The Great Wave of Fund Expiration - What are the Options for Fund Managers besides Termination?

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THE GREAT WAVE OF

FUND EXPIRATION WHAT ARE THE OPTIONS

BESIDES TERMINATION?

CBRE GLOBAL

RESEARCH AND

CONSULTING



























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Contents

4 Introduction

5 Strong fund raising activity prior to the Global Financial Crisis

7 Fund life termination; fund disposition continuing

8 Will the market be able to absorb the wave of disposals?

9 A shortfall exists; what are the other external factors to consider?

12 How can fund managers move forward?

15 Conclusion



























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3 © CBRE Ltd. 2014 CBRE GLOBAL RESEARCH AND CONSULTING

THE GREAT WAVE OF FUND EXPIRATION

Introduction

One Page Infographics



























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Prior to the Global Financial Crisis (GFC) Asia Pacific experienced a boom in real estate fund formation

driven by a heady mix of liquidity, strong capital market fundamentals and expectation of high risk-

adjusted returns. Fund raising activity during the ‘vintage’ period between 2005 and 2008 created a

high water mark in terms of capital raised. CBRE data shows that around US$91 billion of capital was

raised by 184 private real estate funds in the region during this period.

Among these funds, 91% were close-ended funds with a fixed life span (refer to Chart 1). A fixed life

span means that the timing of an exit is crucial. As a consequence, the discipline and skill of fund

managers to administer fund formation, risk management, investment process and subsequent

divestment is the ultimate driver of performance.

Introduction

Chart 1: The typical life of a private real estate close-ended fund in Asia Pacific

Source: CBRE Research, September 2014.

Note: The above chart reflects CBRE views of the typical life of a private real estate close-ended fund in Asia Pacific and should be used for reference only.

The capital raised by funds between 2005 and 2008 was invested shortly thereafter and created a large

pool of liquidity in the Asia Pacific direct investment market. Private equity funds purchased US$32 billion

of assets in 2007 alone, a figure 53% higher than the second peak recorded in 2013 (US$21 billion)

(Chart 3).

Most funds in Asia Pacific – particularly the opportunistic and value-added funds that are so prevalent in

the region – have a lifespan of eight years on average, according to the ANREV Fund Database.

However, in China, some opportunistic funds have a shorter lifespan of six years.

Based on the typical fund life of eight years, CBRE believes that approximately 84 funds are scheduled to

terminate between 2013 and 2016. CBRE analysis of the characteristics of these funds reveals that there

will be a peak in fund termination in 2015 and 2016, when approximately 50 funds with a gross asset

value (GAV) of about US$40 billion will expire.

With reference to historical disposition levels and current investment appetite, CBRE forecasts that the

market will only be able to absorb around 75% of the liquidity created by the disposals of close-ended

funds scheduled to expire in 2015 and 2016. This scenario has critical implications for fund managers

over how they should position their funds and the options they should consider beyond termination. This

leads to two major issues which need to be addressed:

• How should fund managers position themselves in the current environment?

• Are there any alternatives to fund termination that could assist investors in securing returns?



























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5 CBRE GLOBAL RESEARCH AND CONSULTING © CBRE Ltd. 2014


CBRE data shows that around US$91 billion of capital was raised by private real estate funds between

2005 and 2008, a figure two times higher than the amount raised in the four years after the GFC.

Among them, 91% were close-ended funds (166 funds in total). Whilst open for debate, the influx of

capital and resulting acquisitions can be attributed to the following:

Strong fund raising activity

prior to the GFC

Chart 2: Total capital raised by private equity real estate funds in Asia Pacific

Source: CBRE Research, September 2014 .

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Who was investing?

Underpinned by relatively strong performance compared to the rest of the world prior to the GFC and

backed by the Asian growth story, Asia Pacific real estate quickly emerged as a popular asset class

amongst investors from Europe and North America. International investors wanted to take advantage of

the upswing in the property market in the region whilst at the same time diversifying their real estate

portfolios. There were marked differences in terms of investors' preferences prior to the GFC. A large

proportion of European investors preferred to invest into value added strategies whereas American

investors opted to look into opportunistic investments. As a result, most opportunistic funds raised

during the period were by US-centric global fund managers.

