Fund of Real Estate Funds questions (January 2010) Contents

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1 Fund of Real Estate Funds questions (January 2010) Due to current market conditions, a number of key issues and questions have been raised as regard to Funds of Real Estate Funds ( FOREF ) and particularly in the context of the calculation of NAVs and the related production of financial statements. These are related to increased uncertainty with respect to the valuation of real estate and also the impact of current market conditions on other elements of the financial position of investee funds (also known as target or underlying funds) such as the going concern assumption and ongoing liquidity. This is crucial both in regard to NAVs of investee funds which are reported for informational and statutory purposes, and for NAVs that are used to price issues and redemptions, thus affecting the relative value of investors holdings in the investee fund. Contents 7 How should the valuation process be organized when calculating the NAV of a FOREF? IOSCO s Nine Principles of Valuation 2 8 What information is needed when calculating the NAV of a FOREF? Direct source information Additional supporting information Use of information received from investee funds 3 9 How does increased valuation uncertainty affect NAV Production? with respect to investee property portfolios with respect to financial position of investee funds with respect to delayed information from investee funds 4 10 What options do FOREFs have in respect of the issues identified above? Delay reporting of NAVs/financial statements to collect more up-to-date information Suspend issuance of the FOF NAV Continue to produce NAVs/financial statements within normal timeframes 5 11 How may this impact the audit of FOF financial statements? Additional information requests Modifications to audit reports 6 The answers to these frequently asked questions do not constitute regulations in Luxembourg or in any other jurisdiction and should be considered guidance on common practice. Answers are provided on the assumption that the applicable Generally Accepted Accounting Principles (GAAP) used is Luxembourg GAAP and/or International Financial Reporting Standards (IFRS), which are the most commonly used GAAPs in respect of Luxembourg domiciled real estate investment vehicles. In addition, answers are directed at regulated Luxembourg (FCP, SICAV, SICAF, SICAR) and specifically do not address unregulated investment vehicles such as companies, partnerships and securitization vehicles, which may have different legal requirements. This document is being published by ALFI as a general guideline and while reasonable care has been taken in compiling the information, ALFI does not accept any liability for the guidelines and does not guarantee in any way that they will be appropriate to specific circumstances. Readers should take their own professional advice in order to decide how to operate individual REIFs. This document should be read in conjunction with the following ALFI publications: REIFs FAQ 1.0 Financial framework / Valuation of Properties / NAV / Financial Reporting (Nov 2008); REIFs FAQ 1.1 Valuation Uncertainty (Feb 2009). In addition, the brochure Luxembourg Real Estate Investment Vehicles, which is prepared jointly by ALFI and the Luxembourg Bankers Association (ABBL), gives general background information on the legal and taxation aspects of unregulated and regulated real estate vehicles domiciled in the Grand Duchy of Luxembourg. c:\website\ \alfi sc reif faq1.2-fof_2010_final.doc 1 / 6

2 7 How should the valuation process be organized when calculating the NAV of a FOREF? In general, a FOREF invests in illiquid and/or hard-to-price assets, where valuation information is infrequent and it may be necessary for judgements to be made in arriving at a fair valuation of individual assets. The FOREF s Governing Body 1 should ensure that a robust valuation process is designed and clearly documented, with appropriate controls embedded to avoid or resolve conflicts of interest. IOSCO s 2 Technical Committee published a final report in November 2007 on Principles for the Valuation of Hedge Fund Portfolio 3 s. ALFI REIF Sub-Committee believes that these principles are relevant for the valuation of FOREF portfolios. 7.1 IOSCO s Nine Principles of Valuation Comprehensive, documented policies and procedures should be established for the valuation of financial instruments held or employed by a [ ] fund The policies should identify the methodologies that will be used for valuing each type of financial instrument held or employed by the [ ] fund The financial instruments held or employed by [ ] funds should be consistently valued according to the policies and procedures The policies and procedures should be reviewed periodically to seek to ensure their continued appropriateness The Governing Body should seek to ensure that an appropriately high level of independence is brought to bear in the application of the policies and procedures and whenever they are reviewed. Independence may be achieved by, inter alia: a) Third-party pricing services. b) Independent Reporting Lines within the Manager. c) Valuation Committee The policies and procedures should seek to ensure that an appropriate level of independent review is undertaken of each individual valuation and in particular of any valuation that is influenced by the Manager The policies and procedures should describe the process for handling and documenting price overrides, including the review of price overrides by an Independent Party The Governing Body should conduct initial and periodic due diligence on third parties that are appointed to perform valuation services The arrangements in place for the valuation of the [ ] fund s investment portfolio should be transparent to investors. 8 What information is needed when calculating the NAV of a FOREF? What information in respect of investments in real estate funds should fund managers / accounting teams / administrators collect and consider when calculating the NAV of a FOREF? This information will typically include a mixture of direct source information and additional supporting information. The information should be addressed to the fund manager, the FOREF s governing body and/or the pricing committee. Examples of both types of information are listed below. These lists are neither all necessary nor exhaustive: 1 The Governing Body may be a FCP Management Company, the Board of the SICAV or the General Partner, depending on the legal form used. 2 ISOCO is the International Organisation of Securities Commissions. 3 The report can be found under the following link: c:\website\ \alfi sc reif faq1.2-fof_2010_final.doc 2 / 6

