the experts in valuation and risk control.
Distribution of roles
As can be seen, the six pillars outlined above can only be articulated around a precise definition of the roles and responsibilities of the different actors. The legal and regulatory context provides food for thought and recommendations. It is up to the fund to put them in place, according to its precise characteristics, and in the best interest of investors. This transparency is the seventh pillar of governance. A very explicit illustration of this division of roles applies to the fund's managers, of whom there are three in a RIS structure (unlike the FIAR, which allows only two people to be appointed). The FIS respects the constraints of incompatibility of functions described by the Act and the Circulars. Thus, the Cacik Fund manager in charge of internal audit activities is not involved in investment management, risk management and compliance. This guarantees the independence between the third operational line of defense, internal audit, and the other two lines of defense, operational units and support functions, respectively. This transparency of roles and actors is an essential element of a sound management of conflicts of interest, as described in the first pillar.
Finally, any solid internal governance system must be agile, adapting to changing market conditions by constantly monitoring the market and listening to investors and partners, but also by keeping a close watch on regulatory developments. This is how the last pillar, which stabilizes the whole edifice, is consolidated, that of legal and regulatory compliance.
The current health context related to COVID-19 has acted as a full-scale stress test on the governance arrangements of investment funds and companies. At the same time, the European and Luxembourg regulators have been working to standardize the requirements for a solid governance system for all players in the investment world. More than ever before, we can see that systematically applying the principles of this governance feeds a virtuous circle that benefits everyone.
Trust and transparency are, more than ever, at the heart of professional real estate investments. Beyond the regulatory constraints, the investment companies that will do well will be those that have managed to both strengthen investor confidence and rely on the harmonious and interconnected set of players involved in the governance of the fund for optimized risk management and investment. We have successfully experienced this: in a context of social distancing, building a solid and resilient whole by relying on the human resources and talents of each individual is a key differentiating factor. Without a doubt, the industry will emerge stronger and more robust from this enriching experience at the beginning of the decade.
1) The 'dry powder' is the expression that represents the positive difference between the level of funds committed by investors and the funds actually invested, i.e. the reserve of funds available to be invested in case of need or attractive opportunity