Where were they buying?

Funds making acquisitions between 2005 and 2008 displayed a strong preference for assets in major

markets in the region such as Australia, Japan and China. The onset of the GFC triggered capital

values of assets in the region to drop substantially and rapidly. The CBRE Asia Pacific All-sector Capital

Value Index declined by 20% between Q2 2008 and Q2 2009. Of the aforementioned destinations,

Japan and Australia were affected the most, with significant corrections in capital values recorded

during the period. Capital values in Japan fell by nearly 40% and declined by around 20% in Australia.

Capital values later rebounded but continue to remain below pre-global financial crisis levels in a

number of markets, including Japan.



























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Chart 3:Total direct acquisitions by private equity real estate funds in Asia Pacific


What was the risk appetite of the market?

Funds raised between 2005 and 2008 were primarily focused on the opportunistic risk segment, accounting

for 80% of total capital raised by close-ended real estate funds. These funds invest in non-income producing

investments and utilise high leveraging as a capital management ‘tool’ to drive alpha1.

However, taking on higher risks associated with opportunistic strategies may not necessarily result in higher

returns. According to the ANREV Annual Index (Chart 4), opportunistic funds incurred a loss of 2.6% per

annum on average for the period between 2009 and 2013. This is in contrast to an average annual return

of 5.5% reported by value-added funds and the 5.7% recorded by core funds during the same period. The

weak fund performance reflects the fact that many of these pre-crisis funds have not achieved the desired

returns for investors.

In addition, about 78% of these pre-crisis funds were pan-Asia funds which invested in multi-sector multi-

country markets, which added an additional layer of complexity to running such a portfolio.

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1 According to the ANREV fund definition document published in January 2014, opportunistic funds are those with an allocation of

over 40% of their target percentage to non-income producing investments; over 25% of their target percentage to (re)development

exposure; and a maximum LTV ratio of more than 60%.

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Chart 4: ANREV non-listed real estate fund total return index

Source: ANREV Annual Index 2013, April 2014.



























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Close-ended funds have a fixed life span. With funds in Asia Pacific having an average life span of

eight years, CBRE data shows that a total of 84 funds plan to terminate between 2013 and 2016.

Approximately 20 funds formed during the pre-GFC boom have already expired. With several funds

due for expiration in 2013 and 2014 already having extended their fund life, CBRE estimates the

expiration of close-ended funds will peak between 2015 and 2016, involving around 50 funds with a

GAV of about US$40 billion. The remaining funds expire beyond 2016. The GAV of these funds totals

around US$15 billion.

The GAV of funds scheduled to expire between 2015 and 2016 is significant as there are seven large

pan-Asia funds with a GAV of above US$1 billion. Most have a provision to extend their termination

date by one to two years.

The disposal process typically commences two to three years prior to the termination date. Disposal

activity has been underway in Asia Pacific since 2010. Between 2010 and 2013, disposals by real

estate funds totaled approximately US$64 billion. However, only a handful of fund managers have fully

divested their positions well ahead of the fund life. This is because they have recorded significant

returns during the investment period and do not want to dilute the returns as they will hold the assets for

longer.

Fund life termination;

fund disposition continuing

Chart 5: Projected gross asset value of close-ended real estate funds by termination year


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Based on the volume of disposals recorded during 2007 and 2013, a period which covered the peak

and trough of the last cycle, the average annual disposal by property funds in Asia Pacific is US$15

billion. If we assume that the market environment will align with the historical average, the market’s

capacity to absorb the disposals by funds to be terminated in 2015 and 2016 will be about US$30

billion. However, this estimation depends on a number of factors, including:

Investment sentiment: This is expected to remain positive in the coming years although a potential

increase in interest rates will likely exert pressure on already low yields. CBRE holds the view that the

upward increment in interest rates will be mild as it will need to be aligned with the pace of global

economic recovery.

Fund raising environment: This is improving gradually after several years of contraction following the

GFC. During the first nine months of 2014, several funds raised capital in excess of their target

amount. Five Asia Pacific-focused private equity real estate funds each raised over US$500 million.

