Wither Governance? Considerations for real estate investing

Every corporate failure is almost always a governance failure.

In almost every recent corporate collapse and scandal the monstrous lack of appropriate - fit for purpose- controls and oversight has been appalling.?FTX is symbolic of such egregious behavior, by no means the one and only.

How did we get here in every such instance and why does this repeat ever so often?

How did the best and brightest of institutional shareholders, investors, auditors and lawyers miss the elephant in the room? ?Is it unbridled greed, conflicts of interest, complete disregard for lawful conduct with sickening repetition.?

What checks and balances will institutional shareholders apply internally in their Investment Committee processes and externally to their investee companies to prevent recurrence of such outcomes at such a large scale? Are internal incentives of teams in these organizations misaligned to shareholder value? Are large public and private institutional investors also susceptible to fear of missing out, and what can be done to prevent it?

There are no easy answers.?

The only enduring safety investors can seek is in defining a Governance process that is completely non-discretionary in its structure and design. A rigorous, methodologically driven checklist that must be adhered to irrespective of the pace at which investment must be made or the industry to which the operating business belongs.

Let’s examine some key touch points and elements of any such governance process

?1.????Investment Committee (IC) Process

a.????Are there voting members on the IC who stand to gain if an investment approval is granted?

b.????How many IC members are Independent, cross functional or from Risk & Compliance functions?

c.?????Is all information needed to approve such investments ignored at times? Is there a written guideline on what that information should comprise.

d.????Who casts the vote to overrule or break any logjams in any such approval process – are they conflicted?

e.????Do the IC committees have a rigorous process of an annual review to track how investments performed to base underwriting forecasts? ??Is there a feedback loop that goes up and down the deal and IC team to make constant improvements.

?2.????Incentives and compensation

a.????Acknowledgement that monolithic teams by compensation alignment are prone to herding mentality.?

b.????Does the bulk of compensation benefits accrue evenly or with a lag over the underlying investment or is it front loaded?

c.?????What proportion of total compensation is driven by deal driven incentives? Higher proportions combined with front loading accruals of incentives are strongly correlated to bad behavior.

d.????Is the Risk function firmly embedded in such teams? Who does Risk report into?

?3.????Subject matter expertise

a.????Of those who approve an investment, how many are subject matter experts? Are they all part of the same team?

b.????How often do deal/IC members call on external subject matter experts to help fill gaps with information and perspectives.

c.?????To what degree is the reliance on an external counterparty’s representation versus internal, independent assessment?

d.????What is the documented process to arrive at a choice of a certain strategy and counterparty?

e.????Is documentation of any conflicts of interest from the deal team in place as they originate deals for consideration?

?4.????Oversight structures and reporting

a.????Defining the Fiduciary agency function at all levels of decision making internally.

b.????Is there a regular internal audit function focused on approval processes?

c.?????Is anyone from executive management or the deal team on these audits?

d.????When investing in a club/commingled structure, how is risk defined and modelled in investment outcomes? Are you the lead in the consortium or a passive member? Do you know the rights accruing to the lead LP and conflicts of interest with investee company or management?

e.????Are Governance rights negotiated appropriately and what is the history of exercising them? Does any one internally overseeing the investment skilled enough to opine on governance matters or just a figure head?

f.??????What are the minimums that an investee company has in place for governance and audit purposes? Especially important in the case of dealing with a Superstar CEO in whose halo everyone basks.

???????????????????????????????????????????????????i.????Ask for a board of directors?

??????????????????????????????????????????????????ii.????Insist on cash flow statements every quarter?

????????????????????????????????????????????????iii.????Technology and process reviews?

????????????????????????????????????????????????iv.????Environmental impacts and cost of externalities?

??????????????????????????????????????????????????v.????Institute an internal audit process?

????????????????????????????????????????????????vi.????Is the management team comprised of frat boys and buddies or are there adequately credentialed professionals as well?

???????????????????????????????????????????????vii.????What jurisdictions are approved? ?Is there a periodic review in place?

?5.????Crisis Management

a.????What happens when an underlying investment blows up? Is there a documented process of responding to various envisaged outcomes. How often is the playbook updated?

b.????Is everyone on the executive management familiar with their role in such a scenario? Are there external legal, communications, and risk teams who are familiar with agreed response templates who can act swiftly to mitigate losses to reputation and destruction of capital.

c.?????Is there sufficient training within the organization to spot and report red flags at every stage of an investment lifecycle?

d.????What claw backs are available from the external counterparty and internal deal teams for blatant acts of omission, fraud and negligence.

?Great organizations are learning organizations.?Such organizations have well documented processes and create repositories of information to learn from everything good or bad that happens.?

Good organizations are also brave organizations.?Ready to accept mistakes, reduce the chances of the same mistakes being repeated. They work openly and proactively with regulators and peers in the industry to make it better for every stakeholder.

?How this apply to the real estate industry, especially in Asia?

All the above discussed bare minimum safeguards apply to any industry, include real estate.

The bulk of assets under management (AUM) in Asian real estate often reside in family owned/ influenced businesses or within conglomerates that have multiple, often conflicting demands for capital and management oversight.?Not surprisingly, many of these companies and entities have historically been run in a relatively opaque manner with little recorded engagement of purpose and alignment with stakeholders.??Stakeholders have legitimate grounds to call these businesses out to implement best practices that protect minority shareholders in a robust manner.

It is no surprise that all major real estate corporate scandals in Asia are also massive governance failures.?Take the example of the implosion of some mainland Chinese developers.?Aside from the obvious fact that these entities way over leveraged themselves with little or no oversight, they also traded for an extended period through insolvent conditions - which in many jurisdictions is a criminal offence for management and certainly the Board of Directors.?Such failures, due to a litany of every other conceivable reason, are to be found in almost every other Asian country.

In most of these instances, the pretensions of a functioning Board were evident in myriad ways – by deliberate design and structure a fraudulent, monolithic board that is constituted, is comprised of, and administered for all intent and purposes an extension of maximizing the founders profit motive to the detriment of other stakeholders. Little or complete lack of independence of Directors is almost an enduring feature.

The Asian real estate industry must adopt, embrace and exceed corporate governance standards to lead the change in building out the future of the Asian century. The built environment has a significant impact on all aspirations linked to competitiveness and environmental sustainability.

Highly skilled, independent, stakeholder aligned boards are crucial to the success of the Asian real estate industry. ?Every LP, GP, Developer, Consultant and Regulator must have an uncompromising auditable process of Why and How at every stage of the investment life cycle.

After all, well governed investments are the only way to drive sustainably high returns. ?

(Views expressed are personal)