Real estate GPs hope to avoid new laws requiring SEC registration thanks to existing investment company rules but it could be a mixed blessing at best: unregistered funds could find it even harder to raise cash from LPs, and restrict their ability to close deals. PERE magazine October 2010 issue

When Congress passed new financial reforms in July, it seemed real estate fund managers had been swept up in the race to regulate the private equity industry once and for all.

Backed by voter anger over the credit crisis, politicians introduced sweeping changes that required private equity and private equity real estate managers with $150 million of assets under management to register as investment advisors with the Securities and Exchange Commission, in what marked a fundamental change to the way many GPs did business.

However, notwithstanding the new rules, real estate funds managers are hoping exemptions under another act may help them avoid the burdens of registration: the Investment Company Act of 1940. 

Zoe Hughes

Under the ’40 Act, as it’s known, funds investing primarily in real estate, real estate liens or mortgages may be exempt from registering as an investment company. By not having a fund registered as an investment company, therefore, many real estate fund managers anticipate they won’t have to register as an investment advisor as well. 

It’s something that should prompt most real estate GPs to run into the streets singing Hallelujah. After all, registering as an investment advisor with the SEC is no small feat, requiring the appointment of a dedicated chief compliance officer (and undoubtedly a team to support him or her) and vast amounts of time and money spent in reporting regularly, and in a set format, to the government agency.

But is avoiding SEC registration something to celebrate?

As real estate GPs in fundraising mode will attest, limited partners today are extra vigilant when it comes to due diligence. Much more thorough examination of managers is demanded thanks not just to the credit crisis and declining property valuations, but also due to scandals such as Bernard Madoff. 

When an LP considers a new commitment to a fund, it wants to be able to tick off certain boxes as checked: one of those boxes could be SEC registration.

The unspoken fear is that without the SEC seal of approval, LP capital will prove even harder to raise in the future, than it is today.

As one real estate deal professional argued, for many of the larger institutional investors SEC registration will be an absolute must. “This is a game changer for you in terms of how you market yourself,” he said.

The unspoken fear is that without the SEC seal of approval, LP capital will prove even harder to raise in the future, than it is today. 

For the professional in question, his firm registered with the SEC earlier this year as it also manages private equity, as well as private equity real estate funds. 

Of course, private equity funds fall outside the scope of the ’40 Act exemption. Indeed, the real estate exemption in the ’40 Act is only applicable for funds investing in certain deals. By some accounts, physical properties, mortgages and even CMBS may be considered eligible, but buying up shares in a broken REIT, for example, may not. 

The devil is undoubtedly in the detail, but in trying to drive (and grow) a business in today’s distressed markets, will GPs not currently required to register with the SEC as an investment advisor inadvertently throw themselves into registration territory by closing certain deals? Will it get to a point where real estate deal teams are told by their back office compliance staff that, ‘No, you can’t buy shares in that floundering property company for cents on the dollar because we’re nowhere near ready for the SEC’?

And that is the crux of the issue, according to several real estate accountants and lawyers PERE has spoken to.  

It’s crucial to be prepared for the unexpected, even up to the point of doing all the groundwork for registration even if you’re ultimately are not eligible to register. Private equity real estate firms should put in place a compliance team, boost their risk management controls, improve their disclosure, documentation and reporting functions and wholeheartedly accept the “best practices” that SEC registration is advocating, as one partner said. 

It was, he added, about “putting all your ducks in a row and having the flexibility to react to market conditions”.