More funds are being raised with core-plus and value-added strategies. These funds could potentially

emerge as buyers for the assets held by opportunistic funds scheduled to expire, if they have

successfully turned their investments into core stocks and if the timing of the capital deployment of the

new funds and investment strategies match with the assets to be disposed.

Increased participation of institutional investors: In recent years there has been stronger activity among

international and Asian institutional investors in Asia Pacific. However, their allocation to real estate in

the region is still very low. The recent liberalisation of regulations relating to real estate investment by

Asian insurance firms will facilitate buying activity. An estimated US$75 billion is set to deployed by

Asian insurance firms into global real estate markets by 2018, according to a recent report by CBRE

Research Asia Pacific titled “Liberalisation and the Rise of Asian Insurance Investment in Real Estate”.

However, many Asian institutional investors focus on western markets and prefer trophy assets.

Successful disposals to institutional investors are therefore not so straightforward.

Chart 6: Acquisitions and disposals by private equity real estate funds in Asia Pacific


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While these factors may suggest the market has sufficient capacity to absorb the wave of disposals, it

should be noted that successful disposals will depend on the location and quality of the portfolio, which

may not be favourable. These challenges are discussed in the following section. Thus, CBRE holds the

view that the market will only be able to absorb about 75% of the liquidity pool of funds ending their life

cycle. The shortfall between the potential liquidity of funds ending their lifespan and the market’s ability to

absorb these assets is expected to be around US$10 billion. These assets could therefore face difficulty in

finding buyers or in being disposed of at desirable terms.

Will the market be able to absorb the wave of

disposals?

Average annual disposition: US$15 billion



























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The exit and winding down of a fund is the final step in the process of close-ended fund investment. A

number of factors must be considered when planning an appropriate exit strategy to ensure optimal

returns are delivered to investors. Key considerations include: (1) market conditions, (2) portfolio

quality and (3) the alignment of interest between Limited Partners (LPs) / investors and General Partners

(GPs) / managers.

A shortfall exists; what are the factors for a successful

exit?

Current market conditions

A review of the assets available for disposal by funds approaching the end of their fund life shows that

around 65% are in China, Japan and Australia (Chart 7). The majority of the assets were acquired

before the GFC. Office and retail properties comprise the bulk of the assets held by these funds. The

smoothness of disposals will largely depend on the investment market environment in these three

markets.

Chart 7: Country distribution of assets available for disposals by funds entering the

termination phase


Japan

26%

China

24% Australia

15%

South Korea

10%

Singapore

10%

Hong Kong

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India

5%

Taiwan

3%

Malaysia

2%

China: Investors are more selective; vendors face more competition for buyers

In China, the tightening of the lending environment has prompted domestic investors to turn less willing

to pay high prices. Investors are also highly aware of the over-supply situation in the office and retail

sectors. CBRE forecasts that both prime office rents and capital values will face downward pressure in

the next three years, with the rate of capital value correction (-3.3% in three years) being faster than the

rental decline (-2.3%).

Investors have therefore begun to place greater importance on asset-level analysis and real estate

fundamentals. They also require a better entry yield against the weaker future growth. The pricing gap

between buyers and sellers will result in a longer disposal process. Sellers will eventually need to adjust

their pricing expectations in order to speed up transactions, a trend that could affect their returns.

Several Chinese developers have opted to dispose of non-core assets to boost their balance sheets as

lending for development projects remains conservative and housing sales are slowing. This will intensify

competition among vendors seeking out potential buyers and make it more challenging for real estate

funds to sell their assets.



























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Chart 8: China prime office rental and capital value indices

Japan: Capital values recovering

In Japan, many assets held by Japan-focused real estate funds scheduled to terminate in the next two

years were acquired at high prices before the onset of the GFC. Given the subsequent fall in prices, the

values of a considerable number of these assets may still be below pre-GFC levels. Some funds have

revised down their book values to reflect market changes. That said, the momentum provided by the

Abenomics policies implemented from late-2012 has injected liquidity into the real estate market and

boosted overall investment sentiment, although the market remains sceptical about the strength of the

so called ‘third arrow’.