3 8.1 Direct source information ALFI WG Real Estate Investment Funds Sub-Committee - January NAVs / financial statements of the investee fund (in order of preference) Audited, as at the date of the FOREF valuation; Audited, close to the date of the FOREF valuation (either before or after) for non-coterminous period-ends ; Unaudited, as at (or close to) the date of the FOREF valuation; Provisional, as at (or close to) the date of the FOREF valuation; Details of all capital calls made to/distributions received from the investee funds since the last valuation of the investee funds; Detail of significant subsequent events since the last date of the NAV calculation of investee funds, due to the potential mismatch of the NAV frequencies between the investee funds and the FOREF. 8.2 Additional supporting information Additional financial and operational information received by the FOREF under the terms of side letter arrangements with the investee funds; Information in respect to the control environment of the investee funds this could include an understanding of the governance framework of the investee fund as well as specific reports on controls matters such as long form reports (where applicable). This will also include judgments around the quality of the promoter as well as service providers such as the administrator, valuers and auditors; Analyses of historical accuracy of provisional NAVs released by investee funds by comparison to those contained in audited accounts; Independent valuers reports for the real estate portfolio of the investee fund; Analyst or valuers reports regarding market conditions and valuations of the geographical and sector markets in which the investee funds have invested; Meeting minutes or call logs between the FOREF and the investee fund; Minutes of any meetings of supervisory bodies of the investee fund in which the FOREF is represented e.g. investor advisory committees Confirmations from management/administrators of the investee funds in respect of their valuations/nav; Confirmations from custodians regarding the existence of investments in investee funds; 8.3 Use of information received from investee funds It is important that this data is not just collected - the valuations that are assigned to each investment within the FOREF s portfolio should fully take into account all of this information. In other words, those deciding on the valuation of individual assets that will be included in the calculation of NAV and financial statements of the FOREF, whether the FOREF s governing body, a pricing committee or a third-party administrator, need to have access to this monitoring information Consideration also needs to be given to process of how this information is utilized in arriving at valuations and how this is controlled for example the existence of, and input from, a valuation committee or the fund manager. This means that there must be adequate processes and controls at the FOREF level to monitor, utilize, and challenge the information received to enable this information to be used when determining the FOREF NAV Of particular concern is changes in or conflicts between GAAP, where an investee fund reports under a different GAAP to the one adopted by the FOREF. The FOREF s governing body should decide how such issues should be resolved when they establish the FOREFs valuation policy. c:\website\ \alfi sc reif faq1.2-fof_2010_final.doc 3 / 6

4 9 How does increased valuation uncertainty affect NAV Production? 9.1 with respect to investee property portfolios Some valuations of real estate are currently uncertain and increasingly subjective due to a lack of comparable transactions for appraisers to consider. Valuers, for example, may draw attention to the increased uncertainty in their reports or even caveat the valuation amount calculated. The reliability of investee property valuations may impact the reliability of the NAVs reported by these investee funds on which FOREFs base the valuation of their investments. 9.2 with respect to financial position of investee funds As well as the additional increased inherent uncertainties in respect of property valuations, current market conditions may have had further impacts on the financial position, and hence the valuation, of investee funds. These include going concern and liquidity issues due to: Breaches of loan covenants; The need to re-finance expiring facilities; Default of investors in terms of capital calls; Unavailability of capital from new investors; Default of lenders in respect of undrawn credit facilities; Increased difficulties in the rental markets in terms of achieving target rents and occupancy; and Increased requests for redemptions by investors FOREFs themselves, as well as investee investments, may be affected by the above factors. These, for example, may lead to uncertainties with respect to the going concern assumption that will need to be addressed in the FOREFs reporting. 9.3 with respect to delayed information from investee funds The inherent valuation uncertainty is further exacerbated by the fact that there is a time lag between the reporting date of the FOREF and the receipt of information relevant to that date from investee funds. If valuations of investee investments are not based on up to date information there is a risk that these will be unreliable and potentially materially misstated given volatility of pricing due to current market conditions. 10 What options do FOREFs have in respect of the issues identified above? The above factors negatively impact the ability to calculate an accurate NAV of a FOREF. Broadly speaking, management of such FOREFs has three main options in respect of dealing with these with regard to the calculation of NAVs and fund financial reporting: 10.2 Delay reporting of NAVs/financial statements to collect more up-to-date information Management should strongly consider delaying reporting in order to collect as much possible up-to-date and accurate information from investee funds on which to base the valuations. This may include, for example, delaying reporting until audited financial statements of the investee funds have been received so that more comfort exists with regard to valuations and going concern/liquidity issues facing the investee funds and, therefore, management of such funds have more support to base their conclusions for the NAV. Further examples of additional information that could be received are listed in Q7.1 above In such cases, management should be aware of their deadlines to deliver reporting, both on a contractual and regulatory basis. For example, SIFs in Luxembourg are normally required by law to deliver their audited financial statements within six months of their year end, so any delay beyond this date may require an approval from the investors and the CSSF. c:\website\ \alfi sc reif faq1.2-fof_2010_final.doc 4 / 6

