CRE funds – targets for future litigation

There was a wave of negative press about commercial real estate funds during the course of 2023. The higher interest rate environment and the pandemic’s economic and social legacy has stressed the sector. This was reflected in suspensions of redemptions by funds including BlackRock UK Property Fund and Blackstone’s (US) Blackstone Real Estate Income Trust, and the closure of the M&G Property Portfolio fund. Asset valuation concerns are leading to many CRE funds trading at a significant discount to their net asset value. Shortsellers are circling – see for instance, Muddy Waters’ disclosure of a large short position on the Blackstone Mortgage Trust.

The interest rate environment is a challenge for levered investment vehicles in general. However, CRE funds face particular sectoral pressures. They do so while still carrying the well-known inherent fault line in their mismatch between illiquid assets and fluid equity funding. The potential for liquidity spirals is a real concern in these conditions. The European Central Bank, for instance, warned that CRE funds present systemic risk for the European CRE market.

If these sectoral pressures do not abate, these stresses are likely to give rise to disputes and litigation around CRE funds. What might those look like? It is always difficult to predict how economic stresses will play out into litigation between market actors. However, based on current inquiries and experience from past cycles, types of dispute seem likely to include the following:

Gating disputes

To tackle their liquidity mismatch, stressed CRE funds often restrict redemptions to buy time and avoid value-destructive fire sales and potential ensuing spiral. Many investors simply accept the collective interest in such measures. More aggressive investors will pursue their individual interests by testing for potential escape routes. The fund’s governing documents will provide detailed contractual provisions dictating the precise conditions in which a gate can be applied, and how. Gating is a draconian measure, so fund managers and administrators have to take great care not to overstep the fund’s contractual rights. The mechanisms and their triggers are often complex but, to be effective, they need to be deployed at speed. The combination is ripe for error. It is not uncommon to see gates having been implemented unlawfully. For instance, a trigger event may be misinterpreted (eg, one based on an incorrect calculation of NAV) or a validly imposed gate may be misapplied to particular redemption requests (for instance, an error on timing or an error as to how much of an investor’s holding is blocked from redemption). Typically, these result in disputes between investors and the funds and/or fund manager, but the dispute may also arise between the fund itself and its service partners. In extreme examples of fund insolvency, liquidators may seek to undo redemptions made at a preference prior to gating (although outliers, we have tackled situations in which the principals prioritised their personal redemptions from an offshore fund).

Breach of investment guidelines

Unfavourable and distressed conditions will often expose potential claims around breaches of the fund’s investment guidelines or limits. Those are sometimes simply the result of closer scrutiny resulting from poor performance, but there are also dynamic contributors. Falls in asset values can result in breaches of investment guidelines. Those can be accentuated by having to realise more liquid assets to fulfil redemptions, with knock-on effects on the value of the portfolio and compliance with concentration limits.

Misselling claims

Where losses have been experienced, it is not unusual in retrospect to find that term sheets, offering documents and other marketing materials did not match up to reality. Where the stakes justify it, sensible investors will check whether potential claims in misrepresentation or negligent misstatement arise. Less commonly, where the requisite dishonest intent can be established, there may be remedies for fraudulent misrepresentation. Unfortunately, stressed markets can produce the worst incentives.

Statutory claims

In the case of public funds, investors may find recourse in statutory remedies for breach of prospectus disclosure obligations. Private individuals may also have remedies for breach of regulatory rules under the Financial Services and Markets Act 2000, including for any breaches of the Collective Investment Scheme Sourcebook applicable to UK-authorised funds and those which require compliance with investment objectives policies and consistency with prospectus provisions.

Claims against directors

Directors of funds may be exposed to personal liability in claims in negligence or for breach of fiduciary duty. Typically, these are claims which can only be pursued by the fund itself, but in some circumstances, investors may look to bring a derivative action in the fund’s name.

Claims against valuers

Finally, for reasons which are sometimes justified and sometimes not, valuers are always likely targets for litigation in any property downturn. In a typical fund structure, valuers are likely to be somewhat insulated from direct investor claims, but that is no protection from claims from the fund and contributory liability claims from the fund’s other agents.

In summary

We expect 2024 to bring increased legal scrutiny of CRE fund investments. If CRE markets do not turn the corner then, as with previous property cycles, an uptick in litigation seems likely. With the increased presence of funds in the CRE market compared with prior cycles, they are likely to be significant targets for aggrieved CRE investors. Although litigation and disputes are inherently unpredictable and fact-specific, the above illustrates likely types of dispute which they (and others as a result) may then face.

This article was originally published in Estates Gazette