As shown in Chart 9, capital returns in Japan reverted to positive territory in Q2 2013, a trend which is

expected to continue. CBRE expects Tokyo office capital values to record double digit growth in the

coming three years (2014-2016) on the back of strong rental growth. Values are getting closer to the

level where the fund managers can recover a large portion of their equity or even secure a profit.

However, room for further yield compression beyond 2014 will be limited after the strong growth

witnessed this year.

Chart 9: ARES Japan all sector quarterly total returns

Source: The Association for Real Estate Securitisation, September 2014

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Income Return Capital Return Total Return

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Australia: Strong investment appetite for core assets

In Australia, demand from offshore investors and onshore institutional investors including superannuation

funds for core assets with long lease terms has remained firm over the course of 2014 despite increased

vacancy. Downward pressure on Grade A office net effective rents will dissipate in the coming three years

and the market will return to an upward cycle in the medium term. It is therefore dawning on fund

managers and limited partners of core funds that if they dispose of high quality core assets, they may not

be able to acquire similar assets in the market in the medium term.

The strong preference for core assets spells trouble for funds operating higher up the risk curve,

particularly opportunistic funds. Such funds could find it difficult to find buyers as their assets may be

viewed as less attractive. Overall, investors remain conservative towards secondary assets. This trend is

more evident in weaker markets such as Brisbane, where the yield spread between prime and secondary

assets has widened, and is appearing to be pricing in the risk of significant increases in vacancy.

Chart 10: Prime office yields vs secondary office yields

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Quality of portfolio

Since 2010, many fund managers have disposed of more ‘saleable’ assets or assets situated in liquid

markets. Hong Kong and Singapore have seen increased disposal activity of this type, given these

markets’ high liquidity and rapid growth in capital values post-GFC. It is likely, therefore, that assets

remaining in such funds are secondary in terms of location and grade. Such assets may be viewed as

less attractive to buyers and could therefore require a longer disposal process.

As portfolios have grown in size and complexity during the life of the fund, investors are spending

valuable time and resources on managing legacy issues associated with vintage fund investment.

Disposal processes will be lengthened as the size of the portfolio increases. Therefore, questions

surrounding the optimal time to terminate the fund and subsequent actions will become paramount to

investors’ decisions when they consider the quality and size of the portfolio.

Alignment of interest between investors and fund managers

The termination process is a collaborative discussion between fund managers and investors,

particularly when it comes to extension, secondary trading, restructuring and initial public offerings.

However, misalignment of interest can cause rifts. Whilst close-ended funds have defined terms, it is

always in the interest of both parties that the assets are divested in optimum circumstances. This can

sometimes require a balancing act. However, a fund manager should at all times be acting in the best

interest of investors. For funds where market conditions have changed dramatically during their

lifespan, for example in China, there can often be a divergence of objectives at the scheduled fund

termination. This is why alignment of interest between investors and fund managers is crucial and can

affect the available options when it comes to terminating a fund.



























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AVAILABLE EXIT ROUTES

Terminate as

planned

Extension Restructuring Secondary

Trading

IPO listing

CO

NSID

ERA

TIO

N F

AC

TO

RS

Current

Market

Condition

Favourable;

target returns

achieved

Less

favourable

Less

favourable

Favourable;

high liquidity

in secondary

markets

Favourable;

but costly

and lengthy

process *

Quality of

portfolio

Good

quality,

matches

investment

demand

Quality

may not

match with

investment

demand*

Secondary

assets

Good

enough

attract

secondary

buyers

Significant

pool of

quality assets

to meet

listing

requirements

Alignment of

interests

between LP

and GP

Less of an

issue

Needs

agreement

from all LPs

LPs demand

change in the

mandates of

the funds*

Exit of

individual LP

if alignment

of interest

cannot be

achieved

among all

LPs*

LPs agree to

be the

cornerstone

investors of

the REIT

Market likely

to choose this

option

A peak in fund expirations at a time when current market conditions and portfolio quality may not be

totally favourable presents fund managers with two key questions:

• What would be the optimal time to terminate the fund while taking into account investors’

requirements?

• If a fund starts the termination process, how should it formulate exit strategies and ensure efficient

execution?

It is crucial for funds to set out a clear direction towards termination, redemption and other liquidity

events, all of which should be driven by an understanding of investors’ internal drivers. Such an

approach requires a collaborative effort, which is sometimes difficult in discordant situations.