5 10.3 Suspend issuance of the FOF NAV Management may choose to suspend issuance of the FOREF NAV until such time that management believes that the NAV can be produced with an appropriate level of accuracy If management judges that, due to current market conditions, it is not possible to calculate a reliable NAV then consideration may need to be given to suspending the FOREFs NAV. This is particularly important with regard to open-ended funds where NAVs not only are used for information purposes but are also used to price issues and redemptions and thus effect the distribution of value in the FOREF between investors In these circumstances the following options could be considered to the extent that they are commercially viable and in accordance with the FOREFs governing documentation and regulatory requirements: Deferring issues and redemptions until a pricing NAV can be reliably calculated. It may well be, however, that this is not commercially viable the fund may need, for instance, to contribute committed capital to investee funds to protect value and avoid defaulting; investors capital may need to be drawn to do this Arranging short term funding in order to finance operations, to avoid the need to price new issues of units / shares Issuing/redeeming units but delaying pricing these transactions until a more reliable NAV is available. This is a possible solution, subject to the regulatory framework of the fund, where management wants to draw capital from investors and also provide them with liquidity Continue to produce NAVs/financial statements within normal timeframes If management does not wish to delay the issue of NAVs/financial statements then consideration will have to be given to the adequacy of the information received as regards to producing accurate reporting Where this is not sufficient, given current market conditions, management should seek additional information so as to base own-valuations of investee funds on as much data as is available. This could take the form of increased monitoring calls with management of investee funds and further detailed analysis of trends in the geographical markets and sectors in which the investee funds invest It is the primary responsibility of management to ensure that sufficient, reliable data is available and has been used in calculating the NAV of the fund Given the current market volatility compounded by time lags in receiving information in a FOREF environment, and especially if the NAV is used for pricing issues and redemptions, and thus affects the distribution of value in the fund between investors, careful consideration needs to be given as to whether this approach is appropriate. The Valuation Policy of the FOREF should specify whether any adjustments may be made and under what circumstances In any of the above scenarios, management should also provide additional disclosures in their financial statements with respect to valuations and, if necessary, the going concern status of the FOREF. Examples of the information to be disclosed regarding the valuation of investee funds may include: a discussion of the uncertainties in the valuations based on the review of audited financial statements, any caveats made by the valuers of the investee funds in their reports, sensitivity analysis of valuations and a discussion of the uncertainty in respect of the property types and geographical markets that the investee fund is exposed to. 11 How may this impact the audit of FOF financial statements? In general, auditors will have to perform more work with respect to the uncertain elements of the FOREF reporting as described above, such as the valuation of underlying investments into investee funds and the going concern assumption. Auditors will have to review and assess the appropriateness of the assumptions made by management and the reliability of the supporting documentation gathered to support their conclusions. c:\website\ \alfi sc reif faq1.2-fof_2010_final.doc 5 / 6

6 11.2 Additional information requests Auditors may also require additional information to be able to assess the going concern assumption such as: additional representations from the management of the FOREF ; Cash flow forecasts to evidence that the FOREF has a sufficient level of cash to sustain its activities with sensitivity analyses in connection with the market uncertainty Modifications to audit reports Auditors may also consider modifications to their audit report in certain circumstances including where, in their judgment: Assumptions and judgements made by management in valuing the investee funds are inaccurate or inappropriate; Insufficient evidence exists, or has been considered, to reasonably value the investee investments; Disclosures with respect to the uncertainty of the valuation of investee funds are inadequate; There is doubt as to the going concern status of the FOREF; Disclosures with respect to the going concern status of the FOREF are inadequate. Assumptions and judgements made by management in respect of the going concern status of the FOREF are inaccurate or inappropriate. c:\website\ \alfi sc reif faq1.2-fof_2010_final.doc 6 / 6