Impact of Proposed Regulations on Real Estate Advisers
The U.S. Securities and Exchange Commission (SEC) staff under Chair Gary Gensler have been busy developing a raft of proposed new rules that could have big implications for real estate advisers, in particular those that are vertically integrated.
Private Fund Rules
On February 9, 2022, the SEC released a series of proposed rules for private fund managers (Proposed Private Fund Rules), which are described in more detail in our alert, SEC Proposes Sweeping Changes Affecting Private Fund Managers.
Quarterly Statements: While many real estate advisers already distribute quarterly statements to investors, the Proposed Private Fund Rules will necessitate advisers providing specific details on fees, expenses, and performance on a quarterly basis. The proposal also asks whether this provision should apply to pooled vehicles that are not technically “private funds,” including funds holding real estate assets that are exempt from registration under Section 3(c)(5)(C) of the Investment Company Act. This proposed new quarterly statement obligation would involve significant operational complexity to implement, requiring data such as the following:
- Fees and Reimbursements to the Adviser and Affiliates – Detailed accounting of all compensation paid to the adviser and its affiliates, including property management fees, construction management fees, leasing fees, mortgage-servicing fees, and reimbursements for staff time that may be paid by the properties held by the fund(s).
- Expenses – An itemized list of different types of fund expenses, such as those related to environmental reviews, site inspections, and property accounting software.
- Performance Reporting – Standardized presentation of performance information, which must include separate metrics for realized and unrealized investments. The actual metrics that need to be provided will depend on the classification of the funds as “liquid” or “illiquid.” For most real estate managers, their assets will likely be considered illiquid, but the structure of an open-end real estate fund may cause it to be defined as liquid under the current proposed definitions of these terms. Additionally, performance will have to be calculated as if the fund had called capital instead of using fund-level subscription facilities, which are extremely common in real estate funds to bridge capital calls.
Audited Financials: Many private fund managers already obtain financial statement audits for their funds, but the Proposed Private Fund Rules would require all private funds to obtain U.S. Generally Accepted Accounting Principles (GAAP) audits even if they are not currently required to do so under Rule 206(4)-2 (the “Custody Rule”). This would be a significant change for certain real estate advisers that do not currently obtain audits of their private funds because they do not have custody of the private funds’ assets or because they obtain surprise asset examinations instead. Additionally, the Proposed Private Fund Rules would implement an entirely new requirement for auditors to report a termination of their engagement or a modified opinion to the SEC within 4 business days.
Adviser-led Secondaries: Adviser-led secondaries, as a method of restructuring, are increasingly common for real estate managers and a subject of significant scrutiny from the SEC staff. The Proposed Private Fund Rules would require advisers that engage in an adviser-led secondary transaction to obtain a written fairness opinion from a third party. In the context of these proposed rules, adviser-led secondaries would include transactions initiated by the adviser or a related person (such as a general partner) that offer investors in a private fund the opportunity to sell some or all of their interest in a private fund or convert or exchange some or all of their interest in a private fund for an interest in another vehicle.
While real estate managers commonly obtain third-party appraisals of the underlying real estate assets when engaging in an adviser-led secondary transaction, the Proposed Private Fund Rules are not currently drafted to accept a third-party appraisal in place of a fairness opinion. As described below, the SEC is also considering new Form PF reporting obligations for private equity advisers that engage in adviser-led secondary transactions, as the SEC suspects that such transactions could be an indicator of a declining market.
The Proposed Private Fund Rules enumerate several other prohibited activities, including a prohibition on reducing the amount of any adviser clawback by actual, potential, or hypothetical taxes of the adviser or its related persons. Due to the longer-term nature of real estate funds, clawbacks are commonplace, but the 2008-2009 financial crisis indicated weaknesses in the ability of managers to enforce some clawback provisions, rendering them inoperable to the detriment of investors.
Form PF Amendments
On January 26, 2022, the SEC proposed amendments to Form PF (“Proposed Form PF Amendments”) that might have some impact on certain real estate advisers depending on how they classify their private funds for Form ADV and Form PF filing purposes. We have published additional information about these amendments here, but a few highlights that may be of interest to real estate advisers are below.
Relevant Fund Types: The Proposed Form PF Amendments are specifically applicable to funds that are classified as hedge funds, private equity funds, and liquidity funds. The Proposed Form PF Amendments include a new question added to Section 4 for Large Private Equity Advisers where they would have to report the strategy of each PE fund, and “real estate” is one of the options available. If you are uncertain which fund type(s) you have currently indicated for your private funds, consider reviewing and amending, if necessary, during the annual Form ADV and Form PF filing process.
Next Day Reporting Items: The Proposed Form PF Amendments primarily focus on situations that would require “current” reporting (i.e., within one business day) of certain events, and the events that require current reporting will depend on the type of fund. For real estate managers of funds that are classified as hedge funds, current reporting could be triggered by a significant operational challenge or an inability to satisfy redemption requests, and current reporting for private equity funds might be triggered when they engage in an adviser-led secondary transaction or implement a clawback.
Comment Period for Proposed Rules
We anticipate that certain elements of these proposed rules, as currently drafted, will have a significant impact on real estate advisers and signal the more aggressive approach the SEC is taking with respect to private fund managers. The comment period for the Proposed Form PF Amendments ended on March 21, 2022, while the comment period for the Proposed Private Fund Rules is open until April 25, 2022.
How we help
Real estate fund managers have unique needs when it comes to their regulatory obligations and operational resilience. We have worked with 74% of the top 50 real estate firms (As noted in the June 2021 PERE 50). Our team can help you navigate the evolving regulatory landscape while considering the complexity of your firm’s unique compliance requirements.
ACA will continue to monitor these proposed rules as they move forward. If you have any further questions about this alert, please contact our team or your ACA consultant for more information.