How can fund managers

move forward?


Table 1: Factors to take into account when deciding upon termination strategy




























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Fund managers typically have access to four strategies if termination as scheduled is not the ideal way

forward.

Fund Extension

Fund extension has been a popular strategy in Asia Pacific but requires careful consideration. Any

extension of a fund’s term often involves an element of structural change including changes to fees,

revised capital management and/or fund governance.

In this region, fund documents often include two one-year extensions (1+1) at the fund manager's

discretion. Any subsequent extension will often require 75% of investors’ consent, as it may allow

investors to exit the fund at this point if they no longer wish to participate. Investors which vote against

the extension may have the right to choose to exit.

CBRE believes that fund extension is a viable option for fund managers in Australia and Japan. In

Japan, fund managers may have to review their portfolios. Some may choose to take advantage of the

increase in liquidity and prices to dispose of their assets. Others may believe that their assets can further

increase in value if they hold onto them for a further one to two years as occupier market fundamentals

in key markets across the country continue to improve.

In Australia, extension could be a possible option for funds with core strategies or funds holding good

quality well performing assets such as those in the residential sector. Some multi-sector funds allocated

to the residential sector in Australia are likely to opt for extension.

Secondary trading

Private equity fund investments by their nature are illiquid. In the traditional structure, investors have

limited redemption or withdrawal facilities during the life of a fund. However, appetite for secondary

trading is increasing. Since the online platform PropertyMatch ©2 launched in September 2009, it has

recorded US$3.0 billion worth of global transactions in over 486 secondary trades. Secondary trading

is becoming a common strategy to rebalance and reposition allocations.

Secondary trading provides an exit mechanism for investors in unlisted real estate funds. Investors

would consider such an approach for a variety of reasons. These include situations when an investor

may have a relatively small exposure to a fund and requires too much management time dealing with

legacy issues. In another scenario, when market conditions are not optimal and fund managers cannot

act swiftly, investors would consider a secondary trading platform as an exit option, as it would reduce

their downside risk. In both examples, the position is divested and monies redeployed for optimal

returns elsewhere.

This seems to be an increasingly viable option for investors in Asia Pacific to exit their position,

particularly for China-focused funds.

2 PropertyMatch is a live portal for trading units in unlisted real estate funds, established in 2009 by CBRE and wholesale broker

and trading platform technology firm GFI.



























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Initial Public Offering (IPO)

It is unusual for a fund to use an IPO as an exit route as the listing process is time consuming and

transaction fees would be higher than directly selling the asset. Whilst an IPO can offer improved

valuation metrics and increased liquidity, it does not suit all markets. In developed stock markets such

as Singapore, Hong Kong and Japan, IPO exits are more feasible. However, in these markets, the IPO

pipeline is lengthy and competition for equity fund raising is intense. In Australia, an IPO exit may also

be considered as the A-REIT sector is currently in far better shape than in recent years.

In emerging Asian markets, an IPO exit is a less desirable option as REIT markets in such locations

either do not exist or are underdeveloped. Funds with assets in such markets will have to consider listing

in Singapore and Hong Kong, which allow cross-border REIT listings. However, it remains challenging

to structure an offshore REIT and ensure the timely remittance of dividend payments.

That said, IPO REIT listings may emerge as a viable option in India in the coming years. The newly

elected government recently clarified the tax liability for Indian REITs, a move which has been hailed as

a crucial step towards establishing a successful domestic REIT market.

In general, IPO exits are only a viable option in markets with a well-developed REIT structure. Whilst

CBRE does not consider this strategy to be a popular exit mechanism for terminations during 2015-

2016, opportunities may present themselves.

Restructuring

Restructuring usually happens when there is a lack of availability of debt and a fund requires

refinancing. However, it can also occur when investors request that a key individual or fund manager

be replaced. Such a scenario took place within one Asia Pacific focused fund in 2013 and resulted in a

process of restructuring. This situation usually requires a discount to NAV but ensures the fund does not

wind-up with a loss. Nowadays, many investors request that no-fault divorce clauses be inserted in the

governance section of fund documents. This allows investors to terminate their investment or appoint a

new manager at any time when a stated majority of investors elect to make such changes. The clause is

an important tool for investors to ensure a high level of fund governance.

Another type of restructuring involves changing the mandate or style of a fund. This occurs when

investors agree with the fund manager to alter the investment style of the fund such as changing it from

close-ended to open-ended. However, any such structural change requires approval from all investors

and can therefore be a lengthy process. Only a few instances of restructuring have been recorded in

Asia Pacific since 2012.



























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The next two years will see a peak in the termination of close-ended funds in Asia Pacific. Some US$40

billion of real estate assets – primarily in China, Japan and Australia – is scheduled to be disposed. The

active Asia Pacific direct real estate investment market; positive fund raising environment and higher

allocation to real estate by Asian institutional investors will help absorb most of the liquidity set to be

released by the expiry of close-ended funds. Nevertheless, CBRE expects to see the fund disposal

process encounter a number of challenges.

This scenario will affect the exit route for funds in key markets within the region.

• Funds will have to contend with a slower sales market and strong competition from property

companies disposing of assets in China.

• Opportunistic funds will have to cope with a mismatch between the quality of assets they are holding

and the current strong investment appetite for high quality core product in Australia.

• Acceptance of disposals at prices below cost in some cases in Japan.

Liquidation may therefore not be the best option for funds scheduled to expire in 2015-2016. Investors

are advised to evaluate alternative options including extension, secondary trading, restructuring and

IPO. CBRE expects that extensions will be adopted by a number of core or value-added funds whose

investors are looking for longer term exposure to a particular real estate sector. Additional options

beyond termination include secondary trading, exit via IPO and restructuring, all of which can be

utilised to prolong a fund's life beyond its agreed exit date.

CBRE believes that the wave of potential disposals by funds will not exert a significant shock upon the

regional real estate market. However, because of the reasons listed above, CBRE recommends that

fund managers embark upon the careful planning and evaluation of the alternative exit options

discussed in this report.

The coming wave of fund expiries also points to a need for the improved strategic planning of funds

currently being formed. It is also expected to result in:

• A surge of regional capital and investors – Traditionally, Asia Pacific is a net receiver of global real

estate investment. However, since the GFC there has been a significant increase in investment

activity from regional investors such as high-net-worth individuals, sovereign wealth funds and

pension funds. Whilst there is still strong interest from western investors, Asian institutional investors

have recognised that they are under-allocated to real estate and are therefore actively looking into

cross-border investment.

• Growth of regional fund managers - Traditionally, pan-regional funds are the mainstream.

However, with the rise of experienced Asian fund managers, there could be a stronger preference

for a country or sector specific focus.

• Less interest in opportunistic funds: More institutional investors are seeking stable returns and will

therefore prefer lower risk funds with little debt exposure over opportunistic funds.

• More challenging to deliver returns: As prime yields have been compressed to 10-year lows in many

parts of Asia, core assets may not be able to offer desirable returns. Funds will therefore need to

look for core-plus and value-added investment opportunities so as to enhance their returns by

leveraging on their professional experience.

• Higher scrutiny of track records: Cross-border investment continues to grow and international

investors are more aware of the complexity of legal and tax treatments. They will therefore place a

stronger emphasis on track records upon execution.

CBRE believes these trends will characterise the next wave of real estate funds in Asia Pacific. New

funds will be better placed to manage risks as they will be operated by more experienced managers

and will contain more capital sourced from within the region.

Conclusion



























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CBRE GLOBAL RESEARCH AND CONSULTING

This report was prepared by Asia Pacific Research, which forms part of CBRE Global Research and Consulting—a network of preeminent researchers and consultants who collaborate to

provide real estate market research, econometric forecasting and consulting solutions to real estate investors and occupiers around the globe.

All materials presented in this report, unless specifically indicated otherwise, is under copyright and proprietary to CBRE. Information contained herein, including projections, has been

obtained from materials and sources believed to be reliable at the date of publication. While we do not doubt its accuracy, we have not verified it and make no guarantee, warranty or

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Documents

The Great Wave of Fund Expiration - What are the Options for Fund Managers besides Termination?