How Does Recent Guidance on Principal and Cross Trades Apply to Real Estate and Private Equity Advisers?
On July 21, 2021, the SEC's Division of Examinations released a risk alert titled Observations Regarding Fixed Income Principal and Cross Trades by Investment Advisers from an Examination Initiative (the "Cross Trade Risk Alert"). Although this risk alert is focused on fixed income investments, what can real estate and private equity managers, including those that do not invest in fixed income instruments, learn from this risk alert and other SEC staff activities related to principal and cross trades?
First, to clarify some terminology: A "principal trade" occurs when an adviser or an entity with more than 25% ownership from the adviser and/or a controlling person sells a security to or buys a security from an advisory client. A "cross trade" occurs when an adviser effects a trade in a security between advisory clients but does not charge a fee for the transaction. Both of these types of transactions can raise potential conflicts of interest. The Investment Advisers Act of 1940, as amended, requires advisers to obtain consent from the client when engaging in principal transactions. Additionally, clients that are subject to ERISA (including so-called “plan asset funds”) are typically very limited in their ability to participate in principal or cross transactions. Fund governing documents or side letters may also impose restrictions on cross or principal transactions that a real estate or private equity adviser should consider.
Although cross trades are not very common for real estate and private equity advisers (especially relative to public and private credit fund advisers), they do occur on occasion and advisers that do not already have them should consider establishing policies and procedures to govern such transactions. If applicable, you may want to consider enhancing your procedures by describing factors that personnel should consider in determining if a given cross trade is in the best interest of all participating clients and maintaining documentation to demonstrate such analysis. Disclosure is a key topic of the Cross Trade Risk Alert, and the SEC staff have recommended that advisers ensure they have consistent disclosure of the conflict of interest posed by these types of transactions throughout various disclosure documents, such as Part 2A of Form ADV and the private fund offering documents.
Principal trades for real estate and private equity advisers often take the form of "warehoused" investments where an investment is purchased by the adviser or an affiliate prior to the formation of a private fund (typically with the intent of transferring the investment to the fund at the time of its initial closing) and then the warehoused asset is subsequently sold to the new fund. Principal trades could also take other forms such as where a principal of a private equity or real estate adviser acquired investments for his or her proprietary accounts in the past and seeks to transfer such personal investments to one or more private funds whose investment strategies and objectives encompass such investments. Consent for a principal transaction is often obtained from investors when they are subscribing to invest in the private fund at its initial closing, and advisers should take steps to make sure the disclosures about any given warehoused investment and the conflicts of interest related to the investment are very clear to prospective investors and sufficiently customized to allow such investors to provide informed consent to the proposed warehousing transaction on a case-by-case basis (blanket consents are prohibited). In some recent SEC examinations, we have seen the SEC examiners probe the adequacy of such disclosures in the overall context. When engaging in principal or cross transactions, real estate and private equity advisers should typically rely on an independent third-party service provider’s valuation to ensure neither party to the transaction is being disadvantaged.
Although not necessarily a cross or principal transaction per se, real estate and private equity advisers should also be aware of potential regulatory scrutiny when the adviser or an affiliate is buying back a limited partner's interest in a private fund. Although these transactions are often done as an accommodation to investors who would like liquidity, the SEC has in the past taken action against an adviser that allegedly omitted material facts throughout this process, including by not providing updated valuation information related to such investors' interest.
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If you would like to learn more about how your peers are handling principal and cross trade compliance, or would like assistance developing policies and procedures or disclosures related to these transactions, please reach out to your ACA consultant or or contact us below.