Pooled Funds v Contributory Funds

I am regularly asked by investors to explain the difference between a contributory and pooled mortgage fund, as well as the relative merits of each.

What is a Mortgage Fund?

A mortgage fund is a unit trust operated by a fund manager who raises capital by selling units in the trust which, in turn, lends that money out as loans secured by mortgages over real assets. Some mortgage funds may use those funds to invest in other funds (fund to fund investment) or directly into a discrete loan. There are two types of mortgage funds:

  1. Pooled mortgage fund
  2. Contributory mortgage fund

Mortgage funds can provide regular returns when managed correctly, however there are a number of considerations which need to be understood prior to investing.

Pooled Mortgage Fund

As the name suggests, a pooled mortgage fund is one where investor’s money is joined with other investor funds which are then used to advance to borrowers in the form of loans secured by a mortgage over an underlying asset. The investors are effectively outsourcing their investment decisions to an investment manager who chooses which loans to fund. The investor’s capital and return is tied to the risk and performance of the whole mortgage fund. This typically suits investors who want a passive investment experience.

Considerations When Investing in a Pooled Mortgage Fund

  1. Liquidity: Investments tend to be longer term and generally do not provide for liquidity events and if they do, require a notice period and are subject to the fund’s own liquidity. Investors during the global financial crisis wanted to pull their funds out of mortgage funds which created liquidity stress. Subsequently, many funds were frozen. The underlying asset is typically property and cannot be readily liquidated which creates a mismatch between investors wanting their money and the fund’s ability to return their money.
  2. Investment mandate: Some of the pooled funds tend to have broad investment mandates which may result in loans to higher risk securities and borrowers, as happened with Banksia Financial Group.
  3. Diversification: Consideration should be given to whether the security assets and loans are sufficiently diversified to spread the risk over different asset classes, jurisdictions, etc to withstand cyclical changes and movements in property values.
  4. Disclosure: Although ASIC appears to be more vocal about this requirement in recent times, often Product Disclosure Statements (retail investors) and Information Memorandums (wholesale investors) lack a full appreciation of the risk factors and considerations which should be disclosed to the investor. Even if the investor is a sophisticated investor under the Corporations Act (refer to our April 2021 article), there is no justification to under disclose.
  5. Transaction due diligence: In a pooled mortgage fund, it is almost impossible for an investor to identify which assets are securing their investment, which prevents individual loan transaction due diligence.
  6. Investment horizon: An investor needs to consider what period of time they can operate without any of their investment being returned. For example, if they believe they might need some of their investment for a property settlement in six months, then investment in a pooled mortgage fund might not allow the flexibility and liquidity to access funds in time to meet that settlement.
  7. Redemption conditions: An investor needs to understand the conditions under which they can redeem their investment and if there are any fees payable at the time of redemption.
  8. Investment security: An investor needs to understand what percentage of the fund is investing in what type of asset; the lending ratio against specific asset classes; and the ranking of the mortgage security. Typically, a pooled fund manager would prefer a broad investment mandate, but this could result in the underwriting of assets that might not be within the investor’s risk profile.

Contributory Mortgage Fund

Also known as a direct or select mortgage fund, a contributory mortgage fund provides investors with an option to decide which mortgage loan to invest in. The investor can choose to invest based on their own risk profile and the investment results are exclusively tied to the performance of a specific loan and its underlying asset(s).

Considerations When Investing in a Contributory Mortgage Fund

  1. The security asset: Is it a first ranking or second ranking mortgage? Is it a registered or unregistered mortgage? Are there any other liens over the security and if yes, are there priority agreements in place? Are there guarantees from the borrowing entity and directors? Are there any restrictions on the security asset or assets that come under the control of the guarantees?
  2. Valuation report: Is it current? Has it been completed by a valuer with expertise to value that particular asset? Has it been assigned to the lender? What is the basis of the valuation and when was it completed?
  3. Sponsor/ borrower: What is the track record of the borrower? What is the value of their net assets?
  4. Loan to value ratios (LVR): This represents the value of the loan relative to the value of the property and therefore the loan’s margin of safety. Is the LVR based on the “as if complete” valuation, which is typical for construction loans, or as a percentage of the “as is” valuation, which is the value at the time the loan is advanced?
  5. Liquidity: Typically, contributory funds are illiquid until the loan expiry, however there is no certainty funds will be returned on that date as terms may extended.
  6. Redemption terms and conditions: An investor needs to understand the relative merits and likelihoods of the various exits for each loan. For example, will the loan be refinanced by the term end or is the exit reliant on the sale of the property?
  7. Quality and experience of the investment manager: consideration needs to be given to the track record of the investment manager, including their credit policies, compliance, governance and credit operations.

Each of these mortgage fund types have pros and cons. Generally, the contributory mortgage fund will deliver higher returns for an investor, however the pooled mortgage fund will provide diversification of security of assets. Both fund types have challenges around liquidity, credit operations, property cycles etc, however, I believe an investor will invariably make a good investment decision if they consider three important elements:

  1. Exit;
  2. Exit; and
  3. Exit

The answer to the question, “how will I get my money back?” is a pretty good starting point in any risk analysis. If an investor can understand how they will get their money back, then they are a long way down the track to making a good investment decision. If a mortgage manager is unable to convince an investor with their answer to this question, then they already know the answer to the question of “should I invest in this mortgage fund or not?”.

Kevin Said
Director, Chief Investment Officer
TierONE Capital

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