It seemed like a done deal. This July, a prominent Middle Eastern sovereign wealth fund was set to commit around $140 million in equity to a club-style vehicle launched by an Asian real estate manager. The manager was targeting to raise $350 million overall, making the Middle Eastern group a majority investor.
The terms of the deal were agreed by both parties, after which the standard due diligence process was initiated. When the non-disclosure agreement was ultimately sent to the manager’s legal, risk and compliance departments, a red flag was raised. Further investigation showed some of the SWF directors’ names were mentioned in the 2016 Panama Papers, one of the biggest data leaks in history, exposing the offshore dealings of the world’s rich and famous. The manager aborted the deal because it did not want to risk being associated with such a headline-grabbing event.
One executive involved in the deal tells PERE this was the first time in his experience that a marquee institutional investor’s capital was rejected on such grounds. He had previously only seen instances of family offices not accepted into deals because of the principles’ background.
“It was shocking to me,” he says. “These are people with sovereign wealth status, writing a big check. I thought it would be a done deal, especially knowing there are two or three other well-known fund managers that are still letting the LP invest.”
The past few years have seen a series of high-profile whistleblowing scandals and data leaks that have lifted the veil on transparency issues concerning corruption, tax evasion, money laundering and property ownership. Regulators in many countries, especially the US and UK, which lawyers describe as two of the world’s most active enforcement regimes, are further expanding the territorial reach of legislations like the UK Bribery Act and the Foreign Corrupt Practices Act (FCPA).
“The whole issue of the responsible investor is really hitting the shores of the real estate industry”
These are pushing the private real estate industry to heighten its focus on compliance. The Middle East investor’s example is not an isolated case. In light of negative news surrounding Chinese and other emerging market investors, PERE has heard instances of more enhanced due diligence being done on deals involving such investors. We spoke to a dozen industry executives, including investors, lawyers and managers, to understand how cross-border investments are being protected against potential legal risks and penalties in today’s compliance-heavy environment.
“The whole issue of the responsible investor is really hitting the shores of the real estate industry,” says Jeremy Kelly, director, global research, at property services firm JLL.
JLL has published an annual global real estate transparency index every two years since the last two decades, ranking countries on various elements of transparency including financial disclosures, corporate governance and sustainability. Questions on corruption and money laundering were only introduced for the first time while compiling the 2018 index. Kelly admits the Panama Papers leak caused some heavy concerns, because these issues were not explicitly included in the compilation of the 2016 index, which was poised to be published when it happened.
Widening regulatory remit
Regulatory changes are partly why the real estate industry is now paying more attention to these issues, even as other industries like pharmaceuticals, oil and gas and infrastructure are broadly considered more advanced from an enforcement standpoint.
“The real estate industry was slow to realize a lot of the regulations applied to them as well, but boy they are now waking up to it”
Carol Hopper, partner at law firm Ropes & Gray’s London real estate group, says historically real estate was in its “own little legal bubble and basically unregulated in many ways.”
“The real estate industry was slow to realize a lot of the regulations applied to them as well, but boy they are now waking up to it,” she notes.
This focus has strengthened in recent years, with growing enforcement of the FCPA, the US anti-bribery law first enacted in the late 1970s, and the UK Bribery Act, which came into force in 2011.
At present, it is the extraterritorial reach of these legislations that lawyers are grappling with. The UK Bribery Act, for instance, introduced the definition of an associated person, defined as anyone who provides services to someone, and stated that the latter would be responsible for any bribery offences committed by the former. According to David Ellis, Hong Kong-based partner at the law firm Mayer Brown JSM, for his Asian clients it previously meant they had to agree to various covenants in the documentation that they would not be contravening any other anti-bribery legislation or allow their service providers to do so. He says it was easy for counterparties to agree to these covenants but not take any substantive action to control their service providers.
“What I am starting to see for the first time in a couple of deals here in Asia is that suddenly more than just covenants are required. Regulators want evidence that covenants are complied with, and there is a program in place between the parties to prevent bribery,” he says.
And it is not just the fear of enforcement prompting real estate investors across the world to put these issues front and center, but also potential financial and reputational repercussions.
“It is guaranteed that when you go to sell an asset tainted by these type of issues, they will likely come to light. This is because people are really thinking about this and have made it part of the fabric of a deal,” says Amanda Raad, co-leader of Ropes & Gray’s global anti-corruption and international risk practice.
Nevertheless, sorry tales abound. Around 18 months ago, a Western institution was setting up a joint venture with a Chinese investor. The documents were signed, subject to conditional approval. At the 11th hour, it was found that an executive at the Chinese firm had emailed someone to offer a bribe, according to a lawyer involved in the deal. The lawyer says his team spent the next 72 hours investigating and imposed additional punitive measures. The Western investor demanded someone be terminated for cause at the Chinese firm, and individuals with knowledge of the situation were subject to an additional level of compliance review on all subsequent deals. The whole process resulted in legal fees of more than $600,000, the lawyer says.
To avoid such costs, more exhaustive pre-investment due diligence processes are being undertaken. Daniel Levison, partner at law firm Morrison & Foerster’s Singapore office, says, in general, he is seeing more deals where anti-corruption questions have become a gating issue.
Right to terminate
Increasingly, there are additional detailed representations and warranties around this issue in transaction documents. In some cases, firms insist on having a ‘right to terminate’ clause in contracts in case bribery issues arise.
Priyaranjan Kumar, regional executive director for capital markets at property services firm Cushman & Wakefield, says in many jurisdictions, such as Singapore, regulators have pushed hard for investment managers to tighten up KYC and record keeping to involve clarity on ultimate beneficiaries in transactions.
“Where [due diligence] costs are high and legal implications unclear, documentation is changing to build such costs into transactions and money is being turned away where material risks are perceived,” he adds.
While the push for compliance is a global phenomenon, it is hard to ignore the impact on two specific groups within the cohort of emerging market investors. Once China’s most-acquisitive cross-border real estate investor, Anbang Insurance’s fall from grace has had a reputational impact on the entire Chinese investor community.
Last summer, around the same time that Wu Xiaohui, the now-jailed Anbang executive, stepped down from his chairman position, one Chinese firm was in talks for a real estate acquisition valued north of $1.5 billion in New York. According to one person involved, it was keen to invest through a fund manager or JV structure because it did not want to risk being “seen” as doing the deal by its government. All managers approached said their risk and compliance teams wanted at least four to six weeks to run a full due diligence scan on the Chinese firm. Ultimately, the deal did not go through given timing constraints.
Issues of transparency and information disclosure have a bearing on deals within China too.
“It is getting harder to do business in China because people are sensitive to investment in companies,” says Chris Leahy, co-founder of Blackpeak, an international investigative research and risk advisory firm that does due diligence work on behalf of firms. “It is one thing to buy assets, but another to invest in companies or businesses that are promoter-driven, where the promoter might end up behind bars in a year or two because he has fallen out with somebody.”
What makes due diligence challenging in places like China, Leahy says, is understanding true ownership.
“What is publicly available is not perfect by any means,” he says. “So, one of the first things we do in any transaction – including real estate – in China is to try to establish who has the ownership and where the money came from.”
The 1MDB [case] has made people more and more concerned about dealing with sovereign wealth funds from emerging markets. We have had clients concerned about the knock-on effect of 1MDB and the shortage of money on other institutions in Malaysia,” agrees Blackpeak’s Leahy. Before Anbang’s woes enveloped China’s investor community, a multi-billion-dollar corruption scheme linked to Malaysian state-investment fund 1MDB had thrust the South-East Asian country under the spotlight in early 2015. The scandal continues to make headlines.
Regardless of any political and reputational risk, there are real challenges in conducting due diligence on sovereign funds.
“It is very difficult for a fund manager to say no just because of a suspicious event,” Nick Wong, principal at Aon-owned consultancy Townsend Group says. “If someone from a sovereign wealth fund is coming to you, they are representing the government. The operational due diligence work is based on past history. If nothing wrong has happened in the past ten years, how can you provide any evidence or basis to conclude you don’t want to do business?”
Limits to control
Then there is the issue of how to convince non-US or UK entities to comply with the robust requirements of the FCPA and other legislations.
“These rules are written for the West. I see this as a deliberate policy to export these kinds of Western values to other places where these companies operate. I can see a lot of resistance, at least initially, because this is not necessarily market practice in a lot of countries in Asia, even though, obviously, a reduction in corruption benefits society generally,” explains Mayer Brown JSM’s Ellis.
“This is a time of transition for real estate,” Ropes & Gray’s Hopper says. “People are getting to grips with this new model. There is a lot that will fall out of that, and we will see that fall out over the next few years